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The world (of investing) according to GARP.

Can one investment strategy maximize long-term returns, minimize capital gain and income taxes while simplifying the estate planning process?

There is one simple and effective strategy that can best meet these goals for taxable high-net-worth clients - Growth at a Reasonable Price (GARP). This is an investment philosophy used for stocks which has three major tenets:

* Purchasing Growth Stocks. Purchasing high-quality, unit growth companies that investors can hold for the long term.

* Staying the Course. After choosing high-quality companies, set appropriate expectations and avoid frequent changes to the portfolio when companies track expectations.

* Planning for the Future. Under current laws, at the investor's death, the cost basis of the securities will be "stepped up" to market value as of the date of death. The investor (and/or their heirs) will never pay any capital gains tax on the appreciation from those securities.

Although the GARP approach may appear simple at first glance, it is contrary to many of the current investment trends in today's market. In fact, this approach is most appropriate for high-net-worth investors who want to maximize long-term, after-tax performance net of expenses and create wealth. The GARP process requires consistency, patience, and some common sense.

A Strategy for Success

Selecting growth stocks, those whose earnings growth is expected to be higher than average, is the backbone of the GARP investment discipline. By anticipating higher earnings, the market values these stocks at greater than average multiples of earnings, sales, and book value stock. Typically, growth stocks have a relatively high component of total expected return from capital appreciation rather than dividend income.

Investors that want to follow the GARP strategy should seek advisers that have a disciplined philosophy of investing in companies that have a long-term growth rate premium to the S&P 500. These advisers should also place a strong emphasis on research and have a history of finding companies that offer robust volume growth as measured by unit sales and, ideally, a proprietary position in their marketplace. The last key part of the investment equation is valuation - buying the stock at the right price. Strong growth stocks are attractive when their price-to-earnings ratio approximates their three- to five-year earnings growth rate.

Using the GARP approach, investors can hold these top quality companies through periods of slower economic growth or economic contraction with confidence. With growth companies, the stock price should eventually track the earnings growth. Holding the stock for a multiple-year period allows an investor to delay recognition of any gain on the security position and liability for capital gains taxes. In doing so, it reduces the present value of the tax by which the value of the investment will be diminished. If the investor retains the stock until the time of death, the tax savings are even greater. In this case, the investor has not just delayed, but permanently avoided, payment of income tax on the amount of the gain. The stock will, of course, be subject to estate tax in any scenario. The key factor is that the lifetime avoidance of income tax on capital gains leaves a significantly greater amount of assets to pass on to one's heirs.

The Typical Strategy

The GARP approach contrasts significantly with the value investing strategy followed by most mutual funds. By definition, value investing assumes the buying of stocks of average or below-average companies when they are depressed in price. Many of these slow growth companies pay out high taxable dividends. When the stock prices return to normal value, or if a recession threatens the companies' survival, those value stocks must be sold, as there is little expectation for further appreciation. This strategy creates significant turnover, the buying and selling of stock positions, including the attendant payment of trading commissions and recognition of taxable gains.

For example, the average mutual fund had a turnover rate of 84% in 1997. This is why most mutual funds incur high trading costs and such large short-term and long-term capital gain tax bills, which they pass on to their shareholders. In contrast, advisers who practice GARP will typically change as little as 15-20% of the stocks in investors' portfolios annually, leading to fewer transaction expenses and the deferral of capital gains tax.

Why Do Some Managers Have Higher Turnover?

Mutual fund and other portfolio managers trade stocks frequently for five major reasons:

* Turnover generates commissions, which pay for Wall Street research.

* Turnover might (but usually does not) keep the fund's performance at the top of the charts each quarter, and will keep the fund in the newspapers.

* Turnover might (but usually does not) generate some long-term performance (before taxes) which might attract more assets to the fund and raise fees earned by the fund.

* Many funds have significant IRA and 401(k) tax-exempt assets - so the managers do not place a high value on tax savings.

* Many mutual funds and portfolio managers buy securities that are "hot" at the moment, and have no consistent long-term approach to investing.

A key consideration when investing for high-net-worth clients: What you see is not necessarily what you get. While these high turnover strategies may look good on paper or in presentations, they typically do not produce sufficient returns to cover the additional costs, before and after taxes. Success is frequently a matter of simplicity, consistency, research, and common sense. Only these strategies will ultimately help investors reach their financial goals.

Robert E. Harvey, CFA, is president and chief operating officer of Barrett Associates, Inc. based in New York City, Barrett Associates is one of the nation's oldest private investment management firms specializing in serving high-net-worth individuals and families. Send questions to:
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Title Annotation:growth at a reasonable price
Author:Harvey, Robert E.
Publication:The CPA Journal
Date:Sep 1, 1998
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