John Neff Contrarian | Out-of-favour bargain basement stocks

John Neff's record of management of the Windsor Fund for more than 30 years (1964 till his retirement in 1995) is truly astounding. During the time most professional investment managers' returns lagged the market, John Neff delivered an annual average that exceeded the "market" rate of return by more than 3 percent. His results were actually 3.5 percent ahead of the market. After expenses, the net rate of return, over one third of a century, averaged 3.15 percent higher than the market.

Consider what this record really means, given the miracle of compounding (which Albert Einstein regarded as one of humanity's most enlightened ideas). Compounded over 24 years, 3 percent per year actually doubles the original investment! John Neff achieved more than 3 percent for more than 30 years! 

Neff believed in a contrarian approach and perennially found undervalued, out-of-favor stocks in the bargain basement. He liked stocks with a combination of low price-earnings ratios, solid growth in earnings and sales, with an increasing dividend record.

Check out ValuePickr's John Neff Contrarian Stock Screen selections for the Indian stock market, here.

John Neff Investment Approach

John Neff on Investment. John Wiley & Sons. The book reveals his enduring principles and the secrets of his contrarian approach - the primary source and inspiration for this article and the stock screen.

Stock Picking strategy: superior Total Return to P/E

According to Neff, Windsor fund was never fancy, fad-driven, or resigned to market performance. He followed one durable investment style whether the market was up, down or indifferent. These were its principal elements:

• Low price-earnings (P/E) ratio

Neff says his strength always depended on coaxing overlooked, out-of-favour stocks to move up from undervalued to fairly valued. Unlike high-flying growth stocks poised for a fall at the slightest sign of disappointment, low p/e stocks have little anticipation, no expectation built into them. Indifferent financial performance by low p/e companies seldom exacts a penalty, but hints of improved prospects trigger fresh interest. This gave a two-fold edge 1) excellent upside participation and 2) good protection on the downside

Without the stunning growth rates of fashionable stocks, low p/e stocks can capture the wonders of p/e expansion with less risk than skittish growth stocks. An increase in the p/e ratio coupled with improved earnings turbocharges the appreciation potential. Instead of a price gain merely commensurate with earnings, the stock price can appreciate 50 to 100 percent.

The prospects for increasing an out-of-favour company's p/e ratio from say 8 to 11 times, always proves more promising than say a 40 p/e company to register comparable percentage advances, that would have to propel the p/e to almost 55 times, to say nothing of sustaining it.

• Fundamental growth in excess of 7%

Moribund or badly run companies deserve to languish at low p/e, of course. But low p/e companies growing faster than 7% a year tipped Neff of to unappreciated signs of life, particularly if accompanied by an attention-getting dividend.

• Yield Protection (and enhancement in most cases)

Besides growth in earnings Neff looked for another component yield. The yield for any stock merely expresses the dividend as a percentage of the stock's price. For a Rs.100 stock, if it pays Rs. 5 as dividend, the yield is 5%.

Benjamin Graham stressed that yield is the more assured part of growth, whereas only time can tell whether earnings and growth rates meet expectations. A company lowers the dividend only under duress. In fact good companies are much more apt to increase the dividend.

Low p/e and high yields usually go hand in hand. Each is the flip side of the other. That makes dividends high relative to the price. Neff says he never understood why a 15% grower with a 1% yield usually sold at twice the price-earnings ratio of an 11& grower with a 5% yield.

• Superior relationship of Total Return to P/E paid

John Neff defined Total Return as representing what Windsor got when it bought a share of a stock: annual earnings growth plus yield. Total return defined half of a ratio that summarised very neatly, Windors competitive edge. The other half of the ratio, p/e, disclosed what he paid to to secure the total return. He says there is no better way to measure the bang for his investment buck.

Windsor hunted for stocks with what he called a "cheapo" profile. their total return divided by the P/E ratio was notably out of line with industry or market benchmarks. Neff says discounts up to half the going price for growth turned up dozens of winners. He preferred stocks whose total return, divided by the P/E, exceeded the market average by 2:1

• No cyclical exposure without compensating p/e multiple

Cyclical stocks normally comprised a third or more of the Windsor Fund. Whereas growth stocks are expected to increase earnings steadily, the trick with cyclical stocks is to catch them at just the right moment -after one cycle has decimated the stock price, but before improved earnings become apparent to everyone. The very nature of cyclical industries induced Neff to buy the same companies over and over again, buying low and selling high.

• Solid companies in growing fields

Typical Windsor fare featured good companies with solid market positions and evidence of room to grow. Labouring outside the spotlight, they were more vulnerable to investors' whims. So long as the business remained sound, strategic plans were in place, and sufficient resources existed to weather difficult conditions, Neff counted on these to work their way back to center stage.Bad news almost always overshadows good news, and occasionally even great companies do fall victim to investors' malaise.

• Strong fundamental case

 No solitary measure or a pair of measures should govern a decision to buy a stock. You need to probe  whole raft of numbers and facts, searching for confirmation or contradiction. The goal is to develop credible growth expectations for a low p/e company or industry. Fundamental analysis consists largely of appraising corporate performance against industry or market benchmarks. Fundamentals consistent with benchmarks usually reinforce the unrecognised virtues of low p/e stocks; fundamental shortfalls may expose gaps that cripple prospects for p/e expansion.

In the low P/E spectrum (where going against the grain may invite bad news), he recommended going with companies showing positive free cash flow, return on equity and operating margins better than industry medians. These provide hefty protection against negative surprises.

Neff summarises by saying at the end of the day, all the techniques for finding low p/e stocks have one objective: compiling a salable record of accomplishment. Unless other investors see the point you have been trying to make, you won't enjoy the reward you anticipated. Will a single stock fetch a friendly price when you are ready to sell it? There are no guarantees, but a low p/e strategy can tilt the odds in your favour.

John Neff Stock Screen Design

Objective

Primary Criteria

Criteria to locate stocks that match our screening objective

1. Neff uses Total Return (annual earnings growth plus yield) and divides it by the p/e ratio to find stocks that met a simple "cheapo" profile, as he called it. A "cheapo" stock would have a Total Return divided by p/e ratio that was noticeably out of line with the current industry or market benchmarks. Stocks with multiples that were discounted up to half the going price for growth were flagged as winners. 

2. Neff also looked for companies with earnings growth between 7 and 25 percent. More than 7% indicated unappreciated signs of life, whereas greater than 25% might indicate higher risk.

Secondary Criteria

Criteria that ensure that the companies passing the primary screen do not meet our objectives just by coincidence, but because they are deserving candidates and truly meet our objective. Usually these are useful to eliminate the duds from creeping in.

1. Sales growth is considered as important as earnings growth, because ultimately growing sales create earnings growth as there is a limit to squeezing greater earnings from each dollar of sales. Eventually attractive companies must demonstrate sales growth. Between 7 and 20 percent is what we look for.

2. Free cash flow, or cash left over after taking care of capital expenditures was considered next. Neff searched for companies that could use this excess cash flow to pay additional dividends, repurchase stock shares, fund acquisitions, or simply reinvest the extra capital back into the firm. In our screen, we look for positive free cash flow over the last 2 years.

3. Operating margins better than current industry medians, is the last criteria used. Industry medians are used as the benchmark because margins tend to be very industry-specific. Our screen looks for operating margins greater than the industry median over the last 2 years