Higher Returns, Lower Risk

Jeremy Grantham issued a warning.

In a Fortune roundtable discussion, the venerable fund manager cautioned that investors are not being compensated for taking risk. So what's an investor to do?

I think turning to another investing great, John Neff, is a good start.

The master investor and former head of the Vanguard Windsor Fund was the king of finding high returns with little risk and beat the market by more than 3 percentage points per year for more than 30 years. In John Neff on Investing, Neff gave away his market-beating secret: Two of those three percentage points came from dividends. So while he worked hard to buy cheap stocks, dividends were crucial to outsized total returns.

One way Neff found high-return, low-risk opportunities was by using his Total Return Ratio, defined as such:

Total Return Ratio = (analysts' expected earnings growth rate + dividend yield)/price-to-earnings ratio

The idea is to compare company ratios to the market's ratio. Neff liked to look at stocks whose ratios were at least 50% greater than the market's. Doing so, he increased his chances of finding a stock that would give him greater returns than the market turned in while taking on less risk. That's why Neff came to mind when I read about Grantham's warning.

The results
No one can predict the future, so I think we have to take analysts' estimates with a grain of salt. Solely relying on the past is not the way to go, either. The past can offer insights into what can happen, but past growth rates can't happen forever. Thinking that perhaps the answer is somewhere in between the two approaches, I calculated an average ratio.

I first did the screen on a historical basis. But while the past can be important to thinking about the future, again, it can't be relied on exclusively. That's why I took the companies I thought were most interesting on the list and looked up analysts' five-year earnings growth estimates. The results are as follows.

SK Telecom is a South Korean wireless provider. Organic growth prospects are relatively low, since wireless telecommunication is relatively mature in South Korea. However, the company is looking to grow outside South Korea via partnerships and joint ventures, making that 5.3% dividend yield pretty attractive.

Sales at home-furnishings retailer Tuesday Morning have been declining. Still, the company generates enough free cash flow to pay a sizeable dividend -- the current yield is 4.6%. Should the company find ways to jump-start growth again, today's price becomes more attractive.

Bank of America and Wells Fargo are two very well-run banks. Admittedly, banks are not my specialty, but I do know these two stalwarts will be around for a long time.

I wrote a piece on Home Depot a few months back in which I made the case that the home-improvement specialist was more of a value trap than a value play. Since then, quite a bit has changed. However, I thought the commercial-supply stuff was not in its best interest, and I still think getting out of that business would be a good idea.

One of the most interesting on the list is 3M, which recently announced its intent to buy back $7 billion worth of stock over the next two years. Given its high returns on invested capital and relatively cheap stock price, I think this is a good use of capital. Keep an eye on 3M, especially if the stock price declines further.

Someone else thinks energy company TXU is also worth the price, and then some. Private-equity firms Kohlberg Kravis Roberts and Texas Pacific Group are reportedly buying the company for $32 billion. With its trailing free cash flow yield of about 10%, I can understand why these firms would find it attractive.

The Foolish bottom line
The reason Neff's total return ratio is so potent is that it combines value and income: cheap stocks with dividend kickers. The stocks could increase should the market revalue them at higher multiples, and we can take in the dividends along the way. That's the "higher return" part. The "lower risk" part comes from two places as well: the dividend yield and the margin of safety provided by the low price-to-earnings ratio.

It's all about higher returns with lower risk. Given today's market environment, Grantham would say that stocks with low levels of risk and the possibility of high returns are the best investments today.

Tuesday Morning, Bank of America, and TXU are Motley Fool Income Investor recommendations. Home Depot and 3M are Motley Fool Inside Value recommendations. To find out more about how these market beating-newsletters can help improve your portfolio returns, click on either of the links for your free 30-day trial.

Retail editor and Inside Value team member David Meier doesn't own shares in any of the companies mentioned. He is currently ranked 423 out of 23,460 investors in The Motley Fool's CAPS rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.