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
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.