How to pick stocks: GARP Investing strategy

Do you feel that you now have a firm grasp of the principles of both value and growth investing? If you're comfortable with these two stock-picking methodologies, then you're ready to learn about a newer, hybrid system of stock selection. Here we take a look at growth at a reasonable price, or GARP.

What Is GARP?
The GARP strategy is a combination of both value and growth investing: it looks for companies that are somewhat undervalued and have solid sustainable growth potential. The criteria which GARPers look for in a company fall right in between those sought by the value and growth investors. Below is a diagram illustrating how the GARP-preferred levels of price and growth compare to the levels sought by value and growth investors:
What GARP Is NOT
Because GARP borrows principles from both value and growth investing, some misconceptions about the style persist. Critics of GARP claim it is a wishy-washy, fence-sitting method that fails to establish meaningful standards for distinguishing good stock picks. However, GARP doesn't deem just any stock a worthy investment. Like most respectable methodologies, it aims to identify companies that display very specific characteristics.

Another misconception is that GARP investors simply hold a portfolio with equal amounts of both value and growth stocks. Again, this is not the case: because each of their stock picks must meet a set of strict criteria, GARPers identify stocks on an individual basis, selecting stocks that have neither purely value nor purely growth characteristics, but a combination of the two.

Who Uses GARP?
One of the biggest supporters of GARP is Peter Lynch, who has written several popular books, including "One Up on Wall Street" and "Learn to Earn", and in the late 1990s and early 2000 he starred in the Fidelity Investment commercials. Many consider Lynch the world's best fund manager, partly due to his 29% average annual return over a 13-year stretch from 1977-1990.

The Hybrid Characteristics
Like growth investors, GARP investors are concerned with the growth prospects of a company: they like to see positive earnings numbers for the past few years, coupled with positive earnings projections for upcoming years. But unlike their growth-investing cousins, GARP investors are skeptical of extremely high growth estimations, such as those in the 25-50% range. Companies within this range carry too much risk and unpredictability for GARPers. To them, a safer and more realistic earnings growth rate lies somewhere between 10-20%.

Something else that GARPers and growth investors share is their attention to the ROE figure. For both investing types, a high and increasing ROE relative to the industry average is an indication of a superior company.

GARPers and growth investors share other metrics to determine growth potential. They do, however, have different ideas about what the ideal levels exhibited by the different metrics should be, and both types of investors have varying tastes in what they like to see in a company. An example of what many GARPers like to see is positive cash flow or, in some cases, positive earnings momentum.

Because a variety of additional criteria can be used to evaluate growth, GARP investors can customize their stock-picking system to their personal style. Exercising subjectivity is an inherent part of using GARP. So if you use this strategy, you must analyze companies in relation to their unique contexts (just as you would with growth investing). Since there is no magic formula for confirming growth prospects, investors must rely on their own interpretation of company performance and operating conditions.

It would be hard to discuss any stock-picking strategy without mentioning its use of the P/E ratio. Although they look for higher P/E ratios than value investors do, GARPers are wary of the high P/E ratios favored by growth investors. A growth investor may invest in a company trading at 50 or 60 times earnings, but the GARP investor sees this type of investing as paying too much money for too much uncertainty. The GARPer is more likely to pick companies with P/E ratios in the 15-25 range - however, this is a rough estimate, not an inflexible rule GARPers follow without any regard for a company's context.

In addition to a preference for a lower P/E ratio, the GARP investor shares the value investor's attraction to a low price-to-book ratio (P/B) ratio, specifically a P/B of below industry average. A low P/E and P/B are the two more prominent criteria with which GARPers in part mirror value investing. They may use other similar or differing criteria, but the main idea is that a GARP investor is concerned about present valuations.

By the Numbers
Now that we know what GARP investing is, let's delve into some of the numbers that GARPers look for in potential companies.

The PEG Ratio
The PEG ratio may very well be the most important metric to any GARP investor, as it basically gauges the balance between a stock's growth potential and its value.

GARP investors require a PEG no higher than 1 and, in most cases, closer to 0.5. A PEG of less than 1 implies that, at present, the stock's price is lower than it should be given its earnings growth. To the GARP investor, a PEG below 1 indicates that a stock is undervalued and warrants further analysis.

PEG at Work
Say the TSJ Sports Conglomerate, a fictional company, is trading at 19 times earnings (P/E = 19) and has earnings growing at 30%. From this you can calculate that the TSJ has a PEG of 0.63 (19/30=0.63), which is pretty good by GARP standards.

Now let's compare the TSJ to Cory's Tequila Co (CTC), which is trading at 11 times earnings (P/E = 11) and has earnings growth of 20%. Its PEG equals 0.55. The GARPer's interest would be aroused by the TSJ, but CTC would look even more attractive. Although it has slower growth compared to TSJ, CTC currently has a better price given its growth potential. In other words, CTC has slower growth, but TSJ's faster growth is more overpriced. As you can see, the GARP investor seeks solid growth, but also demands that this growth be valued at a reasonable price. Hey, the name does make sense!
GARP at Work
Because a GARP strategy employs principles from both value and growth investing, the returns that GARPers see during certain market phases are often different than the returns strictly value or growth investors would see at those times. For instance, in a raging bull market the returns from a growth strategy are often unbeatable: in the dotcom boom of the mid- to late-1990s, for example, neither the value investor nor the GARPer could compete. However, when the market does turn, a GARPer is less likely to suffer than the growth investor.

Therefore, the GARP strategy not only fuses growth and value stock-picking criteria, but also experiences a combination of their types of returns: a value investor will do better in bearish conditions; a growth investor will do exceptionally well in a raging bull market; and a GARPer will be rewarded with more consistent and predictable returns.

Conclusion
GARP might sound like the perfect strategy, but combining growth and value investing isn't as easy as it sounds. If you don't master both strategies, you could find yourself buying mediocre rather than good GARP stocks. But as many great investors such as Peter Lynch himself have proven, the returns are definitely worth the time it takes to learn the GARP techniques.

source from:http://www.investopedia.com/

How to pick stocks: Growth Investing

In the late 1990s, when technology companies were flourishing, growth investing techniques yielded unprecedented returns for investors. But before any investor jumps onto the growth investing bandwagon, s/he should realize that this strategy comes with substantial risks and is not for everyone.

Value versus Growth
The best way to define growth investing is to contrast it to value investing. Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.

As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.

No Automatic Formula
Growth investors are concerned with a company's future growth potential, but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods - or sets of guidelines or criteria - as a framework for their analysis, but these methods must be applied with a company's particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry's performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.

The NAIC
The National Association of Investors Corporation (NAIC) is one of the best known organizations using and teaching the growth investing strategy. It is, as it says on its website, "one big investment club" whose goal is to teach investors how to invest wisely. The NAIC has developed some basic "universal" guidelines for finding possible growth companies - here's a look at some of the questions the NAIC suggests you should ask when considering stocks.

1. Strong Historical Earnings Growth?
According to the NAIC, the first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. Below are rough guidelines for the rate of EPS growth an investor should look for in companies of differing sizes, which would indicate their growth investing potential:

Although the NAIC suggests that companies display this type of EPS growth in at least the last five years, a 10-year period of this growth is even more attractive. The basic idea is that if a company has displayed good growth (as defined by the above chart) over the last five- or 10-year period, it is likely to continue doing so in the next five to 10 years.

2. Strong Forward Earnings Growth?

The second criterion set out by the NAIC is a projected five-year growth rate of at least 10-12%, although 15% or more is ideal. These projections are made by analysts, the company or other credible sources.

The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company's industry - specifically, what its prospects are and what stage of growth it is at.

3. Is Management Controlling Costs and Revenues?
The third guideline set out by the NAIC focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good, but if EPS has not increased proportionately, it's likely due to a decrease in profit margin.

By comparing a company's present profit margins to its past margins and its competition's profit margins, a growth investor is able to gauge fairly accurately whether or not management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate.

4. Can Management Operate the Business Efficiently?
Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company's present ROE is best compared to the five-year average ROE of the company and the industry.

5. Can the Stock Price Double in Five Years?
If a stock cannot realistically double in five years, it's probably not a growth stock. That's the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock's price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.

An Example
Now that we've outlined the NAIC's basic criteria for evaluating growth stocks, let's demonstrate how these criteria are used to analyze a company, using Microsoft's 2003 figures. For the sake of this demonstration, we'll discuss these numbers as though they were Microsoft's most current figures (that is, "today's figures").

1. Five-Year Earnings Figures

Both of these are strong figures. The annual EPS growth is well above the 5% standard the NAIC sets out for firms of Microsoft's size.

2. Strong Projected Earnings Growth

The projected growth figures are strong, but not exceptional.

3. Costs and Revenue Control

There are two ways to look at this. The trend is down 5.08% (50.88% - 45.80%) from the five-year average, which is negative. But notice that the industry's average margin is only 26.7%. So even though Microsoft's margins have dropped, they're still a great deal higher than those of its industry.

4. ROE

Again, it's a point of concern that the ROE figure is a little lower than the five-year average. However, like Microsoft's profit margin, the ROE is not drastically reduced - it's only down a few points and still well above the industry average.

5. Potential to Double in Five Years
The average analyst projections for Microsoft suggest that in five years the stock will not merely double in value, but it'll be worth 254.7% its current value.

Is Microsoft a Growth Stock?
On paper, Microsoft meets many NAIC's criteria for a growth stock. But it also falls short of others. If, for instance, we were to dismiss Microsoft because of its decreased margins and not compare them to the industry's margins, we would be ignoring the industry conditions within which Microsoft functions. On the other hand, when comparing Microsoft to its industry, we must still decide how telling it is that Microsoft has higher-than-average margins. Is Microsoft a good growth stock even though its industry may be maturing and facing declining margins? Can a company of its size find enough new markets to keep expanding?

Clearly there are arguments on both sides and there is no "right" answer. What these criteria do, however, is open up doorways of analysis through which we can dig deeper into a company's condition. Because no single set of criteria is infallible, the growth investor may want to adjust a set of guidelines by adding (or omitting) criteria. So, although we've provided five basic questions, it's important to note that the purpose of the example is to provide a starting point from which you can build your own growth screens.

Conclusion
It's not too complicated: growth investors are concerned with growth. The guiding principle of growth investing is to look for companies that keep reinvesting into themselves to produce new products and technology. Even though the stocks might be expensive in the present, growth investors believe that expanding top and bottom lines will ensure an investment pays off in the long run.

source from:http://www.investopedia.com/university/stockpicking/stockpicking4.asp

How to pick stocks: Value Investing

In the previous article understand-what-kind-of-stock-investors you are,we mentioned that there are roughly three kind of investors, value investor, growth investor and income investor. Now here is the detail for value investing.

Value investing is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth.

The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investor seeks companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.

Value, Not Junk!
Before we get too far into the discussion of value investing, let's get one thing straight. Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality.

It's important to distinguish the difference between a value company and a company that simply has a declining price. Say for the past year Company A has been trading at about $25 per share but suddenly drops to $10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than $10 - value investing always compares current share price to intrinsic value not to historic share prices.

Value Investing at Work
One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat the S&P 500's performance by about 13.02% on average annually! Although Buffett does not strictly categorize himself as a value investor, many of his most successful investments were made on the basis of value investing principles.

Buying a Business, not a Stock
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.

Contradictions
While the efficient market hypothesis (EMH) claims that prices are always reflecting all relevant information, and therefore are already showing the intrinsic worth of companies, value investing relies on a premise that opposes that theory. Value investors bank on the EMH being true only in some academic wonderland. They look for times of inefficiency, when the market assigns an incorrect price to a stock.

Value investors also disagree with the principle that high beta (also known as volatility, or standard deviation) necessarily translates into a risky investment. A company with an intrinsic value of $20 per share but is trading at $15 would be, as we know, an attractive investment to value investors. If the share price dropped to $10 per share, the company would experience an increase in beta, which conventionally represents an increase in risk. If, however, the value investor still maintained that the intrinsic value was $20 per share, s/he would see this declining price as an even better bargain. And the better the bargain, the lesser the risk. A high beta does not scare off value investors. As long as they are confident in their intrinsic valuation, an increase in downside volatility may be a good thing.

Screening for Value Stocks
Now that we have a solid understanding of what value investing is and what it is not, let's get into some of the qualities of value stocks.

Qualitative aspects of value stocks:
Where are value stocks found? - Everywhere. Value stocks can be found trading on the NYSE, Nasdaq, AMEX, over the counter, on the FTSE, Nikkei and so on.
a) In what industries are value stocks located? - Value stocks can be located in any industry, including energy, finance and even technology (contrary to popular belief).
b) In what industries are value stocks most often located? - Although value stocks can be located anywhere, they are often located in industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term. For example, the auto industry's cyclical nature allows for periods of undervaluation of companies such as Ford or GM.
Can value companies be those that have just reached new lows? - Definitely, although we must re-emphasize that the "cheapness" of a company is relative to intrinsic value. A company that has just hit a new 12-month low or is at half of a 12-month high may warrant further investigation.

Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:
*Share price should be no more than two-thirds of intrinsic worth.
*Look at companies with P/E ratios at the lowest 10% of all equity securities.
*PEG should be less than one.
*Stock price should be no more than tangible book value.
*There should be no more debt than equity (i.e. D/E ratio < 1).
*Current assets should be two times current liabilities.
*Dividend yield should be at least two-thirds of the long-term AAA bond yield.
*Earnings growth should be at least 7% per annum compounded over the last 10 years.

The P/E and PEG Ratios
Contrary to popular belief, value investing is not simply about investing in low P/E stocks. It's just that stocks which are undervalued will often reflect this undervaluation through a low P/E ratio, which should simply provide a way to compare companies within the same industry. For example, if the average P/E of the technology consulting industry is 20, a company trading in that industry at 15 times earnings should sound some bells in the heads of value investors.

Another popular metric for valuing a company's intrinsic value is the PEG ratio, calculated as a stock's P/E ratio divided by its projected year-over-year earnings growth rate. In other words, the ratio measures how cheap the stock is while taking into account its earnings growth. If the company's PEG ratio is less than one, it is considered to be undervalued.

Narrowing It Down Even Further
One well-known and accepted method of picking value stocks is the net-net method. This method states that if a company is trading at two-thirds of its current assets, no other gauge of worth is necessary. The reasoning behind this is simple: if a company is trading at this level, the buyer is essentially getting all the permanent assets of the company (including property, equipment, etc) and the company's intangible assets (mainly goodwill, in most cases) for free! Unfortunately, companies trading this low are few and far between.

The Margin of Safety
A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective. Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions.

This use of a margin of safety works similarly in value investing. It's simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of $30 per share. But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the $26 per share in their scenario analysis. The investor may find that at $15 the company is still an attractive investment, or he or she may find that at $24, the company is not attractive enough. If the stock's intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.

Conclusion
Value investing is not as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there's nothing boring about outperforming the S&P by 13% over a 40-year span!

Understand What kind of stock investors you are?

One of the first things to understand about buying stocks is that what you buy is in some ways a function of who you are. If you're an optimist, growth investing might be for you. Long on patience? Value investing may be the better fit.

Individual investors generally fall into one of three categories: growth investors, value investors or dividend investors.

Growth
A stock's price often reflects how profitable investors think a company will be in the future. So most investors follow a growth strategy, which means that they look for companies with strong prospects for growing their sales and earnings. Definitions vary, but stocks expected to increase their sales (and their net income) from one year to the next by at least 15% generally qualify as growth stocks.

Value
Value investors follow a different path. They believe that the broader stock market always overreacts to news about a company. They seek out formerly hot stocks that have stumbled and whose share prices are at bargain levels.
Being cheap, though, isn't enough by itself. Value investors try to zero in on stocks that were beaten down due to temporary problems that can be fixed.

Dividends
Dividend investors buy stocks that pay a cash dividend based on the number of shares you own, usually on a quarterly basis. Unlike value and growth investors, who only make money when they sell, dividend investors get paid while they hold the stock.

Thus, dividend investors buy stocks as much for the income as they do for capital appreciation (which is what you get when you sell a stock at a higher price than you paid for it). Dividend investors look for financially solid companies with the wherewithal to continue paying their dividends, regardless of what's happening in the economy.

Putting a price on a stock
How do you know whether a stock is a value or priced for growth? Most investors rely on certain ratios that compare a stock's price to the underlying company's results.

The most commonly used valuation ratios are:

Price-to-earnings (P/E): This is a company's stock price divided by how much it earns per share over 12 months (expressed as earnings-per-share, or EPS). Most often, the EPS used is the most recent 12 months' earnings. Another way to calculate P/E is by using the consensus of Wall Street analysts' forecasts for a company's earnings in the current fiscal year. P/E is the most widely used valuation gauge.

Price-to-sales (P/S): A company's stock price divided by the most recent 12 months' sales-per-share. Some investors favor P/S over P/E because sales don’t vary as much as earnings from quarter to quarter. Another advantage is that you can calculate P/S, but not P/E, when a company loses money in a quarterly or annual reporting period.

Price-to-book (P/B): Also called book value, this is a company's assets minus its liabilities. A P/B ratio divides a company's stock price by its book value per share. Value investors tend to favor P/B.
There is no universal agreement on ratio values that define value or growth. Here’s my simplified take.


Defining value and growth
Ratio Value Growth Overpriced Growth
P/E Less than 15 More than 20 More than 50
P/S Less than 2.5 More than 3 More than 10
P/B Less than 3 More than 5 More than 15

Stocks with valuations in the gaps between the value and growth definitions -- say, a P/E of 18 and a P/B of 4 -- could be in either category, depending on the circumstances. Valuations in the Overpriced Growth column define stocks that many investors would consider overpriced.

But remember, your research doesn't end with these ratios. Figuring out whether a stock is worth buying is another task. A stock may be a value in terms of price, but its price may be depressed because something is seriously wrong. These ratios can help you understand whether a company's shares are cheap or expensive. If they are cheap, and you've done your work trying to find out why, then they may be attractive as a buy.