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
Prof. Glen Arnold
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