At the helm of the Vanguard Windsor Fund, John Neff beat the market by more than 3 percentage points per year for more than 30 years. That's an incredible track record -- and the difference between $39,116 and $17,449 on a $1,000 investment, assuming a 10% average return.
Here's the master's secret: Two of those 3 percentage points came from dividends. So while Neff worked hard to buy cheap stocks, dividends were no less crucial to his outsized returns. That's totally cool!
To help find outstanding stocks that offered value and income, Neff used his total return ratio, defined as:
(Analysts' expected earnings growth rate dividend yield) / price-to-earnings ratio
Neff would compare company ratios to the market's ratio. If a company's ratio was at least 50% greater than the market's, he gave it look. If Neff's research revealed that the market misinterpreted the company's prospects, and thus created an opportunity, he purchased shares for the portfolio.
Currently, the market's total return ratio is about 0.95. (I used a Shiller P/E of 20.1, a yield of 2%, and two-year estimated earnings growth of 17.2%.) Thus, to meet Neff's criteria, a company's ratio must be greater than 1.43.
Let's see whether Neff would be interested in taking a peek at Northrop Grumman
|
Company |
2-Year Growth Est. |
Yield |
P/E |
Total Return Ratio |
|---|---|---|---|---|
|
Northrop Grumman Corp. |
18.3% |
3.3% |
8.8 |
2.47 |
|
General Dynamics Corp. |
7.0% |
2.8% |
9.7 |
1.01 |
|
Raytheon Co. |
3.5% |
3.4% |
10.6 |
0.64 |
Source: Capital IQ (a division of Standard & Poor's) and author's calculations.
It looks like Northrop Grumman comes out a clear winner over the competition as a total return opportunity. Both General Dynamics and Raytheon pay nice dividend yields to shareholders. However, neither competitor offers the right balance of growth and value that Northrop Grumman does.
The Foolish bottom line
Neff's total return ratio is beautiful because it combines value and income: cheap stocks with dividend kickers. Investors can profit from multiple expansion while collecting dividend payments along the way. And as Neff showed, when done correctly, this strategy can lead to excess returns over the market. As with any metric, Neff's total return ratio is just a starting point. But with a total return ratio of 2.47, Northrop Grumman certainly seems like a totally cool stock to get to know.
