5 beaten-down buys
This Neff-style screen uncovers unloved stocks for long-term value investors.
By John Reese, Validea
Most investors wouldn't give a fund described as "relatively prosaic, dull, conservative" a second glance. That, however, is exactly how John Neff described the Windsor Fund that he headed for more than three decades.
And while his style may not have been flashy or eye-catching, the returns he generated for clients were dazzling -- so dazzling that Neff's track record may be the greatest ever for a mutual fund manager.
By focusing on beaten-down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards. Over his 31-year tenure (1964-1995), Windsor averaged a 13.7% annual return.
How did Neff do it? By focusing first and foremost on value. To Neff, the price-to-earnings ratio was key because it involved expectations.
If investors were willing to buy stocks with high price-to-earnings ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share. Conversely, if a stock has a low price-to-earnings ratio, investors aren't expecting much from it.
Neff found that stocks with lower price-to-earnings ratios -- and lower expectations -- tended to outperform because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high price-to-earnings ratios often flopped because even strong results couldn't match investors' expectations.
To Neff, however, the price-to-earnings ratio wasn't always a lower-is-better ratio. If investors knew that a company was a dog, they'd rightly avoid its stock, giving it a low price-to-earnings ratio but little in the way of future growth prospects.
Because of that, he wrote that Windsor targeted stocks with price-to-earnings ratios between 40% and 60% of the market average.
He also wanted to see sustainable growth -- growth that was driven by sales and not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates.
One more key aspect of Neff's strategy involved dividends. He believed that many investors valued stocks strictly on their price appreciation potential, meaning that you can often essentially get their dividend payouts for free.
In recent years, my Neff-inspired model has been very stringent, with very few companies passing all of its tests. Here are five stocks that do pass the Neff-style screen:
Royal Dutch Shell PLC (RDS.A)
Questcor Pharmaceuticals (QCOR)
Encore Capital Group (ECPG)
The Neff-based model often treads into the most unloved parts of the market. Because of that, a value-focused strategy can languish for lengthy periods of time. But Neff succeeded by staying disciplined and focusing on value.
By ignoring the crowd and focusing on these companies' strong financials and fundamentals, I think the Neff model will end up benefiting significantly from many of these picks and be a strong performer as time goes on.
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