Market Rider

Systematic bargain hunting

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If the success of Benjamin Graham in stock trading and investing was attributed to his concept of what is called “margin of safety,” John Neff’s investment record of success was built around what is ascribed as “systematic bargain hunting”—a simple, yet very effective value investing method.

Even during his time, while John Neff was a big name among money managers, he was little-known outside the investment community. Accounts say “he is seldom read in the newspapers, much less in the gossip columns; he looks and acts not at all the Wall Street hotshot; he is simple, unfashionable and (wears) slightly messy clothes.”

Neff managed the Vanguard Windsor Fund from June 30, 1964, up to his retirement on Dec. 31, 1995. His record is summed up as follows: “When he retired, the fund had an annual return of 14.8 percent. During that period, $10,000 invested in the S&P 500 would have returned $248,000; the same investment in Windsor would have over twice as much—$587,000.”

Key elements

While John Neff’s investment philosophy similarly revolves around the idea of buying a stock with a relatively low price in relation to its earnings as that of Benjamin Graham, his approach required a number of tests that go beyond just the price-earnings criteria. “These additional hurdles,” according to “Value Investing” author Glen Arnold, “turn his approach from simple low price-earnings investing to a sophisticated one.”

Neff devised a quantitative method of identifying underpriced stocks. This differs from Graham’s “margin of safety” which, in the end, becomes a matter of judgment, thus, a process that is by no means entirely free from the vagaries of human emotion.

The idea of arriving at decisions through mechanical rather than discretionary means was something he picked up as a young boy. This was when their family business went bankrupt and found out that, “when it comes to money, emotional attachment can fool you.”

Thus, later in life as a stock picker, trader and money manager he came up with “the total return to P/E ratio” approach as a means to identify value (underpriced) stocks.

The mathematical formula is expressed as follows: Total returns (earnings growth plus yield) is divided by the P/E ratio (the stock’s market price divided by the most recently reported earnings per share). More importantly, the quotient or hurdle rate result of the “total return to P/E ratio” should be twice the market average. Simply, this requires you to first find out the growth in earnings and dividend yield of the market as a whole and, next, divide the resultant sum by the market P/E ratio.

So, for instance, if the earnings growth for stocks in the market is 6 percent and the market dividend yield is 4 percent and the historic P/E ratio for the market is 20, then the hurdle rate for the stock would be as follows: 6 + 4 (total return) divided by 20 (P/E ratio) x 2.  The result is the hurdle rate, which is equal to 1.0.  Now, if the market P/E ratio falls to 10, the hurdle rate will commensurably become 2.0.

Notice that Neff’s total return to P/E ratio is not a fixed number. It can be 1.0 or more as illustrated because “total return to P/E ratio” is obviously a function of estimated earnings growth rate and dividend yield, and the prevailing applicable P/E ratio.

To further appreciate the merit of his method, Neff’s Windsor fund portfolio in 1989 had an estimated overall capital growth rate of 9.5 percent together with a 4.9 percent yield, or a total return of 14.4 percent. The average P/E ratio of the stocks in the fund was 6. As a result, his portfolio has a “total return to P/E ratio” of 2.3.

Incidentally, he also calls this as the “what you get for you pay for it” or “terminal relationship” figure.

On the other hand, the overall market then had a growth rate of 8.5 percent and a yield of 3.7 percent for a total return of 12.2 percent. With the market’s P/E ratio of 11—which gives 1.15 as a comparable “what you get for what you pay for it” result—Neff’s portfolio was twice as attractive or better as the market as a whole.

Tightly woven into Neff’s sophisticated low P/E ratio approach, he shares a similar philosophy deeply embraced by Peter Lynch, which says “you do not need glamour (highly sought) stocks to make a buck.”  Dull businesses can also make good money. More than that, they are “less likely to attract competition,” thus afford you the comfort of an undisturbed investment nest.

Along with the foregoing principle, Neff also does not believe that “just because a company is down it is not a wise investment. He has discovered that you can actually settle for companies with modest earnings growth, just as long as they have an “evidence of sustainable growth rate (that ranges) from 7 to 20 percent,” coupled by an above average dividend yield record.

Another “must” following his principle as a “low P/E shooter,” his target companies must also pass several criteria, namely: “A sound balance sheet; satisfactory cash flow; an above-average return on equity; able management; good prospect for continued growth; attractive product or an attractive service; and a strong market in which to operate.”

Having identified his stocks, Neff is highly disciplined when buying. He sticks to his target price. He waits, and waits, till the market comes down to his price level. “If the stock’s price doesn’t get there, he simply won’t buy it.”

When selling, Neff’s trigger “is based on the hurdle rate of the whole portfolio.” Actually, Neff’s selling principle is to “sell a stock before it has achieved its full potential gain.” He says “one must leave a sufficient incentive for the next buyer to take the merchandise off your hands.” Therefore, “at 65 to 70 percent of the whole portfolio’s appreciation potential, Neff starts to sell.”

Due to the exemplary performance of his fund, Neff became a member of the Baron’s Roundtable for 25 years, earning the distinction of having the “longest-running participation” in the prestigious forum.

In summary, Neff’s strategy was not just methodical but extremely meticulous. But this made “his fund always land within the top 5 among all funds” during his 31-year tenure at Vanguard Windsor Fund.

Bottom line spin

For the first time, the market ended in positive territory with a weekly gain of 121.72 points or 1.90 percent last week. Total business transaction for the week could be described as extraordinary. Over and above the market’s average in the last two weeks, volume and value turnover went up 78 percent and 289 percent, respectively.

The magnitude and distribution of foreign buying and selling transactions, however, remained largely the same. Along with the market’s daily trading results—that started on the advance on the first three days and falling on the last two days of the week—the signs still point to a downward or, at best, sideways, trend of the market this week.

Looking at other factors that could influence the local market sentiments such as the US, this prognosis on the market’s direction may just extend all the way to the first two weeks of September.

(The writer is a licensed stockbroker of Eagle Equities Inc.  You may reach the Market Rider at marketrider@inquirer.com.ph , densomera@msn.com or at www.kapitaltek.com)

Disclaimer: The comments uploaded on this site do not necessarily represent or reflect the views of management and owner of INQUIRER.net. We reserve the right to exclude comments that we deem to be inconsistent with our editorial standards.

  • OFW_Investor

    From Investopedia
    The PEG Ratio (Price to Earnings Growth)
    XYZ Company
    20 (x times earnings) / 12 (n % anticipated earnings growth) = 20/12 = 1.66
    a figure less than 1 suggest a buy.

    Best Uses for the PEG
    The PEG ratio is best suited to stocks with little or no dividend yield. Because the PEG ratio
    doesn’t incorporate income received by the investor in its presentation of valuation, the metric
    may give unfairly inaccurate results for a stock that pays a high dividend.
    Consider the scenario of an energy utility that has little potential for earnings growth. Analyst
    estimates may be five percent growth at best, but there is solid cash flow coming from years
    of consistent revenue. The company is now mainly in the business of returning cash to
    shareholders. The dividend yield is five percent. If the company has a P/E ratio of 12, the low
    growth forecasts would put the PEG ratio of the stock at 12/5, or 2.50. An investor taking just
    a cursory glance could easily conclude that this is an overvalued stock. The high yield and
    low P/E make for an attractive stock to a conservative investor focused on generating
    income. Be sure to incorporate dividend yields into your overall analysis. One trick is to
    modify the PEG ratio by adding the dividend yield to the estimated growth rate during
    calculations. To give us a meaningful interpretation of the company’s valuation, take a look a
    look at the following example.
    Final Thoughts on Using the PEG
    Thorough and thoughtful stock research should involve a solid understanding of the business
    operations and financials of the underlying company. This includes knowing what factors the
    analysts are using to come up with their growth rate estimates, and what risks exist regarding
    future growth and the company’s own forecasts for long-term shareholder returns.
    Investors must always keep in mind that the market can, in the short-term, be anything but
    rational and efficient. While in the long run stocks may be constantly heading toward their
    natural PEGs of one, short-term fears or greed in the markets may put fundamental
    concerns on the backburner.
    When used consistently and uniformly, the PEG ratio is an essential tool that adds dimension
    to the P/E ratio, allows comparisons across diverse industries and is always on the lookout
    for value.

    Biotech Stock ABC
    -Current P/E: 35 times earnings
    -Five-year projected growth rate: 25%
    -PEG: 35/25, or 1.40
    Oil Stock XYZ
    -Current P/E: 16 times earnings
    -Five-year projected growth rate: 15%
    -PEG: 16/15, or 1.07
    Example – Adding Dividend Yield to the
    Estimated Growth Rate
    This energy utility has an estimated growth rate of
    about five percent, a five percent dividend yield and
    a P/E ratio of 12. In order to take the dividend yield
    into account, you could calculate the PEG like this:
    P/E / (Growth Estimates + Yield) = (12 / (5 +5)) =
    1.2

  • crab2008

    john neff traded in sophisticated and developed markets so forget about his method because, the PSE is still a talipapa, a flee market. without foreign fund this market will not reach the 7000 levels. now that they start to unload, you know where this market is headed.

  • turniphouse

    thank you for sharing this news. insightful!

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