They all went on to rise between 6,184-23,666%. And today, Price’s company manages over $269 billion in assets.

Jim Oberweis, a famous portfolio manager from Chicago, used the same investment strategy that Price did. Since 1987, his flagship fund has averaged a 12.48% gain. A $10,000 investment with Oberweis in 1987 is now worth $111,833.

The investment strategy that made both of these men (and their investors) wealthy many times over is known as GARP — growth at a reasonable price.

GARP combines value and growth investing into one neat little package. A GARP investor wants to own high-growth companies. But he doesn’t want to overpay for the right to own that growth. For instance…

Price bought companies with expanding profit margins, quarter-over-quarter sales increases and a history of accelerated earnings growth (both year over year and quarter over quarter). If a company met these requirements, he wasn’t so concerned if it happened to have a high P/E ratio or not. The theory was simple…

If a company was growing quickly enough, it would narrow the gap between earnings and price over time.

Oberweis has a similar, but more stringent, philosophy. As he said in an interview a few years ago, “We’re looking to buy companies for a P/E not higher than half the rate of growth. So if a company is growing at 50% annually, we don’t want to pay a P/E higher than about 25.”

In addition to buying growth companies for a reasonable price to earnings, Oberweis also insisted on:

1. Rapid earnings growth
2. Future growth potential
3. Earnings acceleration
4. Low relative price/sales ratio
5. Quality earnings
6. Top quartile of relative strength
7. Rapid revenue growth

These criteria make up what Jim calls his “Oberweis Octagon.” Each investment decision must pass his octagon test before it makes it into his portfolio. And while the name is somewhat silly, the results he has racked up are nothing to snicker at. Some people would sell their firstborn son for a 12% annual return over 19 years.

So what stocks might Price and Oberweis buy today?

To answer that, I created a GARP screen of my own (based on both Price’s and Oberweis’ investment criteria). I looked for:

1. Market capitalization of $1.5 billion or less
2. Net profit margin had to improve in each of the last two years
3. Earnings per share growth of 25% or more in each of the last two years
4. Sales growth of 25% or more in the last two years
5. Quarter-over-quarter sales growth
6. P/E of 40 or less
7. Relative strength in upper quartile

Only five companies came up on this GARP screen. They are:

• American Oriental Bioengineering, Inc. (AOB:AMEX)
• Epicor Software Corp. (EPIC:NASDAQ)
• First Regional Bancorp (FRGB:NASDAQ)
• Pinnacle Financial Partners (PNFP:NASDAQ)
• TALX Corp. (TALX:NASDAQ)

(Note: All of these stocks rank in the upper quartile in terms of relative strength.)

If you are looking for a short list of growth stocks at reasonable prices, I would start here. Each of these companies has awesome growth numbers. And unlike many so-called growth opportunities, these actually have real earnings and improving profit margins to boot. That says they have established products, services or brands that command premium prices. It also says management runs the business with the shareholder in mind.

That is a rare combination on Wall Street these days. Just remember one thing if you decide to invest with a GARP bent…

Both Oberweis and Price made their fortunes by holding onto their stocks for years, not months or weeks. You don’t walk away with 23,000% gains in a few weeks. As Price once famously declared:

“Buy stocks of growing businesses, managed by people of vision, who understand significant social and economic trends and who are preparing for the future through intelligent R&D. Sell when the company no longer meets your buying criteria.”

Good investing,
James
October 26, 2006

P.S.: Jim Oberweis is still alive and kicking. In case you are interested in the top holdings in his Emerging Growth Fund, here they are:

1. Focus Media Holding (FMCN:NASDAQ)
2. Ceradyne (CRDN:NASDAQ)
3. Carrizo Oil and Gas (CRZO:NASDAQ)
4. aQuantive (AQNT:NASDAQ)
5. Aspreva Pharmaceuticals (ASPV:NASDAQ)

Investment Strategies of Famous Investors was originally featured in the Penny Sleuth.

Forbes magazine called him the “Sage of Baltimore” and Barron’s referred to him as a visionary.

At a time when most investors were either afraid of the market or were investing only in “safe” stocks like railroads and auto manufacturers, Price was buying small, unknown growth companies for pennies on the dollar — and making a fortune.

For instance…

In the 1930s, he bought Dow Chemical, Coca-Cola, Minnesota Mining and J.C. Penney. In the 1940s, he picked up shares of IBM. In the 1960s and ’70s, he acquired stock in Motorola, Texas Instruments, Avon, Black & Decker, General Electric and Pfizer. And over the years, he also picked up shares of Xerox, Merck and DuPont.

To say those were “wise investments” at the time would be the understatement of the last 100 years. They were some of the best investments ever made — period.

When it was all said and done, he walked away with profits of 23,666% on Merck, 17,025% on Minnesota Mining (3M), 15,528% on Avon Products, 8,540% on Black & Decker and a mere 6,184% on Xerox.

Most people dream about finding just ONE stock that rises thousands of percent or more in a lifetime. Price found dozens of them. But it wasn’t always an easy road to wealth.

Price was a big fan of small-cap stocks. He likened them to human beings after birth. Just as a baby grows out of his clothes every four weeks, a young, growing company can increase its earnings 100% or more for several years in a row. To capitalize on this rapid-growth stage, Price opened a small-cap mutual fund in 1960.

The Baltimore-based visionary loaded up on shares of Xerox and Texas Instruments — small caps he thought would survive the high-inflationary period that engulfed the ’60s.

Great move, right? Didn’t look so at first.

Two years after opening his fund, Price was down 29%, while the S&P 500 was off only 9%. Investors wanted his head on a silver platter. How dare he lose money — especially more than the broad markets? Outrage!

Reporting on this ugly two-year period for Price, Nikki Ross, author of Lessons From the Legends of Wall Street, said, “Clients complained and Price became disappointed and distraught. But he stayed with it, and performance improved. Five years later, the fund gained 44%; the S&P 500 increased only 9%.”

VINDICATION. Price stuck to his guns, and it paid off. In fact, by 1968, small-cap stocks were such the rage that he actually had to close his fund to protect his shareholders from any sort of mania buying at ridiculous prices.

Imagine how all those fair-weather folks who sold off when they were down 29% must have felt!

Price knew that true stock market fortunes were made by people who bought and held — even when the market suffered or stocks underperformed for a few years. As he put it, “The owners of businesses such as Black & Decker, Disney, DuPont, Eastman Kodak, Sears and countless others were long-term investors. They did not attempt to sell out and buy back ownerships of the businesses through the ups and downs of the business and stock market cycles.”

Of course, early investors in all of those companies made a fortune so large it’s ridiculous to even think about. And if you want to make a fortune of your own, there’s a lot you can learn from Price.

First, Price had a long-term investing horizon. He didn’t sell stocks just because their prices fell. He sold only for two reasons: one, if his buying thesis (the reason for owning the stock in the first place) were no longer true, and two, if he needed to raise cash to invest in an even more promising opportunity. If the market simply punished a stock that was perfectly sound, Price believed that was an opportunity to buy more shares. But he certainly wouldn’t sell.

Second, Price believed investors have to be flexible — meaning they have to adapt with the market. During the 1960s, Price bought gold (when no one else was buying) at $35 an ounce. He also bought stock in companies like Atlantic Richfield (oil), Alcan Aluminum, Homestake Mining Co. (gold) and International Paper. His thesis for owning these out-of-favor natural resource companies was simple: The United States was spending millions to fund the Vietnam War and taxes weren’t increasing. As Nikki Ross put it, Price “reasoned that with the large U.S. budget deficit at that time and no increase in taxes to pay for the war, the costs would be paid in the form of accelerating inflation.”

As you know from the last few years, natural resources rise when the economy is in a shambles. And that’s exactly what happened in the 1960s. Once again, Price made a fortune.

Finally, T. Rowe Price believed in the power of solidly run small-cap companies. He bought companies with strong operating margins, track records of increasing sales, solid R&D, low debt loads and potential to grow for years — even when the market was weak. Price knew that a well-selected small-cap stock would grow even when the rest of the market was getting killed. His track record certainly proved him to be correct.

I have a feeling we’ll need to rely on Price’s fortitude in the coming years.

I believe we are entering into a period in which small-cap stocks won’t grow like wildflowers — like they have since 2003. The margin of safety is gone in the small-cap market, especially if you compare them with the average large-cap stock on the S&P 500.

In March 2000, the average P/E ratio of the 50 smallest stocks on the S&P 500 was just 10.1, while the 50 largest traded for 35.6 times earnings. Today, the 50 smallest stocks trade for a P/E of 20, while the 50 largest trade for 17.3 times earnings. In other words…

Small-cap stocks aren’t cheap anymore. In fact, the average small-cap stock is overvalued. Anyone who thinks they can trade in and out of small-cap stocks and walk away with 20% gains a year is foolish.

We are entering a phase in which investors with patience will be rewarded and everyone else will go home crying.

You need to decide right now if you are truly a small-cap investor who is interested in owning fundamentally sound and growing small-cap stocks for the long haul (like Price was) or if you are a trader looking to flip stocks in two months for a gain.

If you are an investor (as I am), we’ll continue to look for great businesses to own at fair prices. If you are a trader who has dreams of making a quick buck, it’s time to look somewhere else. The small-cap market is not where you should be right now.

Happy investing,

James
March 16, 2006

P.S. I quoted Nikki Ross twice in this essay. Her book (which I am in no way affiliated with) Lessons From the Legends of Wall Street is fantastic. If anyone is interested in how guys like Buffett, Graham, Price and Templeton made their fortunes, Ross explains their philosophies in a very easy-to-read and interesting way. I have read it two or three times!

The Sage of Baltimore was originally featured in the Penny Sleuth.