By Ryan Fuhrmann, CFA
Below is Part 2 of a three-article write-up on the presentation by legendary investor John Neff, CFA, during the 2006 Financial Analysts Seminar, hosted by the CFA Institute. Read through for a history of his career, current musings, and a number of stocks Neff currently finds interesting.
Fess up, get out, move on
It can be difficult to know whether you’ve made a correct investment decision. If one year of holding a stock hasn’t proved your thesis correct, Neff suggested that you reevaluate holding the position and even consider getting out. Otherwise, you risk becoming stuck in the proverbial value trap, in which an investor waits for conditions to improve with no move in the stock price. Fortunately, by buying such a low-P/E stock in the first place, your downside should not have been significant, since pessimistic assumptions were probably already baked into the share price.
If your fundamental hypothesis turned out to be spot-on, and a stock is working for you, Neff suggests you take advantage of the share-price appreciation to start locking in some of your gains. He said he wishes he’d taken more gains in some of his homebuilding stocks earlier this year, since the market turned downward more quickly than he had initially anticipated. For example, Neff admitted that he needed to do more work to understand why Pulte Homes(NYSE: PHM) is now expected to report less than $4 per share in earnings, when he projected that $5 should have been achievable for 2006.
When asked about markets that get out of whack, Neff explained — only half-jokingly — that irrational markets took place when the fund he’d previously managed didn’t perform too well. One such market, he said, occurred during the Nifty Fifty era of the 1960s and ’70s, when investors believed in buying a great company at any price. That may imply that Neff felt his holdings were the right ones and the market had yet to catch on, but it also demonstrates that his investment style avoided chasing fads.
Rather than pursue “adrenaline markets,” as he called them in his book John Neff on Investing, he prefers to invest in companies with good fundamentals and low P/Es. During periods of low P/Es, Neff encouraged investors to consider backing up the truck. During our talk, he commented that although the current market environment is not the cheapest he’s ever seen, there are low-P/E stocks out there with good growth prospects.
Neff’s ideal investment will possess an expected total return twice its P/E ratio. Suppose he’s looking for a stock that grows 12% annually and has a 2% dividend yield, for a total return of 14%. For this growth, he would be willing to pay no more than 7 times earnings. It’s tough to find in today’s market, he said, but certain stocks come close.
One to look at
For example, Neff recommended taking a look at Citigroup(NYSE: C). It’s trading close to a single-digit P/E level, and it has a return on equity near 20%. Neff likes its current dividend yield of more than 4%, and he noted that the yield is growing by about 10% per year, even as management is also buying back stock. Neff sees Citigroup’s overall growth at about 10% per year — almost as high as its P/E multiple. In addition, nearly one-third of the bank’s revenue stems from emerging countries. As such, global market gurus also gain exposure to a reasonably valued domestic company.
Below is a chart to show how the large banks stack up. Since all are trading with similar metrics, one could presume that Neff is sticking with Citigroup. It appears to be the cheapest, and its global exposure may give it the greatest growth potential.
|Company||P/E||ROE||Yield||Avg. Earnings Growth Est.|
|Bank of America(NYSE: BAC)||12.4||16.3||4%||9%|
|Wells Fargo(NYSE: WFC)||14.9||19.8||3.2%||11%|
Data provided by Capital IQ.Meeting with management
Neff has always believed that it’s important to meet with company management face-to-face. It didn’t always prove necessary — he estimated that more than 95% of management teams are honest and ethical — but there were occasions when a CEO clearly contradicted himself and signaled that he might be hiding something. Neff termed this corporate “hanky panky;” by meeting with management, he was able to help identify any bad apples among the executive ranks.
Meet Mr. Market
In describing the market’s bipolarity, Neff contended that in general, momentum is eventually wrong on both the upside and downside. He believes that the market is more momentum-driven today, given trends toward indexing and hedge funds that chase similar approaches, but suggested that those who rely primarily on momentum techniques or technical analysis have always been involved in the market. According to Neff, this type of herd mentality can lead to extreme ups and downs in the market. Down periods always lead to low P/E stocks — and subsequent appealing investments.
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Fool contributor Ryan Fuhrmann is long shares of Bank of America but holds no financial interest in any other company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.