With the exception of hard-core technical analysts, all investors want to invest in shares of companies that are “fundamentally sound.” Not even the most risk-tolerant among us wants to put money into a company that has minimal chance of some kind of future success. The question for all of us is how we define “fundamentally sound.”
Investing strategies guide us to look for shares that measure up against a variety of criteria. Broadly speaking, the largest classification schemes are called Value Investing and Growth Investing.
Value shares typically have high Dividend Yields and low Price to Earnings Ratios (P/E), and a Price to Earnings Growth Ratio (PEG) under 1.0. These indicators supposedly reflect the market not correctly recognising the true fundamental value of the company.
Growth shares typically have high Price to Book (P/B) Ratios and high Price to Earnings Ratios (P/E). These indicators supposedly reflect the market’s expectation the company’s future growth will be significant enough to justify its high price.
However, not all shares fit neatly into one category or the other. Some years ago, an American mutual fund manager who would go on to become very successful asked the following question:
Why not Growth at a Reasonable Price?
The manager’s name was Peter Lynch and his question gave birth to what we now call the GARP (Growth at a Reasonable Price) Investing Strategy.
GARP investing avoids the extremes of traditional value and growth investing and aims more towards the middle. However, the strategy does tilt a bit towards value investing in that GARP investors tend to stay away from exorbitantly high P/E shares. The benchmark that best defines GARP is the PEG ratio.
The Price to Earnings Growth Ratio (PEG) is readily available on most Australian financial websites. For your information, the formula for the PEG is as follows:
PEG = Price to Earnings Ratio/Projected Annual Growth
The company supplies the projected annual growth rate and this is one of the drawbacks of this ratio – it is an estimate from a less than objective party. However, few companies overestimate growth rates as their shares can be severely punished if they miss the target.
Peter Lynch popularized this ratio and its meaning – a fairly priced share is one where the P/E ratio equals its growth rate. It follows that if a PEG of 1.0 represents a fairly priced share; anything under 1.0 represents a potentially undervalued share and a buying opportunity.
GARP investors view the P/E Ratio differently than traditional value or growth investors. True Growth investors might not hesitate to pursue a share with a P/E in the 50s and a true Value investor sees a share with a P/E above 15 as potentially overpriced. Although this is not a strict “go/no go” criterion, GARP investors tend to look for shares with P/Es in the 15 – 25 range. They also like shares with high and growing Return on Equity (ROE) and Price/Book Ratios below the average for the industry sector in which the company operates.
Right now, we are going to develop a list of potential target shares that might represent Growth at a Reasonable Price. We will start with one of Peter Lynch’s key investing principles: know what you own. Indeed, to quote from his book One up on Wall Street, “Never invest in any idea you can’t illustrate with a crayon!”
Everybody knows retail, so we are going to generate a list of ASX retail shares that might qualify as GARP targets. To do this, we are going to use a marvelous investing tool, the Stock Screener.
A Stock Screener is a tool investors use to search for shares that meet their preferred investment criteria. For example, you might set your screen to filter out shares in the energy sector with your own prescribed market capitalization, P/E Ratio, Dividend Yield, Annual Growth Rates, Return on Equity (ROE), and PEG.
Unfortunately, there are not many free stock screeners available for ASX shares. Some premium sites have one and you can buy screening software programs. For this analysis, we used the stock screener you can find on Morningstar Australia.
To keep things simple, we only entered two criteria: Retail Sector and a PEG less than 1. From the results of that screen, we selected the following shares that also met other GARP criteria. Here is the list:
(Cash Converters Intl)
Even if you have never heard of some of these companies, the numbers start to tell the story you will need to know before investing. With a P/E of 26.65 – twice that of the P/E for the Retail Sector – Kathmandu (KMD) is at the upper limit of desirable P/Es for GARP investors, but the PEG of .05 makes this share worth a look.
Noni-B (NBL) has more characteristics of a value share, but it also is worth further research. With a P/E Ratio about half that of its industry sector and a dividend yield almost twice the Sector yield, the share seems intriguing. The PEG is also within the general limits of what GARP investors look for.
Retail shares present a unique opportunity for the retail investor. It is not always possible to visit the operational facilities of many of the companies in which we might consider investing. However, anyone can walk into a retail store.
In fact, Peter Lynch tells the tale of one his principal sources for finding target shares. He accompanied his wife and daughters on trips to the local shopping mall and while they were off spending his money, he was shopping for shares! He would wander the mall and look for the crowded stores. That is how he found Pier One – an international importer that had just started doing business in the United States.
If you have some time in the next few days, stop by one of the retail outlets of any one of the shares listed above. You can tell a lot about a company from a site visit.
Next week we will look behind the numbers to flesh out the story behind these shares, and we will chat a bit about what you can learn in a retail outlet simply by walking around.