Discovering Hidden Gems: The Neff Value Investing Strategy

This week, we cover our strategy that focuses on firms passing the AAII Neff screen. Inspired by John Neff — who served as portfolio manager of the Vanguard Windsor Fund from 1964 until his retirement in 1995 — the Neff value investing approach uses a stringent contrarian viewpoint. Neff perennially found undervalued, out-of-favor stocks in the bargain basement. He liked stocks with a combination of low price-earnings (P/E) ratios, solid forecasts in earnings and sales growth as well as an increasing dividend yield. Neff searched for stocks that were unattractive and, in his words, matched the fund’s “cheapo” profile. Neff’s book, “John Neff on Investing” (Wiley, 2001), discusses these value investing principles. His book served as the primary source for the construction of the screen.

The Neff screen has shown strong long-term performance, with an average annual price gain since 1998 of 13.5%, versus the S&P 500 index’s 6.4% price gain over the same period.

Primary Criteria Used for Screening

The Neff screen has four initial requirements that are considered primary screening criteria.

Dividend-Adjusted PEG Ratio

With value investing, there are a number of ways to screen for attractively priced stocks. One way is via a combination of criteria that includes a low price-earnings ratio and a strong dividend yield, with support from solid estimated earnings and sales growth. Another method is to employ the hybrid multiple called the dividend-adjusted price-earnings-to-earnings-growth (PEG) ratio. With this second method, solid earnings growth and sales growth forecasts are again needed.

The dividend-adjusted PEG ratio serves as the foundation of the Neff screen, which was created using AAII’s fundamental stock screening and research database, Stock Investor Pro.

The standard PEG ratio adjusted to reflect the dividend yield is referred to as the dividend-adjusted PEG ratio. It is calculated by dividing the price-earnings ratio by the sum of the estimated earnings growth rate and the dividend yield. The dividend-adjusted PEG ratio encompasses each of the key components of Neff’s value investing style — the price-earnings ratio, earnings growth estimates and the dividend yield.

Low Price-Earnings Ratios

The cornerstone of any value investing approach is low price-earnings ratios. The difficulty with low price-earnings investing is separating the “good” stocks that are misunderstood by the market from the “bad” ones that are accurately pegged because of lackluster prospects. Many low price-earnings ratio stocks are banished to the bargain bins, not because they are bad investments with poor outlooks, but because their earnings and growth prospects do not excite investors, leaving them out of favor among the masses.

Separating the two involves a willingness to roll up your sleeves and dive into mounds of research, analyzing many different industries and reviewing individual company financial statements. Neff continually found and bagged low price-earnings multiple stocks primed for market upgrades.

Estimated Growth

Low price-earnings ratios alone are not enough; adding solid earnings growth estimates to the equation offers validation that the company may not deserve its low ratio. Admitting that growth estimates are nothing more than educated guesstimates, Neff warns that investors must learn to visualize prospects for the company and its industry and look for confirmation or contradiction of the market’s view in the company’s fundamentals. The goal of analyzing growth forecasts, Neff argues, is to establish credible growth expectations.

Monitoring published earnings estimates and consensus estimates also enhances one’s clairvoyance. Neff refers to these consensus estimates as prevailing wisdom in its most literal form. In many cases, the market overreacts if a company misses an earnings estimate — a negative earnings surprise. In this instance, where strong fundamentals remain, buying opportunities present themselves to low price-earnings investors. Concentrating on long-term, five-year estimates, Neff required strong growth forecasts, but not so strong that growth compromised risk. He therefore established a ceiling for any growth forecasts.

Dividend Yield

The results of a low price-earnings ratio strategy often include companies with high dividend yields — low price-earnings ratios and strong dividend yields normally go hand in hand, each serving as the flip side of the other. In searching out low price-earnings ratio stocks, Neff also found that high dividend yields serve as price protection: If stock prices fall, a strong dividend yield can help heal many wounds. For that reason, Neff considers dividends a free “plus,” meaning that when you purchase a stock paying a dividend, you do not shell out a red cent for that dividend payment.

Secondary Screening Criteria

Neff also highlights a group of secondary principles that help support a low price-earnings strategy.

Sales Growth

In terms of important components in a value investing strategy, Neff considers sales growth just below that of estimated earnings growth. His argument is that growing sales, in turn, create growing earnings. Any measure of margin improvement can buttress a case for investing, but truly attractive stocks must be able to build on that by demonstrating formidable sales growth. Therefore, the same parameters for estimated earnings growth are applied for sales growth.

Free Cash Flow

Another secondary component of Neff’s approach is free cash flow — cash left over after satisfying capital expenditures (capex). Neff searched for companies that would use this excess cash flow in ways that favor investors. Such firms could pay additional dividends, repurchase stock shares, fund acquisitions or simply reinvest the extra capital back into the firm.

Operating Margin

The last key ingredient in this dividend-adjusted PEG ratio screen is an operating margin better than current industry medians. Industry medians are used here as the benchmark because margins tend to be very industry-specific. For example, software vendors enjoy operating margins in excess of 40%, while supermarkets and grocery stores work on very thin margins. A robust operating margin shields a stock against any negative surprises. AAII’s Neff screen requires operating margins greater than the industry median for both the trailing 12 months and the most recent fiscal year.

Contrarian, but Not Foolish

As growth stocks continue to ring in the ears of most investors — not to mention the mass of day traders participating in hypermarkets — the ability to hold true to a contrarian style becomes more difficult. As bull markets progress, prevailing wisdom becomes the drumbeat that moves the herd forward while drowning out the arguments made for a contrarian outlook.

Neff wrote his book in this environment because his investing approach has as much merit today as at any time during the Windsor Fund’s reign atop the equity mutual fund world. The arguments favoring value investing are most compelling amid the rage and clamor for hot stocks and hot industries, when investors are least likely to take heed and listen.

Nevertheless, Neff concedes that it is foolish to be different just to be different. It is fine to be contrarian and question the market’s herd mentality, but Neff warns investors not to become so naive that your stubborn nature consumes you and forces bad decisions. If, upon further review, the herd is right about a certain growth stock opportunity, concessions toward your hardened style must be made.

Participation in the Market

The Windsor Fund’s systematic contrarian strategy was very successful but also flexible. Neff developed a plan called measured participation that helped the fund stay clear of old practices like conventional industry representation. This idea allowed the fund to focus on fresh ideas in portfolio management and promoted thinking outside the box when it came to diversification. With measured participation, four broad investment categories were established: highly recognized growth, less-recognized growth, moderate growth and cyclical growth.

However, Neff warns investors not to get caught up in the mix and chase highly recognized stocks, like many investors did in the early 1970s with the Nifty Fifty. Neff suggests that investors instead concentrate research efforts in the less-recognized and moderately recognized growth areas, where earnings growth is comparable to that posted by the big growers, but where lack of size and visibility tends to hold many back.

Among moderately recognized growth stocks, usually in mature industries, solid investment citizens reside. Moderate growth stocks tend to hold fast to prices during difficult markets, thanks in part to nice dividend yields.

Neff concedes that cyclical growth stocks are somewhat tricky and that timing is everything. The trick is to anticipate increases in demand using your knowledge of the different industries. For example, the apparel, audio and video equipment, footwear and jewelry industries are obvious consumer cyclicals. Capital goods producers are also cyclical picks, as well as homebuilding and various construction service contractors.

A final and rather interesting suggestion is to consider investment opportunities at your local shopping mall. Neff recommends visiting a local retailer, listening to what your teenagers think is hot and counting the piles of receipts from your favorite stores. Do some digging — a prospect might just turn up.

Conclusion

While the Neff screen attempts to capture the principles set forth by Neff in his book, it is only a starting point, not a recommended list of companies.

Before making any investment decision, you should gather all pertinent information and understand the investment thoroughly. Also, keep in mind that no one investing technique will be best in all market environments and that the techniques that worked in the past may not necessarily prove to be as useful in the future.

Top 15 Companies Passing the Neff Screen (Ranked by Dividend-Adjusted PEG Ratio)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

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