Get growth at a reasonable price

Ian Tam: As Canadian equity markets continue to show a very swift recovery from the lows of 2018, some investors may be leery of overpaying for stocks that have run up too quickly against their fundamental valuations. These investors are GARP or "Growth At Reasonable Price" strategy may offer some reasonable ideas. GARP investing is a technique made popular by Fidelity manager Peter Lynch whose Magellan Fund consistently outperformed the S&P 500 between 1977 and 1990. Today we use Morningstar CPMS to create a very simplified GARP strategy for the Canadian market.

So here you can see on the screen I have pretty standard pie chart and usually for Morningstar CPMS models we tend to pick factors that are important to us and use those factors to rank universal stocks. So for today I simply use three barely basic factors. The first factor which I have given a weight of about 56% on my strategy is the PEG Ratio. So PEG is another way to say it is the price-earnings per unit of growth. So PEG Ratio is probably that most core GARP metric that is available and I've certainly used it here. So be a bit more specific. The P/E ratio I have used is price over forward earnings. So this is looking at the consensus estimate for the full fiscal year that hasn’t yet been reported and we're using a median number from the Street.

We take that P/E ratio and we divide it by the growth rate in earnings which is expected again from the Street. So for the growth rate we look at the consensus estimate for the upcoming fiscal year against the already reported EPS for the trailing fiscal year. So, that’s how we come up with a growth rate of earnings. So by dividing the P/E or the price-earnings by the growth rate you are ensuring that you are not paying too much per unit of growth. So, here we of course want a nice low PEG Ratio and that’s worth about 56% in my model.

Second factor I use here is the average return on equity over the last five years. So, return on equity is a pretty standard profitability metric or some people may call it a quality metric and essentially we are looking at the average return on equity over the last five years here. And lastly also as a quality or a safety metric I use the five year standard deviation of earnings. We've seen this before in prior weeks but basically we're looking at how consistent a company's earnings are over the last five years. A company like a Canadian Bank will have very consistent earnings and a company like a small cap mining firm may have very volatile earnings over time. So of course we want nice low numbers here.

So using CPMS I take these three factors and I am going to rank the largest 250 stocks in Canada by float. And that’s going to be the first step in my GARP strategy today.

Now for me to consider buying a stock the company must be ranked in the top half or the top 50% of those 250 names based on the three factors I am ranking my stocks on. In addition to that within that top 50% I have a number of different screens I won't talk through all of them but basically what I am looking for is companies that are growing or expected to grow their earnings in the upcoming fiscal year as well as in the following fiscal year after that. Again this is based on consensus estimates from the Street.

We also want a debt-equity ratio to be less than 1.1 times the sector. So what that means is we're avoiding companies that are overly leveraged against the sector to which they belong. A little bit more than the sector is fine. So 10% above the sector I think is okay. But anything above that I would not consider buying a stock just to avoid companies that are propping up their profits by issuing more debt.

Additionally to make sure I don’t buy already overvalued companies. I want to make sure that their price earnings ratio, price to book ratio, price to sales ratios are all within line to the sector to which they belong. So as long as one of those three metrics are with in line to the sector, I am okay to qualify the stock as potentially buying into my model.

I also look at the three-month estimate revisions. So I look at today's estimate versus what it was three months ago and I want that to be generally moving in the right direction to ensure that analyst sentiment is positive. And lastly, I look at the price change over the last three months. So when buying a stock particularly in Canada which is a very cyclical market I just want to make sure that the stocks are moving in the right direction, the positive direction when I purchase them. So that’s going to be my defining factors to potentially buy stock into my model.

And finally, I will sell a stock if the stocks rank drops below the top half of the list as fundamentals change over time. I will also consider selling it if the average ROE over the last five years drops to negative or if the company is no longer profitable over the medium or long term. As well as if the estimates drop by more than 10% over the last three months.

So that, in essence, covers my GARP model for today. So, of course, I am going to use Morningstar CPMS to backtest this model, see how it would have done had I followed these rules consistently over a very long period of time. So I am going to do that for you right now.

So again just as a quick reminder, as I backtest a model in Morningstar CPMS what happens is I am starting with some sort of cash position. So in this particular case I am using $1 million cash to start. I set the limit of this portfolio to 20 stocks equally weighted. So what would have happened in 1992 is I would have started with $1 million cash. I would have purchased the 20 stocks that met my requirements at that point in time using the information at that point in time. At the end of each subsequent month just like always I am going to check to see if any of my sell rules are broken. So for example if the company's rank drops below the top half of the 250 stocks I'll sell it. If the ROE over the last five years goes negative, I'll sell it or if the estimates drop by more than 10%, I will sell it. So if any of those things happen, I sell the stock and I immediately replace it with the next highest ranking stock. The other limit I put in this backtest is to ensure that I am reasonably diversified across the economy. So it is a 20 stock equally weighted portfolio, but I never have more than 4 stocks per economic sector. In that way we make sure that we are somewhat diversified across the full economy in Canada.

Okay so looks like our backtest just finished up here. And you can see that by following that fairly disciplined approach to GARP investing the return on this type of model is in the neighborhood of about 11.4% annualized which is better than TSX by roughly 3%. I didn’t put any management fees or transaction cost here so please keep that in mind as we buffer these results a little bit. The turnover on this model is about 100%. So on a 20 stock model that’s about 5 or 6 trades per quarter on average sometimes more, sometimes less. So going to be a bit more actively traded model if you will.

  - source: Morningstar CPMS

  - source: Morningstar CPMS

If you look at some of the stats here. The Sharpe ratio again which is the return per unit of risk that you are getting for investing in this model is 0.7% which is certainly higher than buying the index. And also looking at some of the stats here, in downmarket so there is a number of quarters in the last 30 years or so where the market was down of those quarters our strategy beat the benchmark about 70% or 69% of the time. In up markets, we beat it about 48% of the time and overall about 55% of the time.

So the top-ranked stock that meets the qualifications in this model today is WestJet Airlines along with several other stocks that will be listed in the transcript attached to this article. WestJet is a Canadian Airline based in Calgary, Alberta that serves about 100 destinations in the Americas, the Caribbean and Europe.

For Morningstar, I am Ian Tam.

Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar® CPMS™, provides quantitative North American equity research and portfolio analysis to institutions and licensed financial advisers. To get exposure to a CPMS-driven portfolio, we recommend you speak with your financial advisor.