Introduction
In the papers Bridging Value and Growth: Designing a GARP Strategy for Australia and Introducing the S&P World Ex-Australia GARP Index, we documented the growth at a reasonable price (GARP) strategy’s effectiveness in markets outside of Australia. We also highlighted that, due to the unique nature of the Australian equity market, certain aspects of index construction may need to be modified to better fit local characteristics.
How does S&P DJI approach the GARP strategy within the Australian equity market?
In this paper, we introduce the S&P/ASX 200 GARP Index, an innovative index that applies the GARP framework to the S&P/ASX 200 universe. This index is built upon the well-established S&P GARP Index Series, focusing on growth opportunities while balancing valuation and quality considerations. The index methodology has also been adjusted to better align with the local market dynamics.
In this paper, we will delve into the index construction, historical performance and characteristics of the index to show how GARP works in Australia. This paper aims to provide insight into how an indexing approach can implement the GARP framework in a more localized manner.
Index Construction
On Aug. 9, 2024, S&P Dow Jones Indices (S&P DJI) launched the S&P/ASX 200 GARP Index. This index begins by selecting the top 150 stocks with the highest Growth Scores from the S&P/ASX 200. The Growth Score is a composite metric that combines three-year sales-per-share (SPS) growth with three-year earnings-per-share (EPS) growth.
From this pool of 150 stocks, the S&P/ASX 200 GARP Index subsequently selects the top 50 stocks based on the highest quality and value (QV) composite score. The QV composite score is derived from two key metrics that assess both quality and valuation: return on equity (ROE) and earnings-to-price ratio. ROE serves as a prominent metric for evaluating a company's quality, while the earnings-to-price ratio is widely recognized as a valuation metric.
The selected 50 stocks are then weighted according to the product of their float market capitalization (FMC) and QV composite score, subject to a 0.1% single-stock floor and a 10% single-stock cap. The index also incorporates a relative single GICS® sector cap of no more than 10% above the corresponding GICS sector weight in the S&P/ASX 200. The index is rebalanced on a semiannual basis in June and December.
While the design of the S&P/ASX 200 GARP Index mirrors the framework of the broader GARP methodology, several adjustments have been made to better align with the characteristics of the Australian market.
- Mild Selection on Growth Metrics: We exclude only the bottom 50 stocks with poor growth characteristics from the S&P/ASX 200 universe. Our previous paper, Bridging Value and Growth: Designing a GARP Strategy for Australia, indicated that when assigning stocks in the S&P/ASX 200 into quintile compositions, the results of the historical growth performance of both EPS and SPS are not monotonic. Additionally, the Australian equity market tends to be more cyclical than the U.S. equity market, with over 50% of the S&P/ASX 200 weight concentrated in Financials and Materials as of August 2024. A moderate screening of growth metrics can eliminate poor growth stocks while helping to smooth out some cyclical fluctuations in the underlying market.
- Exclusion of Leverage Ratio: We have removed the leverage ratio from the calculation of the QV composite score. In Bridging Value and Growth: Designing a GARP Strategy for Australia, we discovered that the leverage ratio is not a suitable metric for the Australian market, which is heavily weighted toward Financials—particularly banks—which has accounted for more than 30% of the S&P/ASX 200 weight on average over the past decade. Leverage ratios may not effectively reflect the riskiness of a company's financial profile, especially with regard to banks.
- Amplified Contribution from QV Composite Score: By selecting 50 stocks with high QV composite scores from the top 150 Growth Score-screened companies and weighting the constituents based on the product of their FMC and QV composite score, we enhance the index's construction. Based on our research in Bridging Value and Growth: Designing a GARP Strategy for Australia, it seems that ROE and earnings-to-price ratios are effective metrics in the Australian market. Identifying companies with strong profitability and reasonable valuations within the growth universe is crucial for finding well-priced opportunities.
- Capping Adjustments: The single-stock cap is set at 10%, and the GICS sector cap is established at a relative 10% against the S&P/ASX 200. This approach better reflects the characteristics of the S&P/ASX 200, which is a more concentrated index with fewer stocks compared to the S&P World Ex-Australia.
