Here’s A Possible Hidden Gem in the Stock Market

Luxury watch retailer Hour Glass Ltd (SGX: AGS) has a market capitalisation of just S$487 million at the moment. That’s not a large number and investors would thus likely not notice it too much – that makes the company “hidden.”

But, the firm may also turn out to be a gem for bargain hunters. Why is that so? John Neff might be able to shed some light on the issue.

Neff… who?

Anyone compiling a list of investing greats would be hard-pressed to not include Neff in there. Neff became the manager of the U.S.-based Windsor fund in 1964 and remained there till his retirement in 1995.

Over his 31-year tenure, Neff had invested the fund’s capital brilliantly, clocking compound annual returns of 13.7%. That far outpaces the 10.6% annual returns delivered by the S&P 500, a widely-followed U.S. stock market barometer, over the same period.

Given his accomplishments, Neff’s views on investing thus carry tremendous weight. In his book John Neff on Investing, Neff had laid out several defining elements of how he had invested while at the Windsor fund.

The legend’s strategy

There are a few of Neff’s elements which we can easily utilise to help narrow the field of possible investments into a more manageable universe for deeper research. Here they are:

  1. A low price-to-earnings ratio

Neff liked investing in cheap stocks and in his eyes, a stock’s cheap if it’s trading at a substantial discount to the market average.

In Singapore’s context, the Straits Times Index (SGX: ^STI) can be used to represent the “market.” According to data from the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which tracks the fundamentals of the Straits Times Index – the market barometer is valued at roughly 12 times its trailing earnings now.

Shares with a price-to-earnings (PE) ratio that’s substantially lower than 12 can thus be a potential investing opportunity for Neff.

  1. Strong fundamental business growth in excess of 7%

Beyond just having a cheap valuation, Neff also wanted a business that could grow its earnings by a rate of between 7% and 20% per year. That’s because a stock with a growing business helps to build value for shareholders over time.

For obvious reasons, a growth rate that’s too low wouldn’t be ideal in helping us to compound our investing capital at satisfying rates. Meanwhile, Neff had decided upon the 20%-ceiling because he felt that stocks with super-charged growth can’t keep up that sort of momentum sustainably.

  1. Having yield protection

In Neff’s view, a stock with a high dividend yield is essentially paying him to wait for the market to eventually recognise the value of the stock – being paid to wait for a good thing to happen sounds like an attractive proposition.

The SPDR STI ETF has a yield of 3.3% at the moment. That number can be used as a benchmark to compare with the yields of different individual stocks.

  1. A business with strong fundamental support

A low valuation, sustainable earnings growth, and a solid dividend yield are all great things to have for Neff. But he also wants a business with strong fundamental support – in particular, he wants to see a strong return on equity.

This is how Neff describes the importance of the return on equity metric:

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

Although Neff did not specifically mention what’s considered a “good” figure for the ROE metric in his book, the experience of another great investor in Warren Buffett suggests that a useful benchmark here would a be ROE of 15% or more on strong balance sheets that have little or no debt.

Ticking the right boxes

Keeping all the above in mind, here’s how Hour Glass stacks up against the four criteria:

  1. At its current price of S$0.695, it has a trailing PE ratio of just 8. That number is nearly 50% lower than the Straits Times Index’s current valuation.
  2. Hour Glass’s earnings per share has grown at a compound annual rate of 11.9% between its fiscal year ended 31 March 2010 (FY2010) and FY2015.
  3. The luxury watch outfit’s dividend yield stands at 3.2% at the moment thanks to an annual dividend of S$0.022 per share in FY2015.
  4. Hour Glass’s average return on equity from FY2010 to FY2015 is an outstanding 17.2%. The number for the 12 months ended 30 June 2015 is 15.2%. There’s something else which makes Hour Glass’s returns on equity noteworthy for the period we’re looking at: The firm had achieved those numbers on strong balance sheets that always had more cash than debt.

As you can see, Hour Glass has ticked most of the right boxes save for its dividend yield that’s slightly lower than the market average.

But, it’s worth pointing out again that Neff’s criteria is meant to narrow the field – it should not be the final word on picking investments.

Investors would still have to dig into qualitative aspects of Hour Glass’s business carefully and answer other important questions. For example, how does the future prospects for the brick-and-mortar luxury watch retail industry look like? How capable is Hour Glass in inventory management given that consumers in the luxury retail sector can be very fickle at times?

Only when these questions and more are answered can an investing conclusion be reached.

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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 writer Chong Ser Jing doesn't own shares in any company mentioned.