Click hePeter Lynch is renowned as the best-performing fund manager. He achieved this status whilst acting as the portfolio manager of Fidelity’s Magellan Fund. During the years from 1977 to 1990, he achieved an annual rate of return of 29.2%, turning a $1,000 investment 13 years later into $28,000. His fund performed consistently, beating the US stock market in all but two of his 13 years at the helm. The asset base grew from $18 million to $14,000 million, making it the largest in the world, and attracted over 1 million shareholders by the time he decided to quit in 1990.
At the age of 46, he chose to spend more time with his wife and daughters and doing charitable work. (This is the same age at which his own father, a mathematics professor then senior auditor, had died. A memory which may have motivated his decision to stop his workaholic habits.)
When looking at an investment, Lynch seeks a particular combination of characteristics. Some of these characteristics are in the list of criteria used by many other value investors, e.g. a strong, competitive business with financial strength; others are peculiar to Lynch.
He liked to favour the best-performing company in an unpopular industry. He is strongly of the opinion that small, private investors can have considerable advantages over professional fund managers, and can outperform them, so long as they do their research and stick to what they know.
For Lynch, investing is not complicated. If the company analysis you are undertaking starts to get too complicated, forget that company and move on to the next share.
There is so much you can learn from Lynch:
Lynch grew up in an era when everyone remembered the depression and distrusted the stock market, saying ‘never get involved in buying shares, it’s too risky. You’ll just lose all your money’.
However, after the death of his father, Lynch did som
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Click herJohn Neff is one of the greatest investors of the twentieth century; a value investor with a particular emphasis on low price earnings ratios. He acknowledged that deciding when to sell is the toughest investment decision. Unfortunately it is far too easy to fall in love with the shares in your portfolio.
You must remember that your shares represent a business and if the underlying business is not performing now, and you see no upward turn on the near horizon, you must part with them.
All Neff’s shares were for sale, yet he was not averse to holding some for three to five years. However, at times if a share was not living up to expectations it may only be held for only a month.
Thus, a share may be sold if the fundamentals of the business have changed (e.g. strategic position or management) since the purchase or a mistake in the original analysis is revealed. Thus it’s important to regularly update your analysis so that each share in the portfolio has a clearly visualized potential for a rising share price.
There are two major hurdles an investor must clear when making the decision to sell.
John Neff said ‘by playing it safe, you can make a portfolio so pablum-like that you don’t get any sizzle. You can diversify yourself into mediocrity.’
You do not have to hold shares in every sector of the economy; merely a reasonable spread, staying within your circle of competence and in areas of the market where there is evidence of undervaluation.
It is stupid to own, for instance, turbine companies if the market is over-excited about this sector.
A dozen or so companies is usually sufficient to provide the private investor with enough diversification. A mutual fund, such as the one I’ll be running next year, needs to be more diversified to be able to withstand a flood of client redemptions at a time of market turbulence to avoid too much dependence on rapid liquidation from a mere handful of stocks; but still I expect to have only around 20-25 companies.
Don’t follow the bull market hype: Over time markets will go through cycles and the pack of investors will go through periods when they invest in quality and use a more selective and risk adverse approach to their stock picking. But as their confidence grows in a rising market, these investors can get carried away.
As the market continues to grow beyond expectations so does the inexperienced investor’s frenzy to follow the latest fad and fashion.
These investors get so caught up with the prospect of making a quick buck, they fail to follow a rational investment strategy undertaking a fundamental evaluation of stock.
Shares are bought and sold on the basis of tips and superficial knowledge, investing without clear understanding and calm reflective thought. Investors seem to have an almost infinite capacity at times to believe in something too good to be true.
It will, at some point, dawn on the crowd that some players have cut their losses and figured out that things have gone too far.
Like sheep, group panic sets in as everyone runs for the exit.
Unfortunately, the aftermath of these bull markets is not a pretty sight and most of the followers go home empty handed.
My advice would be to stay clear of the markets that have lost touch with the fundamentals. Don’t try to play the greater fool game – buying even though you are not convinced of the fundamental value in the hope of selling the stock on to someone else before the market decline comes – you might end up being the biggest fool.
Don’t forget history’s lessons
A value investor requires a
We have discussed at length the criteria used by successful value investors, however, there are several important areas they avoid. I’ll describe two today: glamour shares and chartism.
Take Tesla, with a market capitalization of over $1,150bn. That is many times more than Ford (MCap $81bn) which produces 5m vehicles per year, turnover of $160bn and billions in profits in a normal year. It’s also more than General Motors (MCap $93bn), 7m cars and profits after tax of $5.6bn Tesla is priced at 35 times sales and 375 times profits. It sold 0.5m cars in 2020.
We’ve seen this sort of thing before, for example, internet stocks in the late 1990s. A combination of over-excitement, the obligation of index trackers (and closet index trackers) to buy those shares that have risen (with small free floats) pushed prices to extreme levels. The companies had untested business models and no profits.
Tesla at least has a good business model and profits, but there a hundreds of Tesla wannabes that lack revenue or profits, e.g. Rivian, priced at over $100bn.
Investors need to properly consider the possibility of market entry, competition and the introduction of substitute products. The German car makers, let alone the American veterans, Chinese and Japanese makers are going to give Tesla and Rivian a good run for their money soon.
Even well established companies can be poor investments. Companies such as Diageo, Intel and Unilever are good companies, with excellent financial performances and ar
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Click hGood companies trading on low PERs can be found in different corners of the market, where neglect, fear or misunderstanding brings them low. Here are some categories:
The uncertainty associated with companies going through these transitional periods discourages most investors and the over-reaction that develops can push stock prices below reasonable levels.
An example is Wynnstay Group, the agricultural merchant, in 2019 and early 2020 when it was trading around £3 because of the uncertainty associated with farmer support and potential blocks on exports. It’s now £5.30.
Uncertainty can provide an excellent opportunity to the more analytical and patient investor, but there must be sound reasoning and clear rationale that the company will emerge from this transformation stronger.
If the share is standing on a low PER, you have every reason to assume reasonable growth and if it meets other criteria (e.g. sound management and strategy; low financial distress risk) then take courage and go against the crowd.
Currently, the negative sentiment towards oil and gas – a “dirty” business, according to people speaking in natural-gas-heated offices and driving home later in their diesel cars. With all those engineers and a will to turn green they might end up being the biggest players in turbines, charging points, solar panels and green hydrogen production one day.
This was the case for Capital and Counties, owner of most of Covent Garden, last year when tourists and office workers abandoned central London. I bought in November 2020 at 103p and sold at 174p in September 2021. Apparently everything is going to OK now and people will return to central London so Mr Market is happy to pay a full price for Capco.
Smiths News, a local monopolist or national oligopolist distributer of newspapers, was bought into my portfolio at 15.1p in 2020. It is still, after rising to 37p, on a PER of under 4. And I’m holding until Mr Market pays proper attention to the stability of the cash flows.
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As well as a low price-earnings ratio and a good expected growth rate of earnings (see yesterday's newsletter) John Neff, the value investor, required that companies selected for his portfolio had a superior dividend yield, good prospects in its marketplace and a strong financial structure.
The dividend yield provides a near-term cash return on the investment which offers a satisfactory income while the investor is waiting for the market to recognize the earnings growth potential. It is also far safer to look for a return through dividends than waiting for the uncertain return of growth in earnings. Dividends are rarely lowered and good companies are likely to increase the pay out.
The out-performance by Neff’s Windsor Fund of 3.15% pa over the market average was largely attributed to its superior dividend yield. Neff believed that many investors over-emphasize higher earnings growth potential over higher dividend yields.
He said that analysts tend to evaluate shares on the basis of earnings growth expectations alone, and therefore, in many instances, investors could ‘collect the dividend income for free’.
He found it incomprehensible that investors would regularly pay higher prices for shares with an earnings growth of 15% plus a 1% yield over a share offering 11% growth but a 5% yield.
Neff does not go into great detail about what he meant by ‘superior yield’ but generally it is believed he favoured a yield at least 2 percentage points over the average.
Neff’s success was partly based on a formula, which he used to calculate the total return of a share as a multiple of its price earnings ratio offered in the market - a way to measure ‘the bang for our investment buck.’ He would calculate this by combining the growth in earnings with the dividend yield and placing this over the PER.
Total return = earnings growth + yield .
PER price most recently reported earnings
Investors search for high earnings growth prospects, but also need shares with the lowest price relative to current earnings and dividends.
Neff, after a good deal of experience and experimentation, determined that his rule of thumb hurdle rate was to be two. That is, the total return for a share divided by its price earnings ratio for a particular company should exceed the market average ratio by two to one.
An example would be if the earnings growth for shares generally is 4% and the market dividend yield is 5%, taking the historical PER for the market index as 14 the hurdle rate for a particular share under consideration would equal:
Total Return/PER = (4 + 5)/14 = 0.64. Multiplied by 2 gives 1.28
The hurdle rate will rise to 1.8 if the market PER falls to 10.
The time period used to calculate past earnings growth is critical for estimating future growth. As a minimum Neff would use five years because this time scale allows for economic fluctuations such as extraordinarily good periods causing average earnings to rise by double-digit percentages.
Common sense is required; avoid, for example, extrapolating double-digit real growth figures from bull market periods to infinite horizons.
A reasonable upper limit to the estimate of future profit growth would be to follow the real Gross Domestic Product growth rate (say 2.5%) plus inflation (say 2%) over the long run. To assume higher growth rates is risky, leading to the abandonment of a conservative stance about future prospects.
Good business prospects
Unfortunately, there is no set of purely mathematical or mechanical tools out there that will allow the investor to pick and choose market-beating stocks. Neff shows us that we require both a quantitative and qualitative approach to our analysis.
This includes finding out how an industry ticks. Study the firm and its rivals, the products, and the strategic positioning. He was interested in good companies with powerful competitive strengths that were under-priced and overlooked due to the market’s obsession with glamour stocks.
Neff advises us to visit factories, shops and try the products sold by the specific companies you’re interested in – kick the tyres.
Reading trade mag
John Neff, an American, developed an investment philosophy which emphasizes the importance of a low share price relative to earnings. But he did not stop there; he required the share to pass a number of tests in addition to the price-earnings criterion, and it is through his use of these further screening tools that he successfully evolved his approach from simple low price-earnings investing to a sophisticated one.
Neff employed his investment approach in managing the Windsor Fund for 31 years between 1964 and 1995. It returned $56 for each dollar invested in 1964, compared with $22 for the S&P 500.
The main factors he looked for
Low price-earnings ratio, PER
The Windsor Fund usually bought shares with PERs 40 to 60 per cent below those of the typical share. Neff believed that if these shares also had the promise of steady earnings growth then there was the potential for the appreciation to be ‘turbocharged’.
Low PER shares can get two boosts:
Ignored Inc. on the other hand is overlooked and in an industrial sector that is currently out-of-favour. It has a PER of 12.
Not only do both companies have the same current earnings, but careful analysis tells you that their future annual earnings growth will be the same, at 8 per cent.
So after one year the earnings at both companies stand at $1.08. The market continues to value Famous Inc. at PER ratio of 25 and consequently the share price rises to $27, an 8 per cent appreciation.
During the year the market has slowly come to realize that it has overreacted to the difficulties in Ignored Inc’s industry and a re-rating has taken place. Now the market is prepared to pay a multiple of 20 on recent earnings.
So, if earnings are now $1.08 the share rises to $21.6. This is an 80 percent appreciation in one year!
Neff said that because investors have forced the price of the low PER share to absorb all the bad news, there is little positive expectation built into the price.
Moderately poor financial performance is unlikely to lead to a further penalty – so there is a degree of protection on the downside.
However, any indication of improvement may lead to fresh interest. If you can sell into that fresh interest, when other investors are fully recognizing the underlying strengths, you should produce an impressive return.
Obviously not all investments in a low PER portfolio are going to turn out to be as successful as Ignored Inc’s shares (the operating performance of the firm declines, say, or the market continues to ignore the company), but evidently, it is possible to succeed in a sufficient number of cases for this approach to be useful.
Modest earnings growth
It is not enough to sim
True investors can go for long periods of time against the supposed wisdom of the masses and be able to cope with the psychologically corrosive delay before benefiting from their sound analysis. They have to show perseverance, sometimes waiting years before other investors realized their mistake and appreciated the virtues of a good solid company with steady rising earnings.
A portfolio of good companies
We should not rely on a few shares doing dramatically well. To go home winners, investors need to be consistent and not to rely too heavily on any individual share.
Tennis and the investor
The requirements of consistency, persistence and patience can be explained using a tennis analogy:
Some players are extremely talented and are able to adopt a playing style to win a match. They have brilliant stroke play or a winning serve, say. Most players are not like that. The rest of us should concentrate on our strengths, to win by not losing; to keep the ball in play as long as possible allowing time for our opponent (Mr Market) to make a mistake.
Knowledge of the past
Investors develop a sense of the history of stock market be
Success in value investing requires courage. You need to be brave to buy the down-and-out shares, those rejected by your peers. You may get blank expressions as they try to understand your unusual behaviour, and you must be prepared to accept the risk of embarrassment that follows from being different.
Be on the lookout for out-of-favour, overlooked or misunderstood shares that have earnings growth potential the rest of the market has missed.
If you can buy shares where all the negatives are chiefly known, and therefore the share price is depressed, then any good news will have an overwhelmingly positive effect.
A key mistake made by investors is to buy into shares where investors generally have high expectations of growth and where any negative news could have a devastating effect on the shares.
Markets tend to be led by the latest fashions and fads. This results in over-valuation of the in-vogue shares and under-valuation of the less glamorous but generally good shares. Investors became caught up in a frenzy and ignore the good solid companies.
For a successful investment career you can live without glamour stocks or bull markets. The key requirements to carry you through are judgment and fortitude:
‘Judgment singles out opportunities; fortitude enables you to live with this while the rest of the world scramble in another direction…to us ugly stocks were often beautiful’ says John Neff, one of the great value investors
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I'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk
investing is about making the right decisions, not many decisions.