Stocks were mixed yesterday in a listless session with very little economic or corporate news to move stocks or bonds in either direction. Earnings season is winding down with only the major retailers and a few key tech companies still to report.
This morning, I want to talk about GARP investing. GARP stands for Growth At a Reasonable Price. Sounds logical. Expanded just slightly, the first letter, G, stands for growth, the key long-term determinant of stock prices. While over the short run, valuations can vary based on a lot of other macro factors, especially changes in interest rates, over the long run, a business’s valuation won’t move a whole lot if it doesn’t grow in size. Whether one looks at revenues, earnings per share or free cash flow, growth, preferably in all three, is key.
The last three letters suggest that growth is great but valuation matters as well. Academics, analysts, economists, and investors can argue about what constitutes a favorable valuation. But stocks are no different than everything else in this world. Price alone doesn’t dictate value. A shirt can sell for $5 or $500. Both can be perceived as values to a different set of buyers.
Most investors look to traditional measures to build a framework around what constitutes a “reasonable price”. They look at historic P/E ratios, price-to-book value, or some measure of cash flow. The PEG ratio is computed by dividing price by a presumed medium-to-long term growth rate. All these measures are useful, but none are perfect. For decades, it was perceived that the stock market was expensive if the dividend yield on the S&P 500 fell below 3%. It has been below 3% for most of this century while the S&P approaches 5000. What caused that indicator to fail? Stock buybacks. They were much smaller in the aggregate last century, mostly used to offset shares issued to employees as part of compensation packages. Changes in tax policies and compensation structures made stock repurchases more attractive to corporations than the issuance of dividends. As a result, where most monies returned to owners in the past were in the form of dividends, much more value today is attributed to the shrinking of the share base. Same revenues, same earnings, and fewer shares outstanding yields greater earnings per share. That means more of the value to investors comes from appreciation and less from dividend income.
The point here isn’t to make the case for or against dividends, but rather to point out that structural changes, and this is just one, require adjustments to traditional valuation measures. Look at P/Es. Today, they appear high. Traditionally P/Es average about 15-16x earnings. Today, they are over 20. But take out the Magnificent 6 and the median today is close to historic norms. Conclusion: today overall markets are close to fair valuations. They aren’t cheap nor are they particularly expensive.
But that statement applies to the overall market. We all know there will be stocks that double this year and some whose value will be cut in half. Look at last year. Nvidia# and Meta Platforms# were the top two performers in the S&P 500. Nvidia was a pure growth story surging beyond all start-of-the-year expectations. Meta was a story of both renewed growth and spending discipline. It became #2 because so many investors were ready to give up on it in 2022 when Zuckerberg was extolling the Metaverse. OK, so we know that tech, especially big tech, was a winning sector in 2023. But I think it would surprise many to know that two of the next four top performers were cruise ship companies. In 2020-2022, these were given up for dead. People feared if they were caught on a cruise ship and just one passenger developed Covid, they might be stuck on that ship for the rest of their natural lives. Keeping afloat while owning lots of ships with no passengers is difficult. All the cruise ship companies had to sell a lot of cheap stock to survive. But Covid eventually faded and, as we all know now, 2023 was a catch-up year when everyone fulfilled their dreams that couldn’t be realized in 2020-2022.
Businesswise, it’s hard to make any comparison between Nvidia and Carnival Cruise Lines. If I asked 100 people today which of the two had more favorable growth prospects over the next several years, I would venture a guess that all 100 would vote for Nvidia. Nvidia is up another 40% already this year and now sells at 56 times fiscal 2024 expected earnings. That sounds expensive. But consider this. A P/E ratio measures price divided by expected earnings. One can’t argue about price. It’s a fact. But the same can’t be said about earnings. Last year, thanks to AI and other factors, Nvidia made about three times what had been expected at the start of the year. What about this year? For now, Nvidia’s growth is constrained by the capacities of the semiconductor foundries it uses. That won’t go on forever, but given the explosive need for additional computing power to support the growth of AI, most would bet that analyst estimates for 2024 and 2025 are still too low. That suggests that computed P/Es, using today’s estimates aren’t 56 and 32 respectively, but something lower. Are they low enough to fit inside the GARP square? That’s an open-ended question. Bulls will say yes, and Bears will wait for lower prices.
What this all boils down to are three factors:
1. The number one factor affecting short-term (less than one year) price movements is the variance in earnings from original expectations. Companies that blew past estimates were winners. Companies that missed forecasts were losers.
2. Longer term, growth is paramount. It helps materially to be best-in-class. That could mean Nvidia in GPUs, but it also could mean Chipotle, Lululemon, Caterpillar, Deere or Procter & Gamble. Superior companies have superior managements and capital resources to extend their leads. McDonald’s# doesn’t just grow; it traditionally gains market share. Costco# is Costco. Uni que. I don’t have to say anything more.
3. Valuation always matters. When a company perpetually beats forecasts, it leads to a rise in expectations. Fool me once, shame on me…. That can often lead at some point to expectations that simply get extended. This becomes especially true when thinking about investing in the next David setting out to challenge Goliath. Davids rarely win, but enough do to keep the juices flowing. Trying to find the next McDonald’s? Since the 1960s it hasn’t happened. Indeed, the closest thing might be Chipotle which actually was spun out by McDonald’s. If McDonald’s had kept Chipotle, I would venture to say it never would have achieved the success that it has, given that McDonald’s attention and dollars were aimed at sustaining the growth of the Golden Arches. That is probably the reason McDonald’s chose to spin it out.
Thus, GARP makes a lot of sense. Find growth. Even better, find growing companies where future expectations are too low. Then find a good entry point and buy. You don’t have to buy all at once. Growth stocks tend to be more volatile than value stocks. If you love a particular company, don’t be afraid to overpay a little to get started. Paraphrasing Warren Buffett, it is better to buy a great company at a fair price than to buy a fair company at a cheap price. When you go into a department store, it’s nice to rummage through the 50% off rack, until you realize why that stuff is being priced at 50% off. But it is also smart to scout out what you love, and wait for the 10-20% off sale, knowing that if the product is too hot, it will get sold before it’s discounted. We can all agree that Louis Vuitton handbags are expensive. But Louis Vuitton never has a sale. Sometimes, you have to bite the bullet and pay up…or simply look elsewhere.
Today, Joe Pesci is 81. Carole King turns 82.
James M. Meyer, CFA 610-260-2220