1 Quick Ratio to Help You Find Bargains in the Stock Market

If you’re into investing and have not heard of John Neff, here’s why you may want to: Over his 31 years managing the U.S.-based Windsor fund from 1964 to 1995, Neff turned every dollar invested in his fund into $56, handily outpacing the return of the S&P 500 (a U.S. market index) by two-to-one.

With a phenomenal track record like that, we may want to learn more from Neff’s 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.

Prior to this article, I have written about Neff’s first three investing principles:

  1. Fishing in the low price-to-earnings (PE) pond
  2. Looking for businesses that had fundamental growth of more than seven percent
  3. A preference for good dividend yields in the stocks he chooses

Today, I’ll talk about his fourth principle: A superior relationship of total return to the PE paid.

Paying as little as possible for growth

“In Windsor’s lexicon, “total return” described our growth expectations: annual earnings growth plus yield… Total return supplied half of a ratio that summarised, very neatly, Windsor’s competitive edge. The other half of the ratio, PE, disclosed what we paid for to secure total return…

…We preferred stocks whose total return, divided by the PE, exceeded the market average by two to one.”

— John Neff

As you can see in Neff’s first principle (low PE ratio) and second principle (fundamental growth), he was primarily interested in low priced stocks with growing businesses. The fourth principle is Neff’s way of bring together the first two together and he called it the “total return ratio” (admittedly, Neff says it’s not a catchy name!).

As an example of how we might work the total return ratio, we can use luxury watch retailer Hour Glass Ltd (SGX: AGS) as an example.

The company has grown its earnings per share (EPS) by 11.85% annually in its last five fiscal years. On a trailing twelve months basis, Hour Glass also offers a dividend yield of 2.6% as of its closing price of 84 cents per share yesterday. That  would put the total return (EPS growth plus dividend yield) for Hour Glass at 14.5%. At its current trailing PE ratio of 12.9, this would thus give a total return ratio of 1.1 (14.5% ÷ 12.9).

As seen in the quote above from his book, Neff had preferred to invest in stocks with a total return ratio that exceeded the market average by 2 to 1. But in the absence of information on the total return ratio for Singapore’s market barometer, the Straits Times Index (SGX: ^STI), Foolish investors may have to decide on on a suitable total return ratio on their own.

Foolish takeaway

As Foolish readers may have already noted, there are another three principles to cover in Neff’s overall investing approach. Said another way, there is more to Neff’s approach than just stocks with low PE ratios, steady fundamental growth, yield protection, and a healthy total return ratio.

I’ll be covering Neff’s other investing principles in future articles soon, so stay tuned for more about this investing legend!

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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 companies mentioned.