Investing Tools for Investors Looking to Excel
10/21/02  

This PEG ratio is helpful in more mature businesses sectors. However, with the vast number of development stage companies in the public arena, a large amount of market capitalization is absorbed by companies with no earnings, and, sometimes, negative cash flow. In these cases, an investor is dependent on a building a sensible economic model which allows future cash flows to their Net Present Value.  Most investors and many analysts do not know how to do this type of analysis. These types of stocks can get driven by raw "gold rush" or "tulip mania" emotion.  Here, the ratio is the Price to Fantasy.

The lower the general level of interest rates and expectations for stable to lower interest rates, the higher the P/E relative to the projected normalized growth rate. The higher the general level of interest rates and the more prevalent the feeling that rates will go higher, the lower the P/E relative to the view of normalized growth in EPS.

Higher interest rates hurt growth stocks. Expectations of higher rates can hurt growth and momentum stocks. The sense of higher rates is caused by expected increases in inflation accompanying an acceleration in economic activity. These same feelings will cause money to flow to economically sensitive or cyclical stocks since they will be viewed as beneficiaries of higher unit volumes and increased pricing power. 

Interest rates impact valuations in three important ways:

• Stock prices are the present value of future earnings (the higher the level of rates the higher the discount rate and the lower the present value.).

• Companies that borrow will have lower earnings because of higher borrowing costs (everything else being equal).

• Alternative fixed income investment become more attractive with higher rates and siphon money from equities.

Computer screening capabilities can expedite the task of searching publicly available data bases for growth stocks at a discount. Today there is no scarcity of companies with good and reliable growth histories and good growth prospects for the future. The problem is finding growth at the reasonable price.

With today's elevated valuations, rather than looking for GARP stocks at P/E lower than their sustainable growth rate, one should access public data bases to find the relatively cheapest stocks in this growth category. 

Critique-

The nineties have been typified by investors pursuing stock price momentum and revenue momentum. Note, we said revenue and not profit momentum. Clearly, conventional, time-honored valuation metrics have been thrown out, with investors willing to pay any price to participate in the cyber gold rush. 

It is difficult to find true GARP stocks in the large capitalization stocks. While there are GARP stocks in the small cap realm, there is no assurance the market will come around to these cheaper names. The sell side of the market (the brokerage industry) makes much more money off large caps (underwritings, brokerage volume, merger and acquisition work, etc.), than small caps. Further, analyst coverage of small caps is almost non-existent. With current salaries and signing bonuses, it could be prohibitively expensive for brokerages to provide legitimate coverage of the wide world of small companies.

 What will change this extreme valuation gap is conjectural? I do not see it happening anytime soon.

To find GARP today, you must look at the financials, HMO's, homebuilders, and hospital management.

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