SmartGARP® explained: The eight factors that drive returns

SmartGARP stands for Smart Growth At a Reasonable Price. Or to give it its full name, Sentiment, Momentum, Accruals, Revisions and Top-Down Growth At a Reasonable Price. You can probably see why we tend to just go with ‘SmartGARP’. 

SmartGARP scores stocks against eight complementary factors, such as valuation and momentum, which we believe drive share prices. Stocks with top quintile scores are considered by our fund managers for inclusion in portfolios. Since those of you still reading are likely to have a genuine interest in what these factors actually mean, here is an explanation of the eight characteristics that the SmartGARP tool aims to identify.  

1. Growth 

It stands to reason that for two businesses on similar valuations, you would prefer to invest in the one that has delivered, and is forecast to deliver, better fundamental growth. This is why we incorporate a range of quality and growth metrics in the first SmartGARP component, but have a preference for those that are more stable, such as return on capital, return on equity and return on assets.  

This factor also incorporates more out-and-out growth metrics such as sales and earnings growth, but these have a lower weighting. 

2. Valuation   

Intuitively, for any two businesses with similar fundamental growth rates, you would prefer to invest in the one that is cheaper.  

Within the ‘valuation’ factor, we focus on price-to-earnings and price-to-book ratios, as well as cashflow and dividend yields.  

The weighting of this component can rise or fall depending on the dispersion of valuations and whether the value factor is working. If dispersion is wide and the factor is outperforming, the opportunity is pronounced and so valuation merits a higher weight; on the flipside, narrow dispersion and the underperformance of value warrant more caution (and a lower weight). 

3. Estimate revisions  

You may be thinking, “so far, so-so”: are there any investors who don’t look at growth and value in some sort of combination? But it is when they are combined with other factors such as estimate revisions – for example upgrades and downgrades to profits and sales forecasts – that the benefits of SmartGARP really become apparent.  

Growth and value tend to be slow-moving factors. If you’re a cheap business today, it's likely you'll be a cheap business next month. And if you're growing faster than the market today, it’s likely you’ll be growing faster next month. 

Estimate revisions help us to focus on the point where these characteristics change. The factor is governed by the quarterly cadence of earnings, when analysts have received most of their information about how a company is performing, allowing them to adjust their forecasts accordingly. What we have found is businesses whose profit forecasts are constantly revised up by the analyst community tend to go on to outperform.  

The sub-components of the revisions factor are numerous, but monitor the quantum and direction of forecast changes and take into account the behavioural biases of the analyst community.  

This factor is useful in helping us avoid value traps – we're not buying something just because it’s cheap, we're buying something because it’s cheap and announcing good news, offering not only the opportunity for an outperformance in fundamentals, but also the chance of a re-rating. 

4. Momentum 

We are aware that sometimes the market gets there first and therefore a price-based indicator that highlights where this might have occurred is useful. It also helps with timing our entry and exit: it is better to buy something that is working and sell something that is not. 

Yet while this factor is powerful and pervasive across markets, it is subject to sharp reversals.  

5. Accruals  

This factor points us towards businesses with conservative accounting practices and positive management actions.   

It's called accruals because if you see a lot of these on the balance sheet, it is usually a bad sign as it means a significant portion of declared profits is made up of money the company is owed but hasn’t actually received. It also looks for evidence of other accounting practices, which, while legal, can increase the risk of future underperformance when used aggressively.  

On the positive side, we look at whether directors are increasing their stake in the company or committing to share buybacks, both of which suggest faith in the future of the business.  

6. ESG 

While traditional ESG metrics may provide some comfort to investors, they offer little indication of future returns. Just because a company has great carbon intensity figures, for example, these are unlikely to result in outsized profits. 

However, with help from data provider Truvalue Labs, we found that when there's positive news around a company's ESG credentials or actions, that tends to lead to a more favourable appraisal by investors.  

7. Macro

As well as these six bottom-up components, SmartGARP considers two top-down inputs. The first is macroeconomic data.  

Each factor is designed to point you towards businesses that deliver fundamental growth. Macro-economic variables, whether at a country or sector level, do play a part in the fundamental trajectory of businesses. To point us towards those that are experiencing tailwinds, we incorporate market- and survey-based data, covering interest rates, bond yields, GDP growth, inflation and commodity prices (to name a few). We steer clear of published economic data as this is often subject to revisions.  

We are not attempting to predict the future direction of these readings, but rather to understand whether the current environment is supportive or perhaps warrants more caution.  

8. Investor sentiment 

This focuses on how active managers are positioned, with a preference for names that are under-owned, which can be protective when risk is elevated: if a company is under-owned, investors can't go out and sell it. This is one of the few factors that works in a market-wide sell-off.  

On the flip side, if a company is under-owned and there is a change in sentiment, that initial share price reaction to a shift in capital flows can be quite significant. 

These eight factors can all be accretive to returns on a standalone basis, but put together they are much greater than the sum of their parts. Another reason why, rather than spelling out the acronym, it’s better just to stick with SmartGARP.