Emulating John Neff To Find Low P/E Stocks That Look Fundamentally Sound

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Includes: DVA, ESNT, KB, PAG, UNM
by: John P. Reese

Summary

Using the strategy outlined by John Neff to construct a low P/E multi-factor stock selection model.

Neff-based stock screening model is a combination of Sales growth + Total return/PE ratio + Free cash flow + Persistence in EPS.

We've identified a few names that currently score highly based on the strategy.

Price-earnings (P/E) ratio is one of the most widely used variables in stock analysis, and an indicator of how much investors are willing to pay for every dollar in earnings that a company is generating. For legendary investor John Neff, who managed Vanguard's Windsor Fund from 1964 to 1995, the P/E ratio (a stock's per-share price divided by per-share earnings) is also a measure of what level of growth investors are expecting from a company in the future.

The expectation factor was paramount for Neff, who found that high-flying growth stocks with high P/Es were very sensitive to any disappointment compared to expectations. Low P/E stocks, he found, had fewer expectations built into their pricing, so there was substantial upside if performance beat expectations but little downside if the opposite occurred-since Wall Street had already written them off. According to Neff, "If you buy stocks when they are out of favor and unloved, and sell them into strength when other investors recognize their merits, you'll often go home with handsome gains."

Neff considered himself a "low P/E investor" rather than a value investor. When asked to explain the difference (in a 2004 interview), he responded: "Value is in the eye of the beholder. Low P/E is easily calculated and definitive." He targeted downtrodden stocks, those with P/E ratios that were 40 percent to 60 percent below the market average. But that was only the first test. The challenge, of course, was to discern between those stocks that were beaten down unfairly from those that deserved the drubbing.

One way Neff accomplished this was by looking at earnings growth. In his 2001 book John Neff on Investing, he argued that low P/E companies growing faster than 7 percent annually "tipped us off to underappreciated signs of life, particularly if accompanied by an attention-getting dividend." But he shied away from growth rates over 20 percent, asserting that such stocks would be pricey even though investors couldn't be assured that the high rates of growth would be sustainable.

Interestingly, Neff's book was published at the height of the tech stock bubble (that began around 1997). At that time, many investors ignored earnings while searching for the next high flying tech or internet stock in-the-making. In his book, however, Neff predicted that even the most successful tech stocks of the day couldn't possibly keep up their dramatic growth. Not long after the book was released, the tech bubble burst, leaving countless devastated investors in its wake.

Here are some other metrics that Neff focused on in his analysis, which I used when building my Neff-based stock screening model:

Sales growth: Neff believed that attractive companies had to show sales growth, although he didn't specify growth rates to look for. Our Neff-based model requires a firm's sales growth to equal at least 70 percent of its EPS growth rate.

Total return/price-earnings ratio: This was required to be at least two times either the market or industry average (total return equals EPS growth rate plus dividend yield). Neff relied heavily on this metric to gauge how cheap a stock was relative to its industry or the market as a whole.

Free cash flow: Neff liked to see positive cash flow, which could help a company buy back stock, pay dividends and/or make acquisitions.

Persistence in earnings-per-share: Consistent growth in earnings-per-share for each of the past four quarters.

Since I began tracking 10 & 20 stock portfolios of top rated stocks using the Neff methodology, the optimal performer over time is the 20-stock, quarterly rebalanced portfolio. The portfolio struggled in 2014 & 2015, as many value strategies and smaller cap stocks got hit. But the portfolio has come back and in the last 12 months, despite the underperformance so far in 2017, the portfolio is up 22.7% compared to 15% for the S&P 500.

Using the stock screening models I created based on the strategies of John Neff and other investing legends, I have identified the following five high-scoring stocks:

Penske Automotive Group Inc. (PAG) is an international transportation services company that operates automotive and commercial truck dealerships principally in the United States. The company earns a perfect score under our James O'Shaughnessy-based stock screening model due to persistent growth in earnings-per-share as well as a price-sales ratio of 0.18, well below the maximum allowable level of 1.5. Our John Neff-inspired strategy also assigns a perfect score to the company based on the price-earnings ratio of 10.22 compared to the market P/E of 18.0. Average sales growth (based on 3, 4 and 5-year averages) of 11.9% exceeds the minimum of 7% and therefore passes this screen. Positive free cash flow adds appeal.

Unum Group (UNM) is a provider of financial protection benefits in the U.S. and the U.K., including disability, life, accident, critical illness, dental and vision. The company earns high marks from our Peter Lynch-inspired stock screening model based on the ratio of price-earnings to growth in earnings-per-share (PEG ratio) of 0.63-anything under 1.0 passes this screen. This model considers the equity-asset ratio a better measure than debt-equity to determine whether a financial intermediary is healthy. With an equity-assets ratio of 15.0% versus the required minimum of 5%, UNM passes this test with flying colors.

DaVita Inc. (DVA) is a healthcare company that provides services through its Kidney Care division as well as through DaVita Medical Group. The company scores well under our Neff-based model due to its price-earnings ratio of 10.41, which falls within between 40% and 60% of the market P/E. Sales growth, which is required to exceed 12%, passes at 13.5% (based on 3, 4 and 5-year averages). The company also earns high marks from our David Dreman-based investment strategy due to its positive earnings trend over the past two quarters as well as both its price-earnings and price-cash flow ratios which, at 10.41 and 5.79 respectively, fall among the bottom 20% of the market, as required by this model.

Essent Group Ltd. (ESNT) is a private mortgage insurance company that earns a perfect score from our Validea Momentum investment strategy in light of its annual earnings growth of 18.51% (above the minimum requirement of 18%) and earnings consistency. Current share price ($36.18) is within 15% of the 52-week high, another plus under this model, and return-on-equity of 18.6% is above the minimum requirement of 17%. Our Neff-inspired screen likes the company's growth in earnings-per-share of 18.5% (based on 3, 4 and 5-year averages), which falls comfortably within the preferred range of between 12% an 20%, and our Martin Zweig-based investment strategy gives a thumbs up to revenue growth (63.08%) which far exceeds earnings growth (18.51%), an indication that continued growth will be supported by a strong top line.

KB Financial Group Inc. (KB) is a Korea-based financial holding company that earns high marks from our Neff-inspired screen for its price-earnings ratio of 8.75 which is comfortably within the preferred range of between 7.20 and 10.80 (40%-60% below the market P/E). Persistent growth in earnings-per-share and positive free cash flow-per share are added bonuses under this model.

Disclosure: I am/we are long ESNT, PAG & UNM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.