Fundamental Analysis - Part II

GARP
GARP, aside from being the name of the title character to John Irving's The World According to Garp, is an acronym for growth at a reasonable price. The world according to GARP investors combines the value and growth approaches and adds a numerical slant. Practitioners look for companies with solid growth prospects and current share prices that do not reflect the intrinsic value of the business, getting a "double play" as earnings increase and the price/earnings (P/E) ratios at which those earnings are valued increase as well. Peter Lynch, who may be familiar to you through his starring role in Fidelity Investments commercials with Lily Tomlin and Don Rickles, is GARP's most famous practitioner.
 
One of the most common GARP approaches is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. As the company's earnings per share grow, the P/E of the company will fall if the share price remains constant. Since fast-growing companies normally can sustain high P/Es, the GARP investor is buying a company that will be cheap tomorrow if the growth occurs as expected. If the growth does not come, however, the GARP investor's perceived bargain can disappear very quickly.
 
Because GARP presents so many opportunities to focus just on numbers instead of looking at the business, many GARP approaches, like the nearly ubiquitous PEG ratio and Jim O'Shaughnessy's work in What Works on Wall Street are really hybrids of fundamental analysis and another type of analysis -- quantitative analysis.

Quality
Most investors today use a hybrid of value, growth, and GARP approaches. These investors are looking for high-quality businesses selling for "reasonable" prices. Although they do not have any shorthand rules for what kind of numerical relationships there should be between the share price and business fundamentals, they do share a similar philosophy of looking at the company's valuation and at the inherent quality of the company as measured both quantitatively by concepts like Return on Equity (ROE) and qualitatively by the competence of management. Many of them describe themselves as value investors, although they concentrate much more on the value of the company as an ongoing concern rather than on liquidation value.
 
Warren Buffett of Berkshire Hathaway is probably the most famous practitioner of this approach. He studied under Benjamin Graham at Columbia Business School but was eventually swayed by his partner, Charlie Munger, to also pay attention to Phil Fisher's message of growth and quality.
 
Arguments Against Fundamental Analysis
Those who do not use fundamental analysis have two major arguments against it. The first is that they believe that this type of investing is based on exactly the kind of information that all major participants in publicly traded markets already know, so therefore it can provide no real advantage. If you cannot get a leg up by doing all of this fundamental work understanding the business, why bother? The second is that much of the fundamental information is "fuzzy" or "squishy," meaning that it is often up to the person looking at it to interpret its significance. Although gifted individuals can succeed, this group reasons, the average person would be better served by not paying attention to this kind of information.