Hot Stocks, Cool Prices

As the market surges, here's how to invest in growth stocks without overpaying

company trading at $12 per share, with earnings of $1.20 per share, would have a P/E of 10. To help put those two measures in context, one factor in GARP investing is the so-called PEG (price/earnings to growth) ratio. “We bought Lowe’s (LOW) in early 2007,” says Ron Taylor, portfolio strategist at T. Rowe Price Growth Stock. “Stocks related to housing were falling, but we like how this retailer of home improvement supplies is managed.” He says Lowe’s is growing earnings around 15% a year, and shares have a P/E ratio of 15, generating a PEG ratio of 1.

“GARP investors usually look for a PEG ratio of 1 or lower,” says Tom Roseen, senior research analyst at fund tracker Lipper, based in Denver. “Funds following this strategy may have more consistent returns than other growth funds.” Generally, the lower the PEG ratio the better, as it indicates how much an investor is paying for each unit of growth.
PEG ratios are not the only buy sign, but they are important, says Monica Walker, co-manager of the Lou Holland Growth fund (LHGFX), which also follows a GARP strategy. She says her fund owns shares of the insurer Aflac Inc. (AFL). “Earnings are growing at around 15% a year while the P/E ratio is in the mid-teens, so the PEG ratio is about 1,” she says. “It’s not always possible to buy companies with PEG ratios of 1 or less, though.”

Technology stocks, for example, may have high P/E ratios, which can push up the PEG ratio. Walker says that her fund also owns shares of CDW Corp. (CDWC), a hardware and software retailer. “It has shown that it can keep growing, even during difficult times,” she says. Walker puts CDW’s P/E ratio around 18 and earnings growth in the 12% to 14% range, giving it a PEG ratio of 1.3 to 1.5, which she feels is an attractive metric for exposure to the tech sector.

Indeed, PEG ratios up to 1.75 merit consideration by Eugene Profit, who says that his Profit fund (PVALX) employs “value-sensitive growth investing,” which is a GARP strategy. In 2005, Profit recalls shares of the software company Adobe (ADBE) were trading at less than $30 per share. “We thought the company had good growth potential, and we calculated the PEG ratio around 1.4, so we bought the stock,” he says. Profit’s fund sold Adobe in April at $42.15 per share.

When looking at PEG ratios, investors should keep in mind that earnings growth estimates are just that–estimates. A company with a very high P/E, say of 30 or more, can have a PEG ratio of 1 if projected growth is 30% per year. Before making such an investment, make sure you understand the assumptions behind such an aggressive estimate and feel confident that it is attainable.

Finding a Fund
If this type of fund appeals to you, how can you find one? “Read over a fund’s prospectus to see if a growth fund also talks about capital preservation,” says Dolan. “In addition,

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