What are we looking for?
Lesser-known GARP stocks outside the S&P/TSX Composite Index.
A minor drawback to investing in a broad index is that one might miss growth opportunities in companies that, for one reason or another, have not made the cut to be part of a major index. These lesser-known companies tend to be less liquid, but they can provide reasonable returns for those who have longer investment time horizons.
Today, we search for ideas in this space by considering stocks exhibiting steady GARP (growth at a reasonable price) metrics. Made popular by legendary fund manager Peter Lynch, the strategy looks for companies that are increasing their earnings yet remain reasonably valued relative to their earnings-per-share growth rate.
The most common GARP measure is the PEG ratio, which is the comparison of the price-to-earnings multiple against the growth rate of earnings. Among other things, GARP investors typically seek lower PEG ratios. Alongside this ratio, I used Morningstar CPMS to rank the 484 companies in our Canadian database (which excludes companies in the S&P/TSX Composite Index) on the following metrics:
- Five-year deviation of return on equity and earnings (measures of volatility, lower figures preferred, implying return on equity or earnings have been consistent over the past five years);
- Five-year EPS growth rate (the percentage that earnings have increased annually, on average, over the past five years);
- Five-year average return on equity.
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.
What we found
I used Morningstar CPMS to back-test the strategy from January, 2000, to September, 2021, assuming a 15-stock portfolio that holds no more than four stocks for each economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the universe based on the above metrics. When sold, stocks were replaced with next qualifying stocks not already held in the portfolio, keeping in mind the aforementioned sector limits.
Given that the strategy invests exclusively in non-index stocks, which are typically less liquid, I applied a 2-per-cent liquidity factor to the back-test, implying stocks were bought for 2 per cent higher than the closing price at month-end, and sold for 2 per cent lower. On this basis, the strategy produced an annualized total return of 12.9 per cent, while the S&P/TSX Small Cap Total Return Index advanced 5.2 per cent. The stocks that meet the requirements to be purchased into the strategy today are listed in the accompanying table.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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