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    John Neff's Approach to Contrarian Investing

    by Wayne A. Thorp

    As the technology bubble of the late 1990s showed, the ride up can be dizzying, but the aftermath can be a flameout. While technology issues are certainly sexier, numerous studies have shown that seemingly dowdy value approaches can generate very attractive returns.

    One long-time advocate of value investing—and a famed contrarian—is John Neff, manager of the Vanguard Windsor Fund from 1964 until his retirement in 1995. Mr. Neff followed a methodology that looked for stocks with low price-earnings ratios, solid forecasted earnings growth and historical sales growth, and an increasing dividend yield. This approach allowed Mr. Neff to guide the Windsor Fund over his 31-year tenure to an annual average return that exceeded the rate of return of the S&P 500 by more than 3%.

    Mr. Neff outlined his strategy in his book “John Neff on Investing,” in which he discussed his value investing principles.

    A screen based on Mr. Neff’s stock selection methodology is built into Stock Investor Pro, AAII’s fundamental stock screening and research database.

    Figure 1.
    Neff Screen Performance
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Evaluating the Screen

    AAII tracks over 50 stock screening methodologies and reports the companies passing each of these screens on AAII.com each month. In addition, visitors to the site can view the performance of simple hypothetical portfolios invested in each screening approach that have been backtested over the last seven years.

    Since 1998, the Neff screen has been one of the best-performing and most consistent screens tracked by AAII. It has generated a positive return in every year since 1998, although it has gotten off to a slow start this year with a 9.3% decline through April 1. In its “worst” year, 1998, the Neff screen still managed a 9.3% gain.

    In addition, the Neff screen has outperformed the broad indexes in every year since 2000.

    Overall, the Neff screen has handily outperformed the small-, mid-, and large-cap indexes over this 7¼-year period, gaining a cumulative 627.7% compared to a 21.7% increase in the S&P 500. The companies currently passing the Neff screen have underperformed the S&P 500 by 2.5% over the last 52 weeks, while all exchange-listed stocks have lagged the S&P by 6.0%.

    The characteristics of the stocks passing the John Neff screen are presented in Table 1, while Table 2 lists the 16 companies currently passing the Neff screen. This is slightly below the 18 companies the screen has averaged each month since 1998. Furthermore, the Neff screen has had, on average, a monthly turnover rate of 36.5%. The screening criteria of the Neff screen are listed at the end of this article.

    TABLE 1. Neff Portfolio Characteristics
    Portfolio Characteristics (Medians) John
    Neff
    Screen
    All
    Exchange-
    Listed
    Stocks
    Market cap (million) $880.30 $125.70
    Price-earnings ratio 9.7 19.4
    Price-to-book-value ratio 1.9 2
    Dividend yield 0.00% 0.00%
    Dividend-adjusted EPS Est PEG ratio 0.7 1.5
    EPS 5-yr. historical growth rate 25.10% 9.20%
    EPS 3-5 yr. estimated growth rate 15.00% 14.00%
    Relative strength vs. S&P -2.50% -6.00%
    Monthly Observations
    Average no. of passing stocks 18  
    Highest no. of passing stocks 36
    Lowest no. of passing stocks 4
    Monthly turnover 36.50%

    Profile of Passing Companies

    Neff follows a philosophy of sober reflection—a clear-thinking, objective view of the market that ignores the market’s latest love affair stock or industry. His goal is to identify unattractive and what he called “cheapo” stocks.

    Dividend-Adjusted PEG Ratio
    There are numerous ways to try to identify “value” or attractively priced stocks. One is to find low price-earnings stocks that also have solid earnings growth. This approach can be merged into a single variable, called a PEG ratio, which takes the price-earnings ratio and divides it by either the historical or forecasted growth rate in earnings per share. As a rule, PEG values of 1.0 indicate fairly valued stocks, while values above 1.0 indicate possible overvaluation and those below 1.0 possible undervaluation.

    The cornerstone of the Neff screen is a hybrid of the traditional PEG ratio—the dividend-adjusted PEG ratio. Here, the standard PEG ratio is adjusted to include the dividend yield by dividing the price-earnings ratio by the sum of the estimated earnings growth rate and the dividend yield.

    To pass the Neff screen, stocks must have a dividend-adjusted PEG ratio that is less than or equal to half the median value for the entire Stock Investor database. As of April 8, 2005, this was 1.5, meaning that a stock needed a PEG ratio of 0.75 or lower to pass the Neff screen. The companies currently passing the Neff screen have a median value of 0.7. In comparison, the S&P 500 has a median dividend-adjusted PEG ratio of 1.5, mirroring all exchange-listed stocks. Orbital Sciences Corp. (ORB)—a developer and manufacturer of small rockets and space systems for commercial, military and civil government customers—has the lowest dividend-adjusted PEG ratio of 0.2.

    Price-Earnings Ratios
    In breaking down the dividend-adjusted PEG ratio into its component parts, one component is the price-earnings ratio. A key element of many value investing approaches is a low price-earnings ratio. The hope is to find bargain-priced stocks with promising earnings and growth prospects.

    How do the stocks passing the Neff screen stack up in terms of price-earnings ratios?

    For the stocks passing the Neff screen, the median price-earnings ratio is 9.7, compared to 19.4 for all exchange-traded stocks. Currently Olympic Steel, Inc. (ZEUS), which processes and distributes specialized steel products, has the lowest price-earnings ratio, at 3.0 times earnings. Meanwhile, Alliance Resource Partners (ARLP), a producer and marketer of coal to utilities and industrial users in the United States, is the “richest” stock of the group with a price-earnings ratio of 16.1.

    Forecasted Earnings Growth
    Low price-earnings ratios alone are not enough; adding solid earnings growth estimates to the mix offers validation that the company may not deserve its low price-earnings ratio. Neff uses forecasted, or estimated, earnings with the caveat that growth estimates are merely educated guesstimates. Concentrating on long-term, three-to-five-year estimates, Neff requires strong yet realistic growth forecasts. Otherwise, if the growth estimate is too high, the potential risk becomes too great. Therefore, the Neff screen looks for an estimated earnings growth rate of at least 7% and no more than 20%. The stocks passing the Neff screen have a median estimated earnings growth rate at the high end of this range at 15%, which is slightly better than the 14% for all exchange-listed stocks. All of the stocks currently passing the Neff screen have forecasted earnings growth of at least 10%, with Olympic Steel right at 10%. Innodata Isogen, Inc. (INOD), a provider of data management solutions, rests at the high end of the range at 20%.

    Keep in mind that these screens will serve to eliminate the majority of U.S.-traded stocks, as only about 45% have analyst coverage, which is the source of earnings estimates.

    Dividend Yield
    Stocks that pass any value-oriented screen often pay a dividend and, as a result, have high dividend yields—low price-earnings ratios and high dividend yields are typically synonymous. Neff feels that high dividend yields serve as price protection: If stock prices fall, a strong dividend yield can help ease the pain. Stocks that pay a dividend have an advantage when it comes to the Neff screen—given two stocks with equal earnings growth estimates but only one of which pays a dividend, the dividend-paying stock will have a lower dividend-adjusted PEG ratio as the yield serves to lower the value of the ratio.

    Interestingly, however, most of the stocks passing the Neff screen are not benefiting from a high dividend yield. The median dividend yield for these companies is 0% (the same as for exchange-listed stocks), with only seven of the 16 currently passing stocks expected to pay a dividend over the next 12 months. Alliance Resource Partners has the highest dividend yield among the current crop of stocks passing the Neff screen. Its yield of 4.7% is based on a current (as of April 8, 2005) price of $64.25 and an indicated dividend of $3.00 per share (the dividend the company expects to pay over the next 12 months).

    Qualifying Screens

    When looking for value companies, it is important to look beyond value measures to arrive at a final set of companies that warrant additional analysis. If you focus solely on value indicators—such as price-earnings ratio, price-to-book-value, and PEG ratio—and only pick those stocks with the lowest value measures, you run the risk of finding stocks deserving these low values. These are companies in decline that are lacking growth prospects and, as a result, probably will not see a rebound in their stock price. For this reason, it is important to run qualifying screens to verify the financial strength and/or prospects of the low price-earnings ratio stocks. Among those used by Neff are sales growth and operating margin.

    Sales Growth
    Since top-line sales growth is the driver of bottom-line earnings growth, Neff feels that truly attractive stocks must demonstrate formidable sales growth. As a result, Neff employs the same parameters for sales growth as for estimated earnings growth: Sales growth over the most recently reported five-year period must be between 7% and 20%. For the stocks passing the Neff screen, SkyWest, Inc. (SKYW), a regional airline serving the U.S. and Canada, has the highest sales growth rate of 19.5%.

    Operating Margin
    One other element of the Neff screen is that a stock’s operating margin must be better than its industry’s current median. Industry comparisons are important, as margins tend to be very industry specific. Robust operating margins shield stocks against negative surprises. Our Neff screen requires operating margins greater than the industry median for both the last four quarters (trailing 12 months) and the most recent fiscal year.

    Conclusion

    John Neff employed a value-oriented, contrarian approach to stock selection to attempt to identify attractively priced and neglected stocks with the financial strength to possibly fuel a rebound in stock price. He avoided the latest market fads and herd mentality, unless he felt that the herd was correct. The fruits of his labor were a track record that most investors can only dream of.

    The companies passing this or any other screen, however, should never be viewed as a “recommended” or “buy” list. Any quantitative screening requires further analysis by an individual, not a computer. In particular, it is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing constraints before committing your investment dollars.

       John Neff Screening Criteria
  • The dividend-adjusted PEG ratio (current price-earnings ratio divided by the sum of the estimated growth in earnings per share and dividend yield) is less than or equal to half of the median value for the entire database

  • The estimated growth rate in earnings per share is greater than or equal to 7% and less than or equal to 20%

  • The five-year growth rate in sales is greater than or equal to 7% and less than or equal to 20%

  • Free cash flow per share over the last 12 months and the last fiscal year (Y1 in Stock Investor Pro) is positive

  • The operating margin over the last 12 months is greater than or equal to the industry’s median operating margin over the same period

  • The operating margin over the last fiscal year (Y1 in Stock Investor Pro) is greater than or equal to the industry’s median operating margin for the same period

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