1 Key Sign to Help You Identify Bargain Stocks

When looking for bargains in the stock market, John Neff may be someone you might want to listen to.

After all, Neff had built up a formidable track record over the 31 years that he managed the U.S.-based Windsor fund from 1964 to 1995. Over that three decade-plus period, each dollar invested in his fund would have become $56, handily outpacing the return of the S&P 500 (a U.S. market index) by two-to-one.

With his accomplishments in the field of investing, we may want to learn more 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.

Prior to this article, I had written about six of those elements:

  1. Fishing in the low price to earnings (PE) pond
  2. Finding companies with fundamental growth of more than seven percent
  3. A preference for shares with high dividend yields
  4. Wanting a superior relationship of total return to PE ratio
  5. Investing in cyclical companies only if one was being well compensated for bearing the risks (Neff tried to achieve his aim by insisting on a low prospective PE ratio)
  6. Looking for strong companies in growth industries

In here, I’d take a closer look at Neff’s last principal element: Strong fundamentals.

Going back to the fundamentals

“Return on Equity (ROE) furnishes the best single yardstick of what management has accomplished with money that belongs to shareholders.”

– John Neff

Neff wasn’t satisfied with getting a bargain-priced stock alone. The investing guru also wanted to see fundamental strength in the company that he invests in.

There are a variety of fundamental signs that Neff favors: dollars sales which exceed unit sales (suggesting pricing power); the presence of cash flow (defined as retained earnings plus depreciation); and above all, a healthy return on equity (ROE).

A consistently strong ROE alongside growth in earnings per share (Neff’s second principle) could be a sign of greater things to come.

We can use the dynamic duo of health-care provider Raffles Medical Group Ltd (SGX: R01) and vehicle inspection firm Vicom Limited (SGX: V01) as examples. Over the past 10 years (see below), both companies have demonstrated the ability to maintain a decent return on equity while generating steadily growing earnings per share.

Returns on equity (ROE) for Vicom and Raffles Medical from 2004 to 2014

Earnings per share (EPS) growth for Vicom and Raffles Medical from 2004 to 2014

Source: S&P Capital IQ

The business performance of the duo has not gone unnoticed by the market: Since the start of 2004, Raffles Medical Group and Vicom have bagged capital gains of 1,132% and 604%, respectively.

To be sure, Raffles Medical Group and Vicom are currently trading at prices far above the bargain-basement levels which Neff favours (Raffles Medical Group and Vicom are selling for 38 and 18 times their respective trailing earnings; this compares with the average PE ratio of 13 in the market). But if they did, Neff might be one of the few queueing up to pick up their shares.

Foolish takeaway

So, there you have it.

We have waded through the seven principal elements of John Neff’s investing approach. While there are great insights for investors to pick up from the way Neff had went about investing, it’s very  important to note that Neff had the overall discipline to stick to his seven elements and implement his strategy for more than three decades.

The long term investing discipline he demonstrated is truly inspirational and is one trait that Foolish investors may want to aspire to.

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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 owns shares in Vicom.