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4 Growth Shares at a Reasonable Price (GARP)

4 Growth Shares at a Reasonable Price (GARP)

By Bob Kohut 05.03.2012


Market volatility coupled with the stunning array of potential macroeconomic calamities that we have experienced over the last five years has led many to pronounce the death of the Buy and Hold approach characteristic of traditional Value Investors.  The mantra for many has changed from Buy Low and Sell High to Buy High and Sell Higher, but even that approach has been rocked to its foundations in recent times.

Growth investors worldwide have been stunned by precipitous drops in share prices for which they were willing to pay a premium.  It is somewhat surprising that in the ongoing debate about value investing versus growth investing so little attention is paid to the hybrid strategy known as GARP (growth at a reasonable price).

While some investors who claim to be hard core value or growth advocates sneer at the perceived lack of recognisable criteria for spotting GARP opportunities, the truth is in the modern world there are few investors who actually fail to combine elements of different approaches.  Even the most fundamentally minded investor rarely makes a buy without consulting a price movement chart.

In theory, the GARP approach represents the best of both worlds.  Yes we look for fundamentally sound companies but going forward there must be continued growth to justify our investments.  However, why pay a premium price if we can truly find shares with solid growth potential at reasonable prices?

While GARP investors do vary in the metrics they consider, there is one fundamental bedrock underlying that strategy – the Price to Earnings Growth Ratio.

The P/E is the most used valuation ratio in the investing world.  At its most basic, the ratio tells us the company is beyond the start-up phase and is generating earnings from its operations.  It also tells us what market participants are willing to pay for those earnings, but it is looking in the rearview mirror at past earnings.

The P/EG ratio is forward looking, taking projected or forecasted earnings into account.  A P/EG of 1.0 is a rough measure indicating fair value.  A share with a P/E ratio of 30 sounds too high for the traditional value investor, but if earnings are forecasted to grow at 30%, the P/EG of 1.0 says you are paying a fair price.

For a GARP investor, a P/EG under 1.0 is a must and under .5 represents a potential gem of an investment.  The two other most widely used GARP criteria are a five year history of earnings per share (EPS) growth of at least 15% and forecasted growth between 15% and 25%.  Some hard core GARP investors stick to the belief that growth forecasts of 30% and above are too risky and the consequences of the company failing to meet its forecast too dire.

The following table includes shares that could be categorised as GARP investments, base initially on their P/E and P/EG. (Note that these are merely examples, not recommendations!)

Company
Code 
Mkt Cap
Sector
P/E  
P/EG
Share Price
52 Wk Hi/Low
Kingsgate Ltd 
KCN  
$925mGold 20.33
0.12 $6.69 $10.12/$5.62
Ramelius Resources
RMS 
$358m
Gold 6.06
0.46
 $1.06$1.74/$0.90
Seek Limited
SEK  
$2.26bMedia
 19.41  
0.94$6.69
$7.34/$4.87
Fortescue MetalsFMG $17.62bMining
10.220.72$5.66
$6.99/$3.95

Data as at Friday 2nd March 2012

In contrast to value investors whose preference is for P/E ratios under 15 and preferably under 10, the GARP investor is comfortable with P/E’s approaching 30 as long as the historical and projected performance justifies the price.  The P/EG is an immediate measure of whether it does or doesn’t.  In our table, all four shares meet the preliminary criteria, with Kingsgate and Ramelius Resources representing the potential gems with P/EG’s under .5.  Now let’s see how these shares measure up on the second set of criteria:

Company 
2 Yr EPS Avg  Annual Growth Forecast5 Yr Rev per Share Avg Annual Growth 
5 Year Avg Annual EPS Growth
ROE
KCN 
  202%
10.2%
12.5%
3.4%
RMS
32%
145.4.%
91.2%
40.6%
SEK
25.6%
22.4%
19.4%
31.4%
FMG
14.6%
428%
253.3%
75.4%

 

How can a company like KCN with growth forecast over 200% pass as a GARP share?  Shouldn’t a real GARP investor see those numbers as unrealistic and possibly unattainable?  These are mining companies and new mines coming into production can account for that kind of explosive growth.  

Kingsgate Consolidated’s principal gold-producing mining operation is in the Chatree region of northern Thailand.  Their recent granting of additional licenses to mine in the region is expected to double production capacity from the Chatree mines.  Here is their share price performance for the past year (versus the ASX200):

Chart

While KCN appears to have substantial growth potential, they are a high risk investment due to the myriad issues of operating in a foreign country.  As of 2nd March, 2012 the company had a Buy rating from Deutsche Bank, as well as an Outperform rating from Macquarie (until it went "restricted" recently). The risk of the company is highlighted only too well by the fact that three other brokers downgraded the company to a hold or a sell just last week.

Although tiny junior miner Ramelius Resources has had an impressive five year growth history, their forecast for the next two years is more modest.  They currently operate two gold mining projects at Wattle Dam and Mt Magnet.  They have additional exploration projects underway at both of these locations as well as in the state of Nevada in the US.  Unless you have the time and expertise to thoroughly investigate Ramelius, there are better opportunities.  It is difficult to find analyst coverage of junior miners like RMS.  However, considering its very healthy Return on Equity (ROE) of 40.6%, it may be worth the extra effort.

Australia’s leading online job search site, Seek Limited, represents a classic GARP share with historical performance in the 15% to 20% range and growth estimates approaching 25%.  While their online job search advertising and subscriber revenue may be hurt if unemployment rears its ugly head here, their expansion into online training and learning opportunities has the potential for substantial growth.  Citi, Deutsche, RBS and UBS all have Buys on Seek, with price targets as high as $7.95 (UBS).

Finally, there is Australia’s top performing share over the last two decades, Fortescue Metals.  During that time, FMG presented its shareholders with a total return of 248,625%!

Their five year growth performance reflects that success, but harder times have come, as evidenced by the forecasted growth of only 14.6%.  Here is their one year share price performance:

Chart

While some share market participants may be losing faith in FMG, the analyst community is not.  In mid-February, FMG received a Buy rating from Merrill Lynch, Citi (with high risk), RBS Australia, Deutsche Bank, and UBS. Macquarie and JP Morgan complete the list with an Outperform and an Overweight Rating.  They see the growth, and right now they believe that the price appears reasonable.

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Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.



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