David Kuo talks to Jane Coffey from Royal London Asset Management.
You can listen to or download this podcast here.
David:
This is Money Talk, the weekly investing podcast from The Motley Fool. I am David Kuo, and my question today is, how to invest in companies that are not only growing quickly, but are cheap too. This seemingly too good to be true investing strategy does exist, by the way. It's called GARP, or Growth At A Reasonable Price, and my guest today is a GARP expert. She is Jane Coffey, Head of Equities at Royal London Asset Management. Welcome to The Motley Fool, Jane.
Jane:
Good afternoon.
David:
Good afternoon to you. Now, GARP, apart from sounding something like bad indigestion, also sounds a bit like flying in a Lear jet, but only paying Ryanair prices. How does GARP work, Jane?
Jane:
Well, I think fundamentally I want to invest in growth, but one of the things that goes wrong when you invest in growth is that you pay too much for it. And so this is a good discipline to be looking for growth that is still reasonably priced, so that there is still some ability for the market to re-rate.
David:
But aren't you just sort of looking for the Holy Grail? I mean, you want growth, and you want it to be cheap as well – it doesn't exist, does it?
Jane:
Well, I think it does. I think you'll find, from the stocks that we're looking at today, if you really, particularly at the moment, if you look out in the market, there are a lot of very good quality stocks that are trading really at growth at a reasonable price, around the market multiple or slightly more than the market multiple.
David:
Which is around, what, 14 or 15 at the moment?
Jane:
Yep, in fact probably less than that. I'd say the large cap market multiple right now is around 12 for prospective earnings.
David:
So how do you relate the market multiple, in other words, the P/E ratio, to the growth? How are these two things connected in any way that would allow you to say, this is a GARP share?
Jane:
Well, we have something called a PEG ratio as well.
David:
A PEG ratio?
Jane:
Which is the Price Versus Earnings Growth. So if you have a PEG ratio of less than one, so your P/E and your growth rate, you look at your P/E of 12, and if it's growing at 12% or more, then that would be a PEG ratio, at 12% it would be a PEG ratio of one. If it was growing at 6%, then it would be a PEG ratio of two. If it was growing at 24%, it's a PEG ratio of 0.5. So I'm looking for stocks that are generally growing, with a PEG ratio of above one.
David:
So you just simply take the P/E ratio, and you divide it by the earnings growth rate -- in other words, how quickly the earnings are growing?
Jane:
That's right.
David:
So tell me about this PEG ratio then, Jane. How does it actually work?
Jane:
Well, the PEG ratio is looking at what price you're paying for the earnings growth that you're getting, and the sort of stocks that I want to have should be growing greater than the average of the market. So if we say at the moment the average of the market, earnings growth for this year, is pretty high, because it's a recovery year. So it's going to be difficult to get all your PEG stocks growing more in the market, but what I'm really looking at is medium term earnings growth. So if you look at medium term earnings growth in the market, it's very rarely more than about eight or nine. So I would like to be investing in stocks that are generally, have a medium term earnings growth of around 10 or 11.
David:
In other words, you don't want to be too greedy, do you?
Jane:
No. That's where you'll get the better GARP stocks, rather than looking for something that's got growth of 50% for a year and is a very small company, you're still not going to really be prepared to pay 50 times earnings, because that 50% is very rarely going to be continual.
David:
OK, so are there are any particular sectors that are more GARPish, if there is such a word, than others?
Jane:
Well, I think your standard growth sectors would tend to be within technology, within perhaps healthcare, pharmaceuticals, the less cyclical areas of the market. However, at the moment I think that there are quite a lot of structural but economically sensitive companies that are coming out with very good growth numbers.
David:
So are you saying there's a particular time in the economic cycle when you're going to get more GARP stocks then?
Jane:
I think that using a GARP style actually helps you all the way through the economic cycle, because during the downturns in the economic cycle, when all companies are losing money, actually what you want to have is companies that are much more defensive, that have much more resilient earnings. So say, in 2008, the sorts of companies that outperformed the market, and kept your money relatively safe, were the pharmaceutical companies, and the food companies. Now, these companies didn't have particularly strong absolute earnings growth, but relative to say a mining stock that was seeing its earnings fall by 30%, it was a very good place to keep your money in the market.
So at that point in the cycle, you're getting stocks that don't have earnings downgrades, and have quite low earnings growth, but it's much better than the negative falls in earnings you're getting across the cyclical sectors. In the growth phase of the market, so in the recovery phase in the market, so like now, we have lots of companies that, over the last six months or so, are beginning to show very dramatic returns to profits from big falls in profits. Now, you wouldn't extrapolate that and say, well, OK, it's making 24% more earnings this year, and then I expect it'll be 20% the next year and 20% the next year.
You know that that's going to flatten out. So at that point, you're looking much more for this medium term earnings growth, rather than just today's short term earnings growth. So then, your growth at a reasonable price is helping you if you look for the medium term growth, rather than just this year's earnings.
David:
OK. I know one of your top picks at the moment, in terms of GARP stocks, is Compass (LSE: CPG), so can you point me in the right direction for Compass, please?
Jane:
Well Compass is a very interesting stock. It has been a good performer now in the market for the last couple of years, since new management came in, and they have done a great transformational job at this company. Compass as a contract caterer, has a few different businesses. Primarily it works at schools and healthcare, hospitals.
David:
You mean they make school dinners? And hospital food?
Jane:
Absolutely, doing the dinners, the canteens. It also does a lot of that sort of catering in companies, so the big corporate canteen would also be involved in that. But it has a sports and leisure business, which is very much your corporate entertainment side, and that was hugely cyclical obviously during the downturn.
David:
They obviously don't give these people the same food as they give to schools, do they?
Jane:
They definitely change the food, depending on who is going to be eating it, and they obviously change the price a lot, depending on who's eating it. So in fact their sports and leisure side is a much higher margin, because they have much higher priced food. It's a completely different sort of set up, to be able to do Ascot one week, and Wimbledon the next week.
David:
And not to get too confused, and sort of bring out the fish and chips for Ascot?
Jane:
What the CEO, the new CEO, has been doing is really re-engineering the whole business. So once you've seen employment go down, that would make this quite a cyclical business, so there's less people coming to lunch in the corporate canteen. He has worked out that in fact there's a lot of people that you had in there that you really didn't need to have, if you moved the way things were done around. They really focused on the cost cutting, both from a personnel perspective, but also from buying and that kind of thing, and they kept the margin up.
Now you're beginning to see employment go back up again, you're really beginning to get quite a lot of leverage on that. So your top line is going up, but they've actually found that their capacity is still there, with their current workforce, and that is adding to margins. So their margin has gone up by over 200 basis points over the last two years.
Now that they've got into this whole focus on how you do things better and how you improve at every step of the equation, they realise that they've only just got going, and they're even more optimistic about how they can cut the costs and improve the efficiency of the operation now than they were two years ago, when they started. So rather than thinking, oh the low hanging fruit has already gone, we're now more confident that they've got another 200 basis points to go over the next two or three years.
David:
What is it that makes it a GARP stock then?
Jane:
Well, what makes it a GARP stock is that it has been growing earnings, double digits, for all the way through this downturn, and we expect that to continue to be even more sort of 15% or so over the next two to three years, as we get the recovery coming in from those areas of the business that were under pressure from the economic sensitivity, but also as we get them continuing to expand in many of the underdeveloped areas. So you may think that school dinners and hospital canteens have all been outsourced. That's not actually true, that's still a growth area, and that should be structural growth rather than cyclical, because it is about providing, in this time of austerity that we're expecting from a government perspective, if you can outsource and get the provision of these school meals at a lower price, that's a much better deal for the schools, and it will be more attractive.
David:
Even if the food is slightly inedible, as far as children are concerned?
Jane:
Actually, generally the quality of school meals has been improving.
David:
I know you're going to defend Compass. The thing is, are you saying, I originally thought that GARP was only focused on numbers. In other words, you're looking at a P/E ratio and you're looking at the earnings growth, but from what you're saying now is that you're also looking at these companies from a top down angle as well, so you're trying to look for a story as well as a number?
Jane:
Well, I think so, because in order to look at the numbers, and to believe the numbers, you have to understand what's going to make that number happen. So the market forecast for earnings growth might be 15%, but I want to be comfortable that I understand how they're going to get there. So if they've got a 7% top line growth, and then they've got a margin improvement coming through, and you can understand from the management strategy how that margin is going to come in, then you're going to be much more comfortable about getting to those earnings. It is very important to know what the macro background is, what the top down background is, because that gives you more confidence about the trends that are going to be helping or hindering your companies that you're investing in.
David:
OK, now one aspect of macro policy that you can't possibly ignore right now is what's going on in Australia, in other words, this thing called the resource super profit tax, or the windfall tax on mining companies. Yet despite that, you're still quite happy to tip a mining company as one of your GARP stocks. How do you justify that?
Jane:
Well, the effect on the stock prices of the introduction of the resource tax ...
David:
The super tax, yeah.
Jane:
... the potential introduction of the resource tax, the stock prices have fallen quite a long way, and therefore are already reflecting the effect that that will have on earnings. So on a growth at a reasonable price, if the price has come down, even though the growth has come down somewhat, you're getting a much better package, all in all. The reason that I like the growth though, for Rios in particular, is that it is a company that has much more exposure to iron ore pricing, rather than some of the other metals and mining companies. Iron ore is used in steel, but it's one of the few metals that is not traded extensively on an exchange. So there's not much speculative demand in iron ore, iron ore is bought purely by the end users, and therefore if there is tightness in the market, you can be much more confident that that is true tightness, and not market speculation and people hoarding iron ore.
David:
Yeah, so you think it's a boring commodity?
Jane:
So it's a boring commodity, but it's a commodity whose price is going up quite rapidly at the moment, and that is because of the demand and supply situation. The pricing power is really moving towards the producers of iron ore. They always used to have one year contracts, recently it's moved to a quarterly contract basis, and when your prices are going up, that's quite a good thing, if you renegotiate every quarter, because it keeps them going up with the spot rate, rather than having you locked in at last year's price.
David:
So reading between the lines, Jane, I'm assuming from what you're saying is that growth in China will carry on going, and that China will keep on sucking in iron ore from Rio – is that correct?
Jane:
Absolutely. I believe that China does have structural growth, and that we have seen a slight slowdown in China coming through on the leading indicators, but that was engineered by the Chinese government, because the economy was overheating. It was growing at well over 10%, and that was just too fast. What they've done is, they've managed to stabilise it, and make it grow around 8 or 9% for this current quarter. Now, this is very strong rates of growth, and this is the sorts of rates of growth that any developed nation would give its eye teeth for at the moment. So, although China is, people have worried about China slowing, it's not slowing so much that demand for iron ore is going to fall off a cliff, and because there can't be those kind of speculative bubbles in iron ore, you know that it is end demand that has kept the market tight.
David:
OK. Now, when I knew you were coming in, Jane, I flagged it up on one of our discussion boards – the growth at a reasonable price discussion board, and I told them you were coming in, and asked them if they had any questions, specific questions for you. Lee emailed me, and he wanted to know specifically if you have any proprietary technology plays that you quite like in terms of GARP?
Jane:
Well, I think one of the stocks in the portfolio that I've been holding for the last couple of years has been a company called Spirent (LSE: SPT), and that has very strong technology. It's first or second in its markets, and their markets are telecoms testing equipment.
David:
It was a dot-com share though, wasn't it, Spirent?
Jane:
It was, and a lot of dot-com shares were very over-valued during dot-com, when the sky was the limit as to what that growth was going to be, but now this is very much priced around the sort of 15 times earnings, and it has good, strong underlying earnings growth that is coming from the trend towards smartphones. Smartphones, as we know, the Apple iPhone, all the different smartphones that are ...
David:
I haven't got any of those, by the way, Jane.
Jane:
... out and about on the market.
David:
I haven't even got a BlackBerry.
Jane:
They are ...
David:
The bee's knees?
Jane:
They're the bee's knees, but they're very complicated pieces of equipment that do all kinds of things with the network. So the signalling that the network needs to do, the applications that are on it – there's a lot more that has to work all from one piece of kit. So every time that a manufacturer introduces a new piece of kit, it has to be tested across all the different networks, and make sure that all the applications work. So the more data, the more complex the usage of these phones, the more that Spirent has to have a full range of testing equipment that it supplies to those manufacturers, so this is a very strong growth market for them.
David:
So that's Spirent, so I know you have another company that you quite like, and that's called IMI (LSE: IMI). Now what exactly do they do?
Jane:
IMI do a vast range of valves and precision technology.
David:
You call them valves, but don't they also make those optics that you find in bars and pubs?
Jane:
The drink dispenser spouts?
David:
When you ask for a shot of whisky?
Jane:
They do.
David:
Isn't that also IMI?
Jane:
That is also IMI. That is one of their slightly less high tech elements ...
David:
But a more interesting part of their business.
Jane:
... but something that's much easier for us to picture and understand. The things that they do that are very high tech is very much in their highly critical applications for the nuclear and process industries. There you have to get all your valves and your measurements very very accurate, and they have a very strong ...
David:
I think you need to get the shots of whisky pretty accurate as well!
Jane:
... market share in that area. So particularly with nuclear power, that is now becoming another one of those big strong structural growth stories, because whereas nuclear power was a complete no-no ten years ago, and it was the most environmentally-unfriendly technology, we're now looking forward, and we're beginning to see that, because of carbon emissions, that actually nuclear, which has no carbon emissions, is now perceived as perhaps not environmentally-friendly, but certainly on a par with some of the others, and it's got good and bad sides.
There is a big nuclear expansion, particularly in China, where they're having to build a huge number of power stations to keep going on this 8 to 10% GDP growth. So at the moment, China is planning to increase its nuclear power six-fold over the next ten years. The parts that IMI would provide to a nuclear power station is five million dollars or 250 million dollars within a power station. So they're not constructing the whole thing, they're not doing nothing actually on the uranium or the core nuclear technology, but they're doing all the measuring of valves, all the linking parts, and that's where they're going to get their growth from.
David:
So they're playing a huge part, even though it's a small part, within a big project?
Jane:
Exactly.
David:
OK. Now I know you have another couple of stocks that you would like to talk about. One of them that caught my interest was Holidaybreak (LSE: HBR). Now, how can you justify a campsite operator as being a GARP share?
Jane:
Well, Holidaybreak has diversified out of just being Eurocamp and ...
David:
It's no longer Sid James and Barbara Windsor any more, is it?
Jane:
It's not, and in fact actually those campsites are very different than the Carry On Camping images that you had from the 1960s and '70s. I mean, these are campsites that are now much more mobile homes, sort of static mobile homes or chalets on big parks with restaurants and swimming pools and that kind of thing ...
David:
It sounds great.
Jane:
... over in France, so very much the family market. It's the kind of affordable quality end, they're not expensive holidays, but they also allow you to have the option to drive, take all the kit that you want to go, take the tunnel rather than having to fly. So they're actually doing pretty well during this whole concern about what's going on with the volcanoes, and what's going on with British Airways going on strike, and people generally being a little bit nervous about whether they are going to get their flights, if they book their major family holiday.
So that area of the business, however, is not really a growth area – that is the area that is providing the cash. The growth area is coming from a new business that they got into two or three years ago, when they bought PGL. Now, anybody that's got children probably realises that PGL are the people that have done activity holidays for children, and now are very much involved in providing the activity centres that the kids go to with their class when they go on the class trips for a week to go white water rafting, or activity ...
David:
Outward bound courses and things, yeah?
Jane:
... outward bound courses, and that kind of thing. This really has been a very big growth market within the UK. When I was at school, we used to go on a day trip to Hadrian's Wall, or something, and we lived about 30 miles from Hadrian's Wall.
David:
Lucky you, Jane – I didn't have anything!
Jane:
Now they go away for a week's skiing, or into the Cotswolds, as you say, and do walking and mountain climbing, and all these kind of things. But the thing about these PGL centres is that they are, there's obviously a lot of regulation in health and safety, to ensure that having a lot of children in the same place, that it's very safe, and yet it's got to have the adventure element, because the point is about educating children to push the boundaries, and to sort of learn in a safe but challenging environment.
David:
But is there not a danger, Jane, that as a result of the government austerity measures, that these kind of companies are going to be quite vulnerable? If they start cutting the education budget in any way, this could be one of the areas that go?
Jane:
Generally, these trips are not subsidised, they're actually paid for directly by the parents.
David:
Tell me about it!
Jane:
The reason that in fact having somebody like PGL doing it, they are tending to replace the centres that had previously been run by the local authorities. So it is indeed true that the local authorities are beginning to close their centres, because they haven't been able to operate them profitably, whereas somebody like Holidaybreak can come in and offer them a much better equipped centre, and it's no longer a cost to them, it's actually replacing the costs that they had. So I think it is a growth area, even in these times of government austerity.
David:
Right, the final company that you have is IG Group (LSE: IGG). Now, this is one company that I can visualise as being a high growth, reasonably priced company, but apart from that, are financial companies the kind of things that people want to be in at the moment?
Jane:
I think financial companies vary a great deal between what you're actually buying, and what the influences on them are. Now we're currently still underweight the banking sector, we're still worried about the recovery in banks, and that in fact ...
David:
You and the rest of the world, I think, yes.
Jane:
... indeed, and in fact their deleveraging of their balance sheets means that they're not really going to be growth companies, as soon as they've recovered from being loss-making companies. However, something like IG Group, which is a spread betting company, that is still a very immature market. I mean, the UK actually has one of the more mature parts of this, but IG Group's still seeing 8 to 10% growth in its top line, in its UK market, but in lots of other countries, the regulation hasn't allowed this to happen yet, and so there are still new markets opening up, and IG Group's in a perfect position to go out and exploit that, and move into new markets. The other thing that is very good for IG Group is volatility in markets, so the time when people are attracted to spread betting tends to be when the markets are going up and down a lot, because that's when you could make more money by day trading.
David:
Just like now, yes?
Jane:
Exactly. So they have had fantastic numbers over the last couple of quarters, because there's a lot of opportunity to make money from day trading, or lose money in fact, but they don't mind whether you make it or lose it, because they just want to have the volumes going through.
David:
And they also trade in currencies as well, it's not just stocks and shares, is it?
Jane:
Absolutely, yes. They do either you a contract for difference, which would be more of an investment style, or they even have some sports betting.
David:
Now then, my final question for you, Jane, and this is one that people accuse me of time and time again. They say, David, you're very good at getting guests on, telling us to buy this, buy that, buy the other, but my question for you today, Jane, is this. When you buy a GARP share, how do you know when is the right time to sell it?
Jane:
Well, I think of the things that I spend a lot of time making sure of, apart from those first things that we've said – do we understand where the growth is coming from? – that's the key first thing. The second thing is, is the market still not up to speed with how fast this company is growing, and is the growth still sustainable, or is it rolling over? The last thing you want to hold is a company which people are anticipating it's going to grow at 15%, and it actually grows at 10%, because not only do you get the downturn from the earnings have disappointed, you actually get the rating coming down as well. So you might pay 15 times a stock trading with 15% earnings growth, but you're going to pay ten times for something with 10% earnings growth. So you're getting not just that 5% gap of the earnings having disappointed, but you're also getting the big gap of the de-rating of the stock. So I spend a lot of time checking that the earnings growth is still being revised upwards, and as soon as it starts looking like it's rolling over, and it's being revised down, then you want to start getting out of the stocks.
David:
So in other words, you're looking at the earnings growth, rather than at the P/E ratio itself?
Jane:
Yes.
David:
And when you think the earnings are going to start tapering off, then that's the time to go out?
Jane:
Yes, because in many cases, growth investors, running your winners is a very good strategy. What you want to do is run your winners until the growth starts tailing off, and that's when you get nervous.
David:
Does that mean also that you're not really that interested in the yield at all?
Jane:
Because it's growth at a reasonable price, I would expect the companies generally, particularly all these ones that we've talked about today, they're strong cash-generative companies, and you're looking for a yield, but you're looking for a growing yield. So they don't have to be a premium yield to the market, but you would hope that their yield is actually growing along with their earnings growth, so that you're probably getting 10 or 15% upping of your dividend every year, as well as from the earnings growth.
David:
So in terms of GARP investors, if people wanted to read about great GARP investors, Jane – can you think of a couple that they should be looking at?
Jane:
The first ones that come to mind would be Peter Lynch.
David:
The great Peter Lynch of the Magellan Fund?
Jane:
Indeed, and Jim Slater.
David:
And of course Jim Slater, the Zulu Principle. Jim was with us last year, I think, talking about his great book, the Zulu Principle. Well, thank you very much for coming in today, Jane – that was great, and I think a lot of people will be going away taking away with them some GARP investing ideas.
Now, you may not know this Jane, but I end each podcast with a quote, and I found a quote that I think will sort of sum up today's podcast. Today's quote comes from John Winslow Irving. Now John Winslow Irving is not an investor, but John Winslow Irving wrote the book, "The World According to Garp", which was turned into a movie starring Robin Williams. Now he said, "I don't go out of my way to find or invent things that are bizarre. It just seems to me that I notice more and more how commonplace the bizarre is." I think what he's referring to is, his type of bizarre is not the same as the kind of bizarre that we're seeing, we're seeing a lot of bizarre things happening on the stock market right now, but ultimately it's all happened before, hasn't it, Jane?
Jane:
We go round and round, yes.
David:
Yes, there's nothing new in investing. So this has been Money Talk, I have been David Kuo, and my guest has been Jane Coffey, Head of Equities at Royal London Asset Management. If you have a comment about today's show, you can post it on the Money Talk blog, which you can find at www.fool.co.uk/podcast. If you have a suggestion for future shows, you can email me at moneytalk@fool.co.uk. Thank you once again, Jane, for coming in.
Jane:
My pleasure.
David:
And until next week, everybody, have a great week.
