John Neff on Investing

After eight years as one of the bank's stock analysts, he quickly tired of the bureaucratic, risk-averse strategy of purchasing overbought securities for trust clients. This led him to Windsor's Wellington Management in 1963.

Windsor was a poorly performing fund before Neff's arrival, and Wellington Management had its own fair amount of issues, according to Neff. These tumultuous conditions led to an opportunity for him to prove his worth through an unconventional but no-nonsense value approach to investing.

Neff seized his opportunity by "taking outsized positions where I saw promising returns." He didn't see any benefit to playing it safe and overdiversifying to mediocre returns, as many proponents of modern portfolio theory advocate. Neff beamed that "sticking our neck out worked for Windsor." And it has worked well for many concentrated portfolio managers before and after Neff's time at Windsor. He also proved that an army of analysts was unnecessary; he gave up access to seven Wellington analysts for the exclusive assistance of just one of them.

Neff stressed a simple style of locating appealing growth stocks in basic industries that could benefit from the long-term growth in the overall domestic economy. He also pursued what he termed "measured participation," which is his fancy name for opportunity cost. He "elected to measure our degree of participation in one stock against the relative risks and rewards we would expect to find in other market sectors."

"My inclinations to buy out-of-favor stocks come naturally but by itself doesn't account for beating the market. Success also required lots of perseverance. You have to be willing to hang in when prevailing wisdom says you're wrong. That's not instinctive; more often than not, it goes against instinct."

To Neff, the P/E ratio was key because it involved expectations. If investors were willing to buy stocks with high P/E ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share; conversely, if a stock has a low P/E ratio, investors aren’t expecting much from it. Neff found that stocks with lower P/E ratios -- and lower expectations -- tended to outperform, because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high P/Es often flopped, because even strong results couldn’t match investors’ expectations.

Neff explains why low-P/E strategies are the way to go and why investors mostly project company earnings in straight lines -- in other words, they expect similar levels of earnings well into the future -- when that rarely ends up being the case. Neff chose instead to find stocks where the market was underestimating earnings prospects that could move from undervalued to simply fairly valued or better when multiple expansion was combined with earnings growth.

To Neff, however, the P/E wasn’t always a lower-is-better ratio. If investors knew that a firm was a dog, they’d rightly avoid its stock, giving it a low P/E ratio but little in the way of future growth prospects. Because of that, he wrote that Windsor targeted stocks with P/E ratios between 40% and 60% of the market average.

He wanted to see earnings growth, but here again it was not a case of more-is-better. A stock with too high a growth rate -- more than 20 percent -- could have trouble sustaining that growth over the long haul. He thus preferred to see growth between 7% and 20% per year, the kind of steady, unspectacular growth that could be sustained.

Sustainable growth also meant growth that was driven by sales -- not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates.

He also believed that return on equity "furnished the best single yardstick of what management has accomplished with money that belongs to shareholders."

For the most part, he is pursuing strategies enthusiastically embraced among other superinvestors: a focus on not losing; a long-term, contrarian mindset to finding undervalued companies; and buying into fear while selling into strength.

By focusing on beaten down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards.

Timeless lessons

  • Low P/E ratios.

  • Fundamental growth greater than 7%.

  • Yield protection and growth.

  • Positive tradeoff of total return to P/E paid.

  • No cyclical exposure without compensatory P/E.

  • Strong companies in growing fields.

  • Strong fundamentals.

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