In the study of bull markets, psychologists have found that investor mood tends to progress through very defined phases. Generally, those phases will range between optimism, excitement, exhilaration and euphoria. It’s when the mood hits euphoria that most market-watchers will tell you that prices are about to turn south. It’s when the most money is chasing the most risk – and that’s often a prelude to a crash.
So, where are we now? For some, the market mood – at least in parts – has been euphoric for some time. In the United States, where the main S&P 500 index has been on an eight-year tear, the fear of a crash is almost tangible. In the UK, prices have also been on a very strong run, especially over the past 18 months. Growth stocks have been some of the big winners in that time.
But despite signs of euphoria, there is no certainty when prices might correct themselves. Indeed, there’s no guarantee that the market will crash at all. In a different context, John Maynard Keynes nailed this fact when he said: “The market can stay irrational longer than you can stay solvent.”
So, for investors looking for growth stocks but alarmed by racy multiples and stretched valuations, what are the options? For a start, it’s worth remembering that some of the most successful growth strategies have a valuation component in them.
GARP – or growth-at-a-reasonable-price – is a hallmark of American investors like Peter Lynch and James O’Shaughnessy, as well as UK investors like Mark Slater, Gervais Williams and Dan Nickols. It’s also the approach used by the popular investor, Robbie Burns.
Rapid and reliable earnings growth
The key to a GARP strategy is to target rapid growth but resist overpaying for it. There are different ways of doing this, but it essentially means looking for a track record of historic profitability and the expectation that earnings will keep growing. Sales growth and even dividend growth can be pointers to firms that are not only growing, but are confident that they can keep up the pace.
Modest debt is also a key feature here. Low or no gearing is highly desirable because debt is one of the biggest killers of small firms that are potentially vulnerable to deteriorating conditions.
Growth at a reasonable price
High multiples can point to frothy prices, which not only limits the upside potential but can also be a risk if things go wrong. For a growth investor like Robbie Burns, a guide would be to use a price-to-earnings (PE) ratio of 20 as a yardstick. Anything more than that needs closer investigation. The key is to get a feel for when valuations might be stretched.
A third component of GARP strategies is price momentum. Growth investors are almost always focused on stocks that have already caught the imagination of the market – they’re not interested in falling prices.
There are various ways of slicing and dicing momentum, but it’s desirable to see a positive price change over the past year – and at least 5% higher than its 52-week low. That gives scope for finding stocks that may just be turning a corner. Combined with the other factors in the GARP strategy, they could be poised to re-rate quickly.
This combination of rules has produced a portfolio return (pre-costs and quarterly refreshed) of 42.5% over the past two years, and 21.2% over the past year. Here are some of the companies that currently pass them:
Name Mkt Cap £m PE Ratio EPS Gwth % Sales Gwth % % Price Chg 1y Sector Vertu Motors 176.4 7.12 5.69 6.50 +5.26 Cyclicals Chesnara 576.5 8.43 398.1 303.2 +21.1 Financials Keller 673.9 9.08 51.2 16.0 +37.6 Industrials Alumasc 60.3 9.25 26.2 13.6 +12.5 Industrials Communisis 113.1 9.40 11.8 5.18 +49.0 Industrials Hogg Robinson 244.7 9.97 21.2 5.28 +5.63 Industrials A & J Mucklow 316.3 10.3 22.2 3.78 +12.5 Financials Harvey Nash 73.5 10.8 3.55 16.0 +77.2 Industrials City of London Investment 109.3 11.1 58.7 28.2 +7.46 Financials Eurocell 246 12.0 4.39 13.2 +40.6 Cyclicals
The results of this approach will invariably find growth stocks with momentum in the market, but not necessarily on the super-stretched valuations of some of the most popular names.
Vertu Motors (VTU), which leads this list, is a classic example of a fast growing firm which investors are slightly uncertain about given fears of a slowdown in its sector. Others towards the top include the life and pension book manager Chesnara (CSN), geotechnical firm Keller (KLR), building products business Alumasc (ALU), and marketing group Communisis (CMS).
GARP strategies can use a broad range of investment ‘rules’ or may just rely on a small number of measures. But, in essence, they all look for signs of strong growth at fair prices. With signs of euphoria in the market right now, growth stocks have performed exceptionally well recently, but some may be at risk if confidence wavers.
Indeed, resisting the temptation to overpay for popular growth stocks could help you avoid the worst drawdowns in the future.
Interactive Investor’s Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard’s review of Stockopedia.com and learn more about the site.
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About the Author
Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including “How to Make Money in Value Stocks” and “The Smart Money Playbook”
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.