Exploiting durable inefficiencies in GARP stocks

Our approach as active managers is to try to add value in a variety of ways, from fundamental research to quantitative analysis to a superior asset allocation mix. One of the core tenets of our approach to active management is identifying and exploiting what we believe to be durable market inefficiencies—that is to say, market segments where the price of an asset doesn’t correctly reflect its value. In this piece, the second of a three‑part series, we examine a selection of these inefficiencies.

Fishing in the right pond

When we analyze the investable universe of U.S. large-cap stocks, we begin by eliminating names that have what we consider to be fundamental flaws—such as poor capital allocation and poor management teams. This process narrows the S&P 500 Index from about 500 stocks to approximately 125 that we think have better odds of outperforming over the long term. Within this narrower universe, we have often found that the most compelling opportunities have several factors in common, and we define these companies as growth-at-a-reasonable-price (GARP) stocks. This segment of the market has generated significantly higher cumulative returns than the broader market over the last three decades (Fig. 1).

Our analysis demonstrates that these stocks have not only generated better absolute returns, but they have also tended to trade at a discount and grow earnings faster than the broader equity market. They have also outperformed the S&P 500 Index across a wide range of market environments. In all, we think these companies make up only about 10% of the S&P 500 Index. As we look at the ocean that is the investable universe, we believe strongly in casting our line into the pond of GARP stocks.

Trading at a discount

When we say a stock is trading at a discount, we mean simply that it is trading below the value we believe is indicated by the company’s underlying fundamentals. One key measure we consider in evaluating the fair value of a company’s shares is its next 12-months’ price-to-earnings ratio (NTM P/E). By dividing the price a stock is trading at today by the projected earnings of the company over the next 12 months, based on consensus estimates, we arrive at the company’s multiple. As an example in practice, an NTM P/E ratio of 15x tells us that the price of a stock today is 15 times its projected earnings per share over the next 12 months. This multiple gives us a key point of comparison for a company relative to its competitors, its sector, and the market.

Part of what makes GARP stocks so attractive to us as portfolio managers is that the multiple for this market segment is consistently and meaningfully lower than the broader market. Put simply, we believe we are paying less for future earnings when we are buying these kinds of stocks (Fig. 2).

Placing a premium on profitability

Another key measure of corporate fundamentals that separates GARP stocks from the broader market is return on equity (ROE). ROE measures the net income reported by a company relative to its shareholder equity to provide a view of profitability, where a higher ROE represents greater profitability. While only one measure, a high ROE can indicate that a company allocates capital effectively and is likely to generate excess returns that can create shareholder value through reinvestment, stock buybacks, and dividends. GARP stocks have typically offered a significantly higher ROE and typically lower earnings variability than the equity market (Fig. 3). Considering these factors, we think GARP stocks are an opportunity to buy shares of more profitable and better managed companies at a material discount.

GARP in action

Companies that we find fit our definition of a GARP stock are often not household names. One such example is Danaher, which we own in the Capital Appreciation Fund, Capital Appreciation and Income Fund, and Capital Appreciation Equity ETF.¹ Danaher is a medical and industrial conglomerate that has leading positions in life sciences tools and diagnostics. While Danaher has not offered the explosive growth we have observed from names in semiconductors or software, the stock has had more consistent earnings growth and been less volatile than the broader market over the last decade.² These attributes are central to our focus on GARP stocks. In Danaher, we see a company that has tended to allocate capital exceptionally well, through acquisitions of companies that had faster organic growth rates than their core business, for example. We also have seen that management has focused on investing in research and development to drive future growth, increasing market share and improving margins, and divesting noncore businesses. These actions supported profitability over the long term and are the types of behaviors that tended to create shareholder value.

Durable inefficiency

In the funds we manage,³ investing in this segment of GARP stocks is a core tenet of our investment process and a key way in which we seek to generate alpha. We think this inefficiency has continued to exist because there is no natural buyer for GARP stocks, which has allowed us to typically purchase these stocks at a discount.

• In the same way that we narrow the broad equity market to names that fit our investment style, growth investors are seeking names with particular characteristics that fit their growth orientation. These characteristics may include double‑digit revenue or top-line growth, or mid-teens or higher earnings per share growth. GARP stocks, which tend to have lower but less volatile growth rates and earnings, are not likely to meet the mandate for growth investors.
• Value investors similarly narrow their universe in ways that are likely to exclude GARP stocks. For example, when many names in value sectors, such as financials and energy, trade at a multiple of 11x–13x, GARP stocks trading at a multiple of 16x–22x are likely to represent an untenable premium for value investors.
• Similarly, many hedge fund investors and, interestingly, retail investors, tend to prefer names with significantly higher growth and more upside potential than GARP stocks, as these investors often tolerate greater volatility for the chance at greater near‑term returns.

Risk and return

Given the discount we have observed for these stocks, and their demonstrably higher ROE, it follows that these stocks would tend to perform better than the broader market over longer time periods. What makes them even more attractive to us, as portfolio managers, is that GARP stocks have generated not only better absolute returns, but better risk‑adjusted returns (as measured by the Sharpe ratio from 1990–2024).

Confidently contrarian

As portfolio managers, we are willing to go against consensus, question commonly held assumptions, and follow through on our research and process. Identifying and investing in GARP stocks offers one such opportunity to go against the grain and pursue attractive risk-adjusted returns in an area we think the market underappreciates and misunderstands. Through fundamental research, taking a longer view, and asking the right questions, we are committed to uncovering opportunities that can add value for our shareholders.

Since 1990:

• The Sharpe ratio of GARP stocks is 0.66,⁴ compared with a ratio 0.47 for the S&P 500 Index,⁵ indicating better returns and less risk.
• GARP stocks have experienced 17 percentage points less downside than the S&P 500 Index.⁶
• The average drawdown⁷ for GARP stocks was less severe than for the S&P 500 Index, and also took less time to recover. From trough to the previous peak, GARP stocks recovered in 54% of the time it took for the S&P 500 Index to similarly recover.⁸
• GARP stocks also tended to outperform during periods of market turmoil and drawdowns.
  • When the dot-com bubble burst in 2000 and 2001, GARP stocks outperformed the S&P 500 Index in those years by 28 and 17 percentage points, respectively.
  • During the global financial crisis in 2008, GARP stocks again outperformed the S&P 500 Index by 12 percentage points for the calendar year.