Here's a more detailed description of each musketeer. The first
musketeer is the change in
stock valuationexpressed as the change
in pricetoearnings ratio (P/E). The GARP
investor's focus is not so much on the purchase
price itself but rather on the price paid for the
company's earnings. Just as the price per
ounce (P/Ounce ratio) of mayonnaise helps shoppers
decide which brand might be a bargain, the
P/Earnings ratio for a stock helps capture whether the
asking price for earnings is a bargain. The
first musketeer has an impact on an investment's
performance, either positive or negative, when the P/E changes over time. For some value investors, a P/E focus
represents their hook, line and sinker. To the GARP
investor, it is only the hook, line OR
sinker. While the GARP investor has high
regard for this first musketeer, he also values the
contributions of the other two.
The second musketeer is the growth in earnings per
share of a company. Much as with P/E change, it's not the initial
earnings that necessarily matter, but the annualized
rate at which these earnings grow. For
example, if
corporate earnings grow 6% annually, and the price
keeps pace with these growing earnings (i.e., the
P/E doesn't change), and the company pays no
dividend, then only the second musketeer contributes to
performancenetting the investor a 6% annual return. For some growth
investors, earnings growth represents the bacon,
lettuce and tomato on their sandwich. To the GARP
investor, you guessed it, it's only one of the
three.
The third musketeer is the income paid,
expressed as dividend yield. Dividends are typically paid out of
corporate earnings and expressed in
dollars and cents per share. If an
investor pays MORE for earnings, the dividend yield will
typically be lower. In contrast, paying less, all
other things equal, results in a higher dividend
yield. For example, if an investor earns $0.50
in dividends annually per $14 share, his yield will
be $0.50/$14, or about 3.5%. If that investor
pays $24 for his $0.50 dividend, his yield will
be $0.50/$24, or only about 2%.
To summarize, we're shopping for bargains. We seek
companies whose earnings are growingthe second
musketeerand in order to narrow the universe of
growing companies, we send the first musketeer in
search of valuation bargains. Essentially, our
goal is to buy companies that are underappreciated
by most other investors. Where they see less
earnings growth, our research may lead us to see
more. And especially when others are
frightened by the fear du jour, driving pricesand
P/E'sto bargain levels, our three
musketeers are all poised to contribute to our
investment success.
Let's bring it all
together with illustrative examples (another neat
teacher trick):
Valuation, Growth &
Income Scenarios

Initial Valuation
(P/E) 
P/E in 5 Years 
Annualized P/E Change (%) 
E.P.S.
Growth Rate 
Initial Dividend Yield 
5Year Average Annual Return* 
Comments 
A 
14
(Average) 
14
(No
change) 
0.0% 
6%
(Average) 
3.5%
(Average) 
9.5% 
No valuation change + average growth & income netted an average return. 
B 
24
(Expensive) 
14
(Decline) 
10.2% 
6%
(Average) 
2.0%
(Low) 
2.2% 
A high purchase P/E and a lower
subsequent P/E netted a poor return. 
C 
11
(Bargain) 
14
(Increase) 
4.9% 
9%
(Good) 
4.5%
(High) 
18.4% 
Successful GARP investing. Touché! 
(*5year average annual returns are approximate.)
In this table, the first musketeer is represented by the Annualized P/E
Change (%) column. The second musketeer is
represented by the
E.P.S. Growth Rate column and the third
musketeer by the Initial Dividend Yield
column.
Look at scenario A: The initial valuation is near an historical
average of 14, and it remains so five years later.
Therefore, no valuation change means no contribution
to return from the first musketeer. The earnings
growth is also at an historically average level
(6%), as is the dividend yield (3.5%). So these
two musketeers contribute all of the investor's
ultimate return, which is close to the historical
average. Not
bad, but not great either.
Now look at scenario B: The initial valuation is significantly
higher than average, and it declines
over the next five years to a more averagein other
words, typicallevel. The first musketeer appears
to be aiding and abetting the enemy!
By the way, the approximate P/E of the S&P 500
is currentlyyou guessed itaround 24. If it
declines to a more typical historical level over the
next five years, that first musketeer will be acting
the turncoat for S&P 500 returns.
But to continue analyzing this second scenario, earnings growth
is average for this company and the dividend yield
is low. (Remember, if an investor pays more for his
earnings, the dividend yield will usually be less.)
So earnings growth is normal, but the dividend yield contributes
only modestly to total returnand
valuation change is actually working against
the investor's total return. The result is a
very poor outcome for the investornegative, in
fact. Earnings growth is there, but value
isn'ta case of growth at an UNreasonable
price. Maybe the
investor had been hoping for betterthanaverage
corporate earnings growth. As long as the P/E
ratio declines, even MUCH better than average
earnings growth wouldn't necessarily do him
much good.
Now consider scenario C, the GARP investor's dreamcometrue.
Valuation is initially a bargainwell below
historical levelsand five years later the
valuation change musketeer has done his partearned
his stripes, if you will. Earnings growth is higher
than typical, as is the dividend yield.
This is a successful GARP investmentall three
musketeers aligned to fight the good fight!
So there you have itGARP investing. Of course, finding the investments that
will ultimately lead to scenario C is far more
difficult than describing how it's done. At J.
V. Bruni and Company, we devote ourselves to the
rigorous, independent research that is required to
find successful investments for our clients'
portfolios. There are many great publicly
traded companies with good potential for earnings
growth; however, very few are available at a bargain
price. We like to use the following analogy.
If you buy a Lexus, you can be pretty sure that
you'll own a great car. However, if you pay $500,000
for it, although you'll still own a great car, you
paid an unreasonable price for itand that's not
such a good investment, is it? You sure
wouldn't find it in
a GARP investor's garage!
Sarah F. Roach
Vice President 