In this article I cover strategy focused on companies that follow Neff’s strategy. Inspired by John Neff, who served as portfolio manager for the Vanguard Windsor Fund from 1964 until his retirement in 1995, Neff’s value investing approach uses a starkly contrasting viewpoint.
Neff permanently found the undervalued, invalid stock in the transaction vault. He liked stocks with a combination of low dividend yields, strong earnings growth expectations and sales growth, along with an increased dividend yield. Neff searched for stocks that weren’t attractive and, in his words, matched the fund’s “cheap” profile. Nev book titled John Neve on investing (Wiley, 2001), discusses these principles of value investing. His book served as the primary source for this stock checking article.
The AAII Neff screening model has shown strong long-term performance, with average annual gains since 1998 of 13.3%, versus 5.5% for the S&P 500 over the same period.
The basic criteria used in the examination
These preliminary requirements are considered the primary screening criteria.
Adjusted Earnings Link Ratio
With value investing, there are a number of ways you can check out attractively priced stocks. One method is a set of criteria that includes a low price-to-earnings ratio and a strong dividend yield with the support of strong estimated earnings and sales growth. Another method is to use a hybrid multiplier called a dividend-adjusted P/E ratio. With this second method, strong earnings growth and sales growth forecasts are again needed.
The adjusted price-earnings-growth (PEG) ratio serves as the basis for the Neff stock screen presented here, which was generated using AAII’s core examination and research database, Stock Investor Pro.
The standard price-earnings-growth ratio adjusted to reflect the dividend yield is referred to as the adjusted price-earnings-money ratio. It is calculated by dividing the price-earnings ratio by the sum of the estimated earnings growth rate and the dividend yield. The adjusted P/E ratio includes each of the key components of the Neff value investing method – the P/E ratio, earnings growth estimates, and the dividend yield.
Low P/E Ratios
The cornerstone of any value investing approach is low price-to-earnings ratios. The difficulty of investing in low-price earnings is separating the "good" stocks that are misunderstood by the market from the "bad" stocks that are pinned neatly by lackluster expectations. Many stocks with low P/E ratios are being turned away to deal funds, not because they are bad investments with bad prospects, but because their earnings and growth prospects do not excite investors, making them unpopular among the masses.
Separating the two involves getting ready to roll up your sleeves and diving into heaps of research, analysis of many different industries, and a review of the company's individual financial statements. Neff consistently finds and holds multiple stocks at low prices and gains geared for market updates.
Low P/E ratios alone are not enough; Adding strong earnings growth estimates to the equation provides confirmation that the company may not deserve its low percentage. Recognizing that growth estimates are nothing more than educated guesswork, Neff cautions that investors should learn to visualize the company's prospects and industry and seek confirmation or contradiction of a market view in the company's fundamentals. Neff believes that the goal of analyzing growth forecasts is to establish reliable growth forecasts.
Monitoring published earnings estimates and consensus estimates also enhances one's insight. Neff refers to these consensus estimates as the prevailing wisdom in its most literal form. In many cases, the market overreacts if a company misses its earnings estimate — a negative earnings surprise. In this case, where there are strong fundamentals, the same buying opportunities present to low-income investors. Focusing on long-term five-year estimates, Neff required robust growth forecasts, but not so strong that growth jeopardized risks; So he put an end to the growth forecast, which will be discussed in more detail in this article.
The results of a low P/E strategy often involve companies with a high dividend yield – low P/E ratios and strong dividend yields go hand in hand, acting as the other. In his research on stocks with low P/E ratios, Neff has also found that higher dividend yields act as price protection: If stock prices fall, a strong dividend yield can help heal many wounds. For this reason, Neff considers dividend "plus" free, which means that when you buy a stock that pays a dividend, you don't dispense with a red cent for that dividend payment.
Secondary examination criteria
Neff also highlights a set of secondary principles that help support a low-price earnings strategy.
In terms of important components of a value investing strategy, Neff's sales growth is just below estimated earnings growth. His argument is that higher sales, in turn, increase profits. Any margin improvement measure can support an investment case, but a truly attractive stock should be able to build on that by showing massive growth in sales. Therefore, the same parameters are applied for the growth of estimated earnings for the growth of sales.
free cash flow
Another minor component of the NEV approach is free cash flow—the cash left over after capital expenditures have been satisfied. Neff researched companies that might use this surplus cash flow in investor-friendly ways. Such companies can pay additional dividends, buy back shares, acquire funds, or simply reinvest additional capital in the company.
The final major component of this adjusted price-earnings-growth ratio screen is operating margin that is better than current industry averages. Industry averages are used here as a benchmark because margins tend to be very industry specific. For example, software vendors enjoy operating margins of more than 40%, while supermarkets and grocery stores operate at very small profit margins. A strong operating margin protects the stock from any negative surprises. Our monitor requires operating margins greater than the industry average for the last 12 months and the most recent fiscal year.
Contradictory, but not a fool
With stocks still growing in the ears of most investors - not to mention the mass of day traders involved in hypermarkets - the ability to stick to a contradictory style becomes even more difficult. As bull markets progress, the prevailing wisdom becomes the drumbeat that moves the herd forward, while drowning out arguments made for a conflicting outlook.
Neff wrote his book in this environment because his investing approach has as much advantage today as ever during the Windsor Fund era at the top of the mutual fund world. The arguments in favor of value investing are most compelling amid the rage and clamor of hot stocks and hot industries when investors are likely to be least interested and listening.
However, Neff admits that it's foolish to be different just to be different. It's fine to be ambivalent and question the herd mentality in the market, but Neff warns investors not to get so naive that your stubborn nature consumes you and forces you to make bad decisions. If, upon further review, the herd is right about a particular growth opportunity, concessions must be made toward your hardened style.
The systematic contrasting strategy of the Windsor Fund has been very successful but also resilient. Neff developed a plan called Measured Participation that helped the fund move away from old practices like traditional industrial representation. This idea allowed the fund to focus on new ideas in portfolio management and encourage "thinking outside the box" when it comes to diversification. By measuring participation, four broad investment categories were created: Highly Recognized Growth, Less Recognized Growth, Moderate Growth, and Cyclical Growth.
Neff cautions investors, however, not to get caught up in the mix and chase the highly recognized stock, as many investors did in the early 1970s with the Nifty Fifty. Neff suggests that investors instead focus their research efforts in less well-known and moderately recognized growth areas, where earnings growth is similar to the growth reported by top growers, but where a lack of size and visibility tends to hold many back.
Among the moderately recognized growth stocks, usually in mature industries, citizens with strong investment reside. Moderate growth stocks tend to hold prices during tough markets, thanks in part to good dividend yields.
Neff admits that cyclical growth stocks are somewhat challenging, and that timing is everything. The trick is to anticipate increases in demand using your knowledge of different industries. The clothing, audio and video equipment, footwear and jewelry industries, for example, are obvious consumer cyclicalities. Capital goods producers are also cyclical choices, as are various home building contractors and building service contractors.
One last and somewhat interesting suggestion is to consider investment opportunities in your local shopping mall. Neff recommends visiting a local retailer, listening to what your kids think is hot, and counting the piles of receipts from your favorite stores. Do some digging - a possibility may just emerge.
While the stock screens here attempt to capture the principles Neff outlines in his book, it's only a starting point, not a recommended list of companies.
Before making any investment decision, you must gather all relevant information and thoroughly understand the investment. Also keep in mind that no single investment technique will be the best in all market environments and that techniques that have worked in the past may not necessarily prove beneficial in the future.
Stocks that meet the approach criteria do not represent a 'recommended' or 'buy' listing. It is important to perform due diligence.
If you want an edge during these market fluctuations,Becoming a member of AAII.