Systematic bargain huntingBy Den Somera
Philippine Daily Inquirer
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.”
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 email@example.com , firstname.lastname@example.org or at www.kapitaltek.com)
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