This is Where You May Find Investing Bargains in the Stock Market Now

John Neff’s an investor who not many outside of investing circles might know of, but he’s actually one of the greats in the business.

Neff made his name while managing the U.S.-based Windsor fund from 1964 to 1995. During his 31-year tenure, each dollar invested in his fund would have returned $56, handily outpacing the return of the S&P 500 (a U.S. market index) by two-to-one.

With Neff’s sterling track record, we may want to learn from his investment approach.

To do that, we can turn to Neff’s book John Neff on Investing, where he laid out seven principal elements of his investing style. We will look at his first principle today: investing only in shares with a low price-to-earnings ratio.

The allure of cheap stocks

“Low PE ratio stocks populate bargain basements because its underlying earnings and growth prospects don’t excite most investors. As a low PE investor, you have to distinguish misunderstood and overlooked stocks selling at bargain prices from many more stocks with lackluster prospects.”

— John Neff

Neff preferred to hunt for stocks with a low PE ratio as he felt that such stocks generally provided excellent upside participation while simultaneously giving protection against losses.

The upside from a low PE ratio can come from an expansion in the PE ratio as the company grows. To make his point, Neff gave the example below on the benefits of PE expansion.

2015-06 Neff Table

Source: John Neff on Investing

As you can see, even though there is a similar growth rate between the two companies (Static P/E and Expanded P/E), the company with the lower initial PE had generated a much higher return as a result of an expansion of its earnings multiple.

How low is low?

For some perspective on what’s a low-enough valuation that might attract Neff, he generally preferred to hunt for stocks that are trading at a PE multiple that’s 40% below that of the market average.

In our local context, we can use the SPDR STI ETF’s (SGX: ES3) valuation as a proxy for the market average; the SPDR STI ETF – an exchange-traded fund tracking Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a current PE ratio of 13.4. As such, investors who would like to emulate Neff’s approach might prefer a PE ratio of around 8.

Foolish takeaway

If Neff was a fisherman, then the pond with low PE stocks would be where he would fish. That said, it says little about what fish (stocks) he’s looking out for. Moreover, my Foolish colleague Ser Jing has warned that not all low PE stocks are worth picking up, so one shouldn’t sink a hook blindly into the low PE pond and indiscriminately haul up whatever is caught by the hook.

There is more to Neff’s approach than just fishing for a low PE stock and like I mentioned earlier, he had another six more principles. These will be covered in future articles shortly, so stay tuned for more on John Neff!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn't own shares in any company mentioned.