B400: Your Weekly Newsletter from the Barron's 400 Index.

GARP: From Theory to Practice

Federal Reserve Chairwoman Janet Yellen spooked the stock market on Wednesday by suggesting the six year-long stock market rally may be getting long in the tooth, stating that equity valuations “at this point are generally quite high,” during a conversation with IMF Director Christine Lagarde in Washington D.C. This was a reprise of her remarks last July 15 when, in a Fed biannual report, she said, “valuation metrics in some sectors do appear substantially stretched, particularly those for smaller firms in the social media and biotechnology industries.” At least this time she refrained from calling out specific industries or market segments, perhaps mindful of how markets reacted last year. We thus have, once again, the head of the world’s most powerful central bank inserting her opinion into the ongoing discussion about stock market valuations, which, really, have been front and center in investors’ minds for the better part of two years. A discussion worth having, we would agree, but one where we believe there is an element largely absent: growth.
A report on Ms. Yellen’s recent remarks must inevitably include a reference to the S&P 500’s price to earnings ratio, which is often (and correctly) cited against a historical backdrop. Dutifully, the financial media has reminded us that the S&P is trading at 17.5 times trailing earnings, a premium to the historical average of about 15.5 and roughly a point above where it was almost a year ago when the Fed’s Chairwoman last discussed the subject. Conclusion: the stock market today is more expensive than it has been in the past. We, of course, feel compelled to opine and, as you may suspect, we’ll do so from the perspective of the Barron’s 400 Index. When Ms. Yellen last spoke about stock market valuations in 2014, B400’s constituents traded at average and median trailing P/Es of 21.3 and 19.5 respectively. A year later, despite having gained 7.8% since July 15 of last year, B400 trades at average and median trailing P/Es of 21.7 and 19.1. Hmm. How would you explain this? Our answer, you guessed it, is … GARP.
You see, the way B400 is constructed varies quite a bit from the S&P 500, which is, essentially, a collection of the country’s largest stocks by market capitalization. Nothing new to most of our regular readers but nevertheless a good reminder of the difference between price and value, as Ben Graham once said: “Price is what you pay; value is what you get.” How is this relevant to B400 and GARP? Well, going back to investors’ concerns about current stock market valuations, most casual observers rightfully worry about the S&P’s current P/E if they expect there to be no growth in that ratio’s denominator. Without earnings growth, higher prices are difficult to justify. And with most S&P 500 companies having already reported first quarter earnings, the news is less than encouraging: their earnings last quarter grew basically zero percent from 2014. B400 companies, on the other hand, were on pace to report a median gain in earnings per share of 8.45% over the 2014 period, as our own John Prestbo recently reported in his B400 Diary. This is why B400 usually sports a higher P/E ratio than the S&P 500; it is buying growth at a reasonable price.
MarketGrader’s fundamental analysis research system, responsible for selecting the companies in B400, is what we would call ‘elastic’ in measuring companies’ valuations. Rather than labeling a stock cheap or expensive because its P/E ratio is below or above a certain number, from an earnings perspective, we measure the stock’s valuation based on its earnings growth. In fact, our system includes an adaptation of a Ben Graham formula in which we incorporate a company’s growth rate and the market’s risk free rate of return (much lower today than in Ben Graham’s days in no small part thanks to Ms. Yellen) and calculate what we call an “Optimum P/E Ratio.” This refers to the valuation we believe could be justified for that company based on its earnings growth rate. We then compare its forward (12 months) P/E to this Optimum P/E and depending on the premium or discount, assign a grade. And this is only from an earnings perspective. The rest of MarketGrader’s Value grades include other valuation multiples that look at price relative to sales, cash flow, book value and operating income, all measured using different methodologies. The bottom line is that our value analysis, while strict, isn’t done in a vacuum. Growth is very much a part of it. This is part of our GARP approach.
Value, of course, is only one of four aspects of a company’s fundamentals that MarketGrader evaluates. The other three are Growth, Profitability and Cash Flow. If a company falters in any of these its grades will suffer and it is thus unlikely to make the mark to be included in B400. Profitability and Cash Flow measure, some would say, quality. A company that doesn’t make any money or is poorly run is unlikely to receive a high grade, regardless of how much it grows or how cheap it is. We have written before about the interplay between Growth and Value (see The Barron’s 400: Growth or Value Newsletter from November 9, 2013), which is a topic that has resonated with many of our readers and clients and one on which we keep getting plenty of questions, so we figured we’d address it again today in the context of where B400’s valuation stands as well as to add more color to our GARP approach to investing.
As described in the Newsletter cited above, MarketGrader’s 24 fundamental indicators are aggregated into a final numerical score between zero and 100. B400 companies today have an average MaketGrader fundamental grade of 68 while all companies in the U.S. stock market average 45. No surprise there. By blending fundamental indicators across Growth, Value, Profitability and Cash Flow, we adhere to a growth-at-a-reasonable-price investment philosophy where we also ensure companies are run in the best interest of their shareholders (the quality part of the analysis). Besides calculating an overall grade across all four categories, we calculate two more in order to measure whether a company is a growth or a value stock. In each one, we simply dial up the weight assigned to Growth or Value, dial down the weight assigned to the other and maintain significant weights for Profitability and Cash Flow. When a company gets a higher overall ‘Growth’ grade, we consider it a growth stock and vice versa for Value. We use these grades mostly for informational purposes and to break down our coverage universe into growth and value. We also use them to analyze the breakdown in B400 companies between the two styles.
In B400’s most recent rebalance, on March 20th, MarketGrader selected 187 companies with dominant growth characteristics (46.8%) and 202 with dominant value characteristics (50.5%). The remaining 11 didn’t tilt one way or the other. Examining the growth and value traits of each group relative to those of the entire B400 set offer a great illustration of GARP at play within the index. For example, all ‘growth’ components had an average trailing P/E of 26.6 while the average for all ‘value’ components was 17.3. Not surprisingly, all ‘growth’ companies traded at an average premium of 22.1% to their Optimum P/E while all ‘value’ companies traded at an average discount of 16.8% to theirs. Not surprisingly, ‘growth’ companies sported three-year average sales and operating income growth rates of 198% and 121%, respectively, compared to 42% and 60% for the ‘value’ group. The table below displays how these and other characteristics in each group compared relative to all of B400 at the March rebalance.

  Growth Group Value Group All Companies
Number of Companies 187 (46.8%) 202 (50.5%) 400
Trailing P/E 26.6 17.3 21.7
Forward P/E 26.6 18.6 23.0
Optimum P/E 23.8 23.8 24.5
Discount/Premium to Opt. P/E 22.1% -16.8% 3.8%
Avg. EPS Growth Rate 35.6% 32.8% 35.4%
Avg. 3Yr. Sales Growth Rate 198% 42% 114%
Avg. 3Yr. Op. Income Growth Rate 121% 60% 89%
Avg. Overall Grade 70.4 68.9 69.7
Avg. Overall Growth Grade 74.1 64.3 69.1
Avg. Overall Value Grade 62.5 76.5 69.8
Avg. Growth Spread 11.6 -12.1 -0.7

Such a nice and tidy analysis notwithstanding, pragmatic investors may be asking: at current valuations, is B400 “stretched” as Ms. Yellen [not] so subtly put it? As many of our answers go, it depends. Mostly, it depends on whether companies in B400 can sustain growth rates in their businesses that are generally higher than those for, say, S&P 500 companies. Much of this will depend on whether the U.S. economy can get back on track after a poor GDP showing in the first quarter and whether it can get a little more help form other parts of the world. In the long term, our bet is things will be just fine, but what about in the next year or two? A good illustration might be found among the roughly 10% of companies currently in B400 that have been selected to the index at least eight consecutive times, or a minimum of four years in a row. More specifically, how have their stocks done since they were first selected to B400 and at what valuation did B400 ‘buy’ them? Of the 42 companies that have been selected at least four consecutive years to B400, seven have been in it at least seven years in a row and 29 at least five. The average cumulative gain in their share price has been 244% and the median cumulative gain has been 159% since entering the index. A more appropriate measure, however, has been how much they have gained on average per year since their tenure varies. The answer is 41.9% with a median yearly gain of 31.5%. Most relevant of all, though, to our GARP analysis is how these companies were valued when B400 first selected them (in their current unbroken run as members of the index). Their average and mean trailing P/Es on the month they were selected were 22.1 and 20.8 respectively, in fact higher than the 21.7 and 19.1 average and median P/Es, respectively, for all of B400 when it was last rebalanced in March. History, indeed, doesn’t repeat itself. But it often rhymes.

Companies With at Least Eight Consecutive B400 Selections
Ticker Company Name First 
Selections* Cum.
Avg. Gain
Per Year
WMT WALMART STORES INC 3/19/04 26.5 23 42.17% 3.67%
MSFT MICROSOFT CORP 9/16/05 22.2 20 64.38% 6.44%
AAPL APPLE INC 9/15/06 26.5 18 1101.72% 122.41%
GOOGL GOOGLE INC 3/16/07 46.4 16 156.24% 19.53%
CTSH COGNIZANT TECHNOLOGY SOL. 9/21/07 39.5 16 236.97% 29.62%
PCLN PRICELINE GROUP INC 3/21/08 34.8 15 895.68% 119.42%
BKE BUCKLE INC 9/19/08 16.9 14 25.61% 3.66%
APEI AMERICAN PUBLIC EDUCATION 3/20/09 43.2 13 -23.39% -3.60%
DLTR DOLLAR TREE INC 3/20/09 16.9 13 509.02% 78.31%
NUS NU SKIN ENTERPRISES INC 3/20/09 10.2 13 530.26% 81.58%
UNH UNITEDHEALTH GROUP INC 3/20/09 11.2 13 477.02% 73.39%
RMD RESMED INC 3/20/09 24.0 13 347.68% 53.49%
BBBY BED BATH & BEYOND INC 9/18/09 21.2 12 91.73% 15.29%
PII POLARIS INDUSTRIES INC 9/18/09 10.6 12 575.85% 95.97%
SHOO MADDEN STEVEN LTD 9/18/09 12.4 12 245.74% 40.96%
CMG CHIPOTLE MEXICAN GRILL INC 9/18/09 26.8 12 633.79% 105.63%
TSCO TRACTOR SUPPLY CO 3/19/10 17.2 11 494.97% 90.00%
MA MASTERCARD INC 3/19/10 22.9 11 265.57% 48.28%
DLX DELUXE CORP 3/19/10 7.6 11 247.64% 45.03%
FFIV F5 NETWORKS INC 3/19/10 42.4 11 86.91% 15.80%
FOSL FOSSIL GROUP INC 9/17/10 12.5 10 63.02% 12.60%
HD HOME DEPOT INC 9/17/10 16.2 10 288.32% 57.66%
ROST ROSS STORES INC 9/17/10 12.5 10 294.66% 58.93%
NKE NIKE INC 9/17/10 17.6 10 162.65% 32.53%
BEN FRANKLIN RESOURCES INC 9/17/10 13.8 10 52.33% 10.47%
MKTX MARKETAXESS HOLDINGS INC 9/17/10 22.6 10 424.94% 84.99%
PRAA PRA GROUP INC 9/17/10 19.1 10 144.28% 28.86%
UNP UNION PACIFIC CORP 9/17/10 15.4 10 182.09% 36.42%
EMC EMC CORP 9/17/10 26.0 10 27.61% 5.52%
LOPE GRAND CANYON EDUCATION I. 3/18/11 20.4 9 211.50% 47.00%
CPSI COMPUTER PROGRAMS & SYS. 3/18/11 27.2 9 -9.81% -2.18%
BWA BORGWARNER INC 3/18/11 23.5 9 62.61% 13.91%
QCOM QUALCOMM INC 3/18/11 22.9 9 35.50% 7.89%
EGOV NIC INC 3/18/11 33.5 9 54.07% 12.02%
M MACYS INC 9/16/11 11.9 8 136.63% 34.16%
RGR STURM RUGER & CO INC 9/16/11 13.9 8 58.82% 14.70%
ULTA ULTA SALON COSMETICS & FRA 9/16/11 42.9 8 117.40% 29.35%
CACC CREDIT ACCEPTANCE CORP 9/16/11 13.1 8 202.29% 50.57%
CBOE CBOE HOLDINGS INC 9/16/11 20.0 8 117.93% 29.48%
JBHT HUNT JB TRANSPORT SERVICES INC 9/16/11 26.2 8 122.04% 30.51%
NSR NEUSTAR INC 9/16/11 12.6 8 -14.46% -3.62%
MANH MANHATTAN ASSOCIATES INC 9/16/11 23.6 8 485.38% 121.35%
    Mean 22.1 11.4 243.5% 41.9%
    Median 20.8 10.0 159.4% 31.5%
*First time selected and number of selections to B400 without interruption to date.


The latest B400 Diary entries by John Prestbo:

B400 Companies Predicted to Deliver Strong 1Q Results
Investors worried about lackluster first quarter profit and revenue results must not be thinking about companies in the Barron’s 400 Index. They are expected to report healthy increases from year-before levels.


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