How to Find a Great GARP Stock

One of the questions I get most often as an analyst is, "How do you find the stocks you recommend?" There are actually a number of ways to go about idea generation, but one of the best and most replicable for investors at home is screening. This means asking a computer to look for companies that fit several predetermined and desirable criteria.

The difficult part of screening, of course, is knowing what to ask the computer to look for. So to help you out, I thought I'd share with you one of the screens I'm using to identify promising GARP (which stands for growth at a reasonable price) stocks for my portfolio. GARP investing blends the best of growth and value investing by identifying companies with solid growth potential but only buying them when their valuations make us value folks lick our chops.

Step 1: Identify a GARP stock
I'll be the first to admit that growth and value can occur in any geographic region, but for the sake of simplicity, we'll stick to looking at companies that trade on the major U.S. exchanges. The first thing one needs to do when looking for a stock with both growth and value characteristics is to define what growth is and what a reasonable price is.

  • Growth: I'm concerned mostly with sales growth because it is the first domino that makes the other financial dominos (like earnings and cash flow) fall. Being a long-term investor, I look for average sales growth above 10% over the past five years.
  • Reasonable Price: Instead of focusing on earnings, I like to look at the enterprise-value-to-EBITDA ratio. It can be interpreted just like a P/E ratio but it is more comparable across firms. With value blood coursing through my veins, I look for an EV/EBITDA ratio below eight.

According to my screen, there are 442 companies trading on the major U.S. exchanges that have exhibited solid five-year growth and seem to be trading at a reasonable price. That's too many to be helpful, which means we need additional criteria.

Step 2: Identify a profitable business
Return on equity is one of the best ways to measure the profitability of a business. It measures the returns a company earns on each dollar of equity invested, and a high ROE can be the sign of a competitive advantage. But remember, we care about growth in the context of value, so I like to look at ROE compared to the P/E ratio. As a ratio, I'm happy to see an ROE:PE of one or better. Getting a ratio of 1.2 or more makes me feel like I'm getting a chugging locomotive for the price of a Vespa.

According to my screen, there are 172 companies remaining that have an ROE:PE ratio greater than 1.2. So far, we've whittled down our universe of 6,000 stocks by 97%, but we need to go further.

Step 3: Health before wealth
We want to ride our GARP investment for the long haul, so we need to make sure we find a healthy company that can withstand economic cycles. To judge health, I look at debt levels and market cap.

  • Low debt: The less debt a company has, the more financial freedom it possesses to invest in new projects or share its profits. In addition, a company with high debt levels can report a great ROE, so we need to control for that. Although debt levels vary by industry, I stick to companies with a debt-to-capital ratio less than 25%.
  •  Proven business: While market cap isn't a perfect proxy for a proven business, it serves this purpose just fine for our screen. Stick to businesses that have a market capitalization greater than $250 million, indicating that they've been around long enough to have a proven product or business but still have room to run.

After adding these two criteria, a nice, round 50 companies remain. That's a reasonable number to look over and find candidates to further research.

Our candidates
Looking over each of the 50 finalists, here are five that caught my eye:

Company

5-Year Sales Growth

EV to EBITDA

ROE to PE

Debt to Capital

Market Cap (MM)

Gilead Sciences (Nasdaq: GILD  )

37.1%

6.0

4.7

9.4%

$29,990

Ross Stores (Nasdaq: ROST  )

11.2%

5.8

3.4

10.9%

$6,273

Darling International (NYSE: DAR  )

14.9%

5.9

1.3

10.1%

$679

Apache (NYSE: APA  )

10.6%

5.1

1.3

22.1%

$35,051

MEDNAX (NYSE: MD  )

15.4%

7.7

1.2

4.3%

$2,444

Source: Capital IQ, a division of Standard & Poor's.

Each of these stocks meets the GARP characteristics that I look for and deserves further research. Gilead's shares are likely on sale because investors question its drug pipeline and long-term patent position. Apache, on the other hand, has suffered from investors fleeing energy companies on the back of the Gulf oil spill and low natural gas prices, both of which may only be temporary bumps in the road. Darling International is a company that has been on my radar for a long time -- I love its dirty business and have been watching its transformation into a green company. Apparently Motley Fool Hidden Gems feels the same way, having recently recommended it as a portfolio candidate in its monthly newsletter.

But remember: Screening is just the start of the research process. Savvy investors still need to look deeper at the numbers and investigate criteria one can't screen for, such as the market opportunity going forward.

That said, I'll dig into each of these five names further as I seek out businesses whose growth that I can buy at bargain prices for my own portfolio. If you're interested in starting to use screens yourself, click here to check out our free Motley Fool stock screener.

Bryan Hinmon does not own shares of any company mentioned. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 12, 2010, at 1:03 AM, dgmennie wrote:

    The idea that you can gather existing data on corporate health and project it into the future as a helpful method to pick stocks is as old as the hills. The "desirable numbers" and their definitions shift around from decade to decade, but what are the results? If Bryan Hinmon could GO BACK IN TIME (to say some specific point in 1980 or 1990), run just his criteria on the corporate data that THEN existed, and compare his "picks" with what actually happened to the selected stocks (and the market in general), then we might have something (assuming the results moving forward were good). Instead, we are offered just another untested theory, a list of cadidate stocks, and the inevitable huge unknown of the future. Wanna guess what will happen in five years?

    Keep your day job.

  • Report this Comment On August 12, 2010, at 3:25 PM, TMF42 wrote:

    dgmennie:

    I think you are misinterpreting the purpose of this article. As I state in the first paragraph, the purpose is to screen to generate ideas. I go on to say in the final paragraph:

    "Screening is just the start of the research process. Savvy investors still need to look deeper at the numbers and investigate criteria one can't screen for, such as the market opportunity going forward."

    I tried to be as clear as possible there. I completely agree with you that financial performance will change, often dramatically, over the course of a decade. Screening is only the first step in the process, and since some people don't have access to good screening tools, I included some of the results from the tools that I have access to.

    Furthermore, please don't fall into the trap of thinking that a backtested strategy will continue its success going forward. It is pretty clear that further analysis of a companies competitive strategy and future prospects - together with the price paid and luck - are what will determine a successful investment or a poor investment.

    Lastly, these are not my "picks." They are simply the results of a screen to that satisfy an investing philosophy: GARP. Many people think GARP itself is bunk. I never suggested that GARP investing was right or superior, I was simiply trying to answer the question: "How do you find the stocks you recommend?" (see the first sentence).

    Best,

    Bryan

    TMF42

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