Growth at Reasonable Price is an ideal approach
Throughout stockmarket history there is one approach that ideally serves your interests best of all: shares in a sound growing business, offered at a modest to fair price. Warren Buffett actually amended his "value investing" approach from balance sheet numbers to a closer consideration of qualitative issues such as a firm's competitive position and management calibre - to enormously successful effect.
In the UK, Jim Slater rather mirrored a "Growth at Reasonable Price" - or GARP approach as it's known on Wall Street - by advancing a price earnings to growth or "PEG" ratio. This is a simple method of screening for growth shares which involves dividing the P/E multiple by the forecast annual earnings growth rate. To qualify for the PEG approach, a share needs at least four years of uninterrupted earnings growth; or five years for cyclicals. Perhaps you can already see that while this approach can offer a better sense of growth than merely the P/E, it introduces the possibility the growth rate may be peaking.
More recently, Joel Greenblatt, a US hedge fund manager and author, has shown that combining a return on capital measure can be highly effective for share selection.
Combining such quantitative aspects of a share, with qualitative of the company, can still work out very well for the kind of investor who seeks to tuck shares away for the long term, say in a SIPP or ISA, and devote less time to short-term trading. It's also generally less risky than many other areas of the stockmarket, such as early stage companies, and more satisfying than very big companies which find it harder to grow earnings. A mid-size growth share accompanied by a rising chart, usually offers better risk/reward than a share that has crashed and is attracting traders hopeful for a turnaround.
But you still need to exercise care with timing.
At any time in a growth share's evolution, investor hopes may be running so high, the prospects are more than priced in; and once a company has published a few years of impressive growth then unless its market has high barriers to entry then its margins may suffer from competition. Might the figures be massaged and/or growth been achieved with a high-risk financial structure? The PEG approach has identified shares such as Surrey Free Inns, JJB Sports (JJB) and Healthcare Locums (HLO), just three examples that became stockmarket casualties.
So you need to look at broader factors than one narrow quantitative measure, especially to judge the risks with a fast-growing firm.
This approach also tends to work well during the mid-part of an economic cycle; it won't help you pick recovery shares from the turning point, nor from company figures and brokers' forecasts can it dependably inform you when the economy is peaking out - and/or a shock such as the 2008 crisis, may be revealed. To more effectively trade against the crowd, you need another tool in your kit.
- Trading and Investing Strategies
- Edmond Jackson's investing master class
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- Value investing for beginners