Where Have The Low P/E Stocks Gone? Here Are Five To Consider

|
Includes: HNP, IX, MGA, NMFC, SBS, USA
by: John P. Reese

Summary

One of Buffett's best investments was when he doubled down on GEICO at 8x earnings decades ago.

Investors can learn from Buffett and other greats like John Neff in finding deeply discounted stocks with sound fundamentals.

I used Validea's Neff-inspired Low P/E model to uncover a handful of value names that are worth looking into further.

When Warren Buffett, a guru I emulate on Validea, purchased his first shares of GEICO back in 1951, there were no funny commercials or talking lizard mascots to entice him. It was Buffett's limitless curiosity about the company's then-chairman Benjamin Graham—one of Buffett's professors at Columbia University as well as his mentor and "hero"--that led Buffett to visit Washington DC on a cold Saturday morning to visit what was then the General Employees Insurance Company.

After spending several hours with GEICO executive Lorimer "Davy" Davidson, Buffett's interest peaked regarding the insurance industry and GEICO's predecessor in particular. In fact, the company was one of Buffett's earliest investments—he purchased 350 shares at a multiple of about 8 times earnings. Given the market PE at the time (around 15), that was a good deal, but a steal given the current market PE of 24.

Today's robust market includes few companies with low P/E ratios, but there are some. In fact, one of the stock screening models I created for Validea was inspired by the legendary investor John Neff, who managed Vanguard's Windsor Fund from 1964 to 1995. For Neff, the P/E ratio (a stock's per-share price divided by per-share earnings) was 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 discerned between value investing and low P/E investing. In a 2004 interview he explained, "Value is in the eye of the beholder. Low P/E is easily calculated and definitive." Neff looked for companies with low P/E ratios that were also growing at a good clip—higher than 7% annually. He believed this to be characteristic of an underappreciated stock. That said, he avoided growth rates of over 20%, arguing that such growth could be unsustainable and the stocks could be overvalued.

Here are some of the metrics that Neff used in his investing approach and which I integrated into my Neff-inspired 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.

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:

Magna International Inc. (USA) (MGA) is a global automotive supplier. The company earns a perfect score according to our James O'Shaughnessy-inspired stock screening model due to its size (market cap of $17.9 billion) and persistent growth in earnings-per-share. Price-sales ratio of 0.48 (based on trailing 12-month sales) is well under the maximum allowed of 1.5, and the stock's relative strength of 64 adds interest. Our John Neff-based investment strategy likes the company's price-earnings ratio of 8.77, which falls comfortably within the preferred range for a non-cyclical company of between 7.60 and 11.40 (between 40% and 60% of the market P/E). For dividend payers, this model likes to see earnings-per-share growth (based on 3, 4 and 5-year averages) of between 7% and 20%. At 11.1%, the company passes with flying colors.

New Mountain Finance Corp. (NMFC) is a closed-end, non-diversified management investment company that earns high marks under our Neff-based investment strategy for its P/E of 7.68 and historical earnings-per-share growth rate of 18.5% (which falls within the preferred range of between 7% and 20%). Historical sales growth (based on 3, 4 and 5-year averages) is favorable at 44.4%, and positive free cash flow is a plus. Our Martin Zweig-inspired screen likes that the company's revenue growth of 44.39% is considerably higher than its earnings growth of 18.54% (based on 3, 4 and 5-year averages), as earnings must be supported by a comparable or better top line to be sustainable.

Orix Corporation (IX) is a financial services company that earns a perfect score under our O'Shaughnessy-based investment strategy due to its size (market cap of $20.8 billion) and price-sales ratio of 0.86, well below the maximum allowed of 1.5. Persistent growth in earnings-per-share and favorable relative strength adds interest. The company also earns high marks from our Joseph Piotroski-inspired investment strategy based on its book-market ratio (inverse of price-book ratio) of 1.09 which falls within the top 20% of the market as required by this model. Return-on-assets of 2.42% passes this screen as well as operating cash flow of $5.20 billion.

Huaneng Power International Inc. (HNP) is a China-based company principally engaged in the development, construction, operation and management of power plants. The company scores well according to our Peter Lynch-based investment strategy due to its favorable ratio of price-earnings to growth in earnings-per-share (PEG ratio, a hallmark of the Lynch model) of 0.37 (anything under 1.0 passes, but a ratio of under 0.50 is considered best case). Our David Dreman-inspired screen favors the company's price-earnings, price-cash flow, price-book and price-dividend ratios (8.51, 3.90, 0.84 and 16.78, respectively), all of which fall in the bottom 20% of the market.

Companhia de Saneamento Basico (SBS) is a water and sewage service company that serves 360 municipalities in the state (and city) of Sao Paulo. Our Lynch-based model favors the company's PEG ratio of 0.43 (based on 3, 4 and 5-year averages) as well as earnings-per-share of $1.40 (required to be positive to pass this screen), and our Neff-inspired strategy likes the price-earnings ratio of 7.92 as well as the historical earnings-per-share (based on 3, 4 and 5-year averages) of 14.4%, which falls comfortably within the preferred range of between 7% and 20%. Positive free cash flow adds appeal.

Disclosure: I am/we are long MGA, NMFC, IX AND SBS.

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.