I'm not a huge fan of shortcuts -- largely because of all the times I was caught slipping through neighbors' yards on my way to and from school, which eventually landed me in detention. Lesson learned: trampling across someone's lawn might shave five minutes off your walk, but you'll pay many times over if caught.
True to form, most shortcuts in life work just about the same way. You may save a little time, but more often than not you're giving up something of greater value. This is doubly true in investing. However, when I came across John Neff's total return ratio in his book John Neff on Investing, I have to admit I was curious about the potential use for the formula.
Who is this Neff guy anyway?
John Neff is a master investor who built his performance largely around dividend-paying stocks. In his 30 years at the helm of the Windsor Fund, he returned 13.7% per year vs. the S&P 500's 10.6%. Dividends were such an important part of his strategy that if you strip dividends out of the mix, his yearly return drops two full percentage points to 11.7% per year.
Neff focused on dividends largely because most investors don't. They're so focused on earnings that they ignore the market-beating potential of a sizable dividend with a bit of capital appreciation . It also doesn't hurt that above-average dividend yields are by nature almost always paired with low price-to-earnings (P/E) or price-to-cash flow valuations. As the final piece of the puzzle, Neff also liked the share-price protection that a strong yield offers; while investors (traders) may ignore a 3% yield in the total return picture, they rarely ignore a quality business with a yield of 5% or more.
Neff's total return ratio
Neff dubbed his ratio for evaluating an investment the "total return ratio." It's as simple as it sounds. To calculate the total return ratio, simply take the expected earnings growth and add the stock's current yield to arrive at the total (expected) return. Next, divide that total return by the P/E ratio. For example, if Nate's Widgets (Ticker: WIDGT) is expected to grow 10%, has a 3.5% yield, and a P/E of 9, the total return ratio would be 1.5 (13.5 / 9 = 1.5).
In practice, Neff liked to purchase companies with total return ratios at least twice that of the S&P 500. For example, the S&P 500 currently yields 1.86% and carries a P/E of 18.7. If we expect the S&P 500 to grow by 10%, the total return ratio would be 0.63 (11.86 / 18.7 = 0.63). So, for an investment to meet Neff's criteria, it would need to have a total return ratio of at least 1.26. The table below highlights five companies that, at first glance, appear to match Neff's screen.
Company |
Growth Estimate |
Yield* |
P/E* |
TRR** |
---|---|---|---|---|
IndyMac Bancorp (NYSE: NDE ) |
12.00% |
4.40% |
9.1 |
1.80 |
Cedar Fair (NYSE: FUN ) |
12.00% |
6.43% |
10.5 |
1.76 |
Chevron (NYSE: CVX ) |
10.00% |
2.90% |
9.5 |
1.36 |
Deutsche Telekom (NYSE: DT ) |
5.50% |
4.80% |
7.9 |
1.30 |
Fresh Del Monte Produce (NYSE: FDP ) |
9.00% |
3.60% |
10 |
1.26 |
**TRR = total return ratio
Foolish final thoughts
Unfortunately, investing can't be boiled down into a nice, neat little equation, and while a handy formula, Neff's total return ratio is really a relative measure where low P/E stocks will shine. This isn't a surprise because Neff's primary strategy was low P/E investing, and it works if you know what you're doing. But if you look at companies like Anheuser-Busch (NYSE: BUD ) and Johnson & Johnson (NYSE: JNJ ) -- both of which are nearing the point where they are attractive based on my discounted cash flow models -- they would fail to meet the criteria of the formula, because their current total return ratios are below the 1.26 threshold. The formula is a handy way to screen for ideas for further research, and it's tough to ask for much more than that from such a simple equation.
Cedar Fair is aMotley Fool Income Investorpick, and a few more Income Investor picks were unearthed in the screen used for this article, but were omitted from the table. If you'd like to get thoroughly vetted investment ideas that offer an above-average yield for a below-average price,click hereto take a free trial to Income Investor. Or subscribe and take home a free copy of The Motley Fool'sStocks 2006report, which features 12 great investing ideas for the year ahead.
NathanParmeleedoes not own shares in any of the companies mentioned. You can view his profilehere. Fresh Del Monte Produce is a Motley Fool Hidden Gems selection, and Anheuser-Busch is a Motley Fool Inside Value selection. The Motley Fool has a disclosure policy.