How is a GARP strategy different from a traditional growth or value strategy? S&P DJI’s Jason Ye sits down with Andrew Geoghegan from Ausbiz to unpack the growth at a reasonable price approach and explore its relevance to market participants in Australia.
[TRANSCRIPT]
Andrew Geoghegan:
The debate surrounding value investing versus growth investing has been a long-standing topic in the investment community, but does an investor have to choose between one or the other? Well, not necessarily. Hello, I'm Andrew Geoghegan from Ausbiz. Today we have Jason Ye, Director of Factors and Thematics Indices at S&P Dow Jones Indices, to discuss an investment strategy called GARP, growth at a reasonable price, which bridges value and growth investing. Jason, thanks for joining us. So Jason, what is a GARP strategy, and how does it differ from a traditional value or growth strategy?
Jason Ye:
Great question Andrew. So GARP stands for growth at a reasonable price. It's a factor-based strategy that measures growth opportunities while considering valuation. Traditional value investing is characterized by investing in low-valuation stocks as defined by valuation metrics like price-to-earnings and price-to-book ratios. A pure value investor seeks to find stocks that are trading at a bargain price, and valuation is the only metric that matters. However, unlike value, growth investing is less well defined. Some argue that high valuation, or the opposite of value, is equivalent to growth, while others use growth metrics such as earnings growth or sales growth to define it. A pure growth-oriented investor would often be willing to pay for growth at any price, even if the valuation is extremely high. A GARP strategy attempts to act as a bridge between value and growth strategies. So the GARP strategy was popularized by fund manager Peter Lynch, who argues that growth investing should also take valuation into consideration. This dual focus is intended to help investors identify stocks that may not only be poised for growth but are also supposedly priced attractively relative to their growth potential.
Andrew Geoghegan:
So then, how can we implement a GARP strategy?
Jason Ye:
At S&P Dow Jones Indices, we have been measuring GARP strategies through an indexing approach since 2019. In August 2024, we launched the S&P World Ex-Australia GARP Index and the S&P/ASX 200 GARP Index, extending our GARP index family beyond the U.S. market. Our GARP indices take a two-step, multi-factor approach. So we first screen companies with what are considered strong growth characteristics like earnings growth and sales growth. And then, within this growth universe, we screen companies with low valuations, strong profitability and low leverage. An index-based GARP strategy comes with a few unique characteristics. First, it's a rule-based systematic approach to avoid active, individual discretionary decisions. Second, the index comes with a comprehensive methodology that's publicly available on our website. The index methodology describes the index construction in detail, which provides transparency behind the strategy. And lastly, our index follows a periodical rebalancing schedule, which is designed to ensure that we consistently target the companies that meet the index objective, to include companies with strong growth, reasonable valuations and high quality.
Andrew Geoghegan:
So Jason, you mentioned Peter Lynch, who's famous for using the PEG ratio as a GARP metric. Why then does S&P Dow Jones Indices not use the PEG ratio to screen for GARP stocks?
Jason Ye:
So first let me define what a PEG ratio is. A PEG ratio is calculated as dividing the price-to-earnings ratio by the growth ratio. So the idea behind the PEG ratio is to evaluate a stock's valuation against its growth rate. A common rule of thumb is that a PEG ratio of less than one means that a stock’s valuation is reasonable against its growth, and that's where growth at a reasonable price, or GARP, comes from. However, as we performed further empirical research, we found a few challenges behind the PEG ratio. So the first is that the PEG ratio is influenced by the market environment and the overall valuations. The number of stocks that meet the “PEG ratio of less than one” threshold fluctuates through time and across markets. So for example, in low-interest-rate environments, the overall market valuations went up, which resulted in a fewer number of stocks meeting the “less than one” threshold. Also, it's hard to compare a U.S. stock with an Australian stock, even if the U.S. stock’s PEG ratio is above one and the Australian stock’s PEG ratio is below one, because the overall market valuation differs. Looking at the S&P 500 stock universe, in some periods there were more than 200 stocks with a PEG ratio of less than one, which may require further screening to narrow down the basket. The second challenge is that when we sorted stocks based on the PEG ratio and assigned them into five groups, we found that in both the U.S. and Australian markets, the groups with the lowest PEG ratio had the highest return volatility historically, and that higher volatility sometimes dragged down the overall risk-adjusted returns. And given those challenges, we found that an index simply focusing on the PEG ratio might not be sufficient to implement the GARP strategy, and that's why we take a two-step sorting approach. The two-step screening can first ensure that we start with a universe of stocks with strong growth characteristics, and then within that growth characteristics universe, we blend other factors like valuation and quality into further screening down to a narrow basket. This is how we designed the S&P World Ex-Australia GARP Index.
Andrew Geoghegan:
So Jason, can you tell us more then about the S&P World Ex-Australia GARP Index?
Jason Ye:
Yes, so the S&P World Ex-Australia GARP Index starts from the S&P World Ex-Australia Index universe, which measures the performance of the large- and mid-cap stocks in developed markets, excluding Australia and Korea. To be included in the S&P World Ex-Australia GARP Index, companies are required to have positive earnings and must have been trading for at least 10 months. We then calculate the growth score and the quality/value composite score. Our growth score combines a three-year earnings per share growth and a three-year sales per share growth. The quality/value composite score combines the ROE, financial leverage and earnings-to-price. A company must have both a growth score and a quality/value score to be eligible. And then, within that eligible universe, we sort stocks based on the growth score, first selecting the 500 companies with the highest growth score to be the growth-eligible universe. Within this growth-eligible universe, we sort companies based on the quality/value composite score and select the top 250 stocks. The final constituents are weighted by their float market capitalization times their growth scores. We also apply a 5% single-stock cap and a 40% single-GICS-sector cap to ensure the diversification requirement. The index is rebalanced on a semi-annual basis in June and December.
Andrew Geoghegan:
And how has the S&P World Ex-Australia GARP Index performed historically?
Jason Ye:
So based on the back-tested data, the index has shown strong historical performance. During the back-tested period between July 2004 and July 2024, the S&P World Ex-Australia GARP Index showed a positive 12.97% annualized total return, outperforming the S&P World Ex-Australia Index by 377 basis points. The additional performance came with a 4.74% annualized tracking error to the S&P World Ex-Australia Index, which resulted in a 0.75 information ratio historically. And looking at the different market environments, so during the up months, the S&P World Ex-Australia GARP Index outperformed about 59% of the time, with an average overperformance of 24 basis points per month, while during the down months, the S&P World Ex-Australia GARP Index outperformed 48% of the time, with an average overperformance of six basis points. So historically, the S&P World Ex-Australia GARP Index tended to perform higher when the market was up. However, that doesn't mean that the index underperformed in each of the downcycles. So for example, according to the back-tested data, during the global financial crisis between the years 2007 and 2009, the S&P World Ex-Australia GARP Index would have outperformed the S&P World Ex-Australia Index by 9%,when the latter index would have been down by 37.25%. And looking at the fundamental data for the period between June 30, 2004, to July 31, 2024, the S&P World Ex-Australia GARP Index has historically had a higher EPS growth and SPS growth, a lower price-to-earnings ratio, a better ROE and a lower leverage compared to its underlying index, which once again speaks to its GARP characteristics.
Andrew Geoghegan:
So Jason, can you then explain how the S&P World Ex-Australia GARP Index is relevant to Australian-based market participants?
Jason Ye:
So the index is relevant to Australian-based market participants for the following reasons. First, the S&P World Ex-Australia GARP Index measures equity markets outside of Australia, which can serve as a diversification benefit. This index covers more than 20 developed markets, with more than 50% of the weight in the U.S. market. Second, the S&P World-Ex Australia GARP Index has a different sector weighting than the S&P/ASX 200. The S&P/ASX 200 is heavily weighted towards financials and materials, while the S&P World Ex-Australia GARP Index is more weighted towards sectors like Information Technology historically. Therefore, the two indices complement each other with a more balanced sector exposure. Lastly, a hypothetical combination of the S&P World Ex-Australia GARP Index and the S&P/ASX 200 would have resulted in a better risk/return profile historically. So between July 2004 and July 2024, a hypothetical combination of 40% S&P World Ex-Australia GARP Index with 60% S&P/ASX 200 Index would have resulted in a 10.6% annualized return with an 11.79% annualized volatility, which would have been better than the 8.72% return and 13.81% volatility for the S&P/ASX 200 Index.
Andrew Geoghegan:
Jason, thanks for your insights.
Jason Ye:
Thank you, Andrew.
Jason Ye:
To learn more about GARP strategies and how they work for the Australian market, and S&P Dow Jones Indices’ latest data and research, please visit the link below. www.spglobal.com/spdji
