John Neff's Investment Strategy
John Neff (September 19, 1931 – June 4, 2019) was an American investor, a philanthropist, and a mutual fund manager notable for his investment styles and his role in the Vanguard Windsor Fund.
Famously called “The Professional's Professional,” he made the Windsor the highest return and largest mutual fund throughout his 31-year career during his tenure in the business until his retirement.
Between 1964 and 1995, John Neff, then portfolio manager of the Vanguard Windsor Fund, increased the company's funds from $75 million to more than $11 billion.
To put it in perspective, an investment of $10,000 in Windsor at the beginning of his career in 1964 (with dividends reinvested) would have been more than $564,000 at the time of his retirement.
This is a fantastic feat for the manager of such a large fund in that period of time.
Known for his contrarian and sometimes “dull” investment methods, Neff, until his retirement in 1995, delivered an annual average return that exceeded that of the S&P 500 index by more than 3% (13.7% as against S&P's 10.6%).
Neff considered undervalued, unattractive, and out-of-favor stocks worth investing in because his concentration was more on the low price-earnings ratio, growth forecasts in earnings, and sales growth.
His strategies and philosophies were summed up in his own book “John Neff on Investing,” and we will be looking into some of these value investing principles as we try to find out what made this man so successful in the investment world.
Neff's Investment Strategies
John Neff hinged his ideology on portfolio concentration as opposed to diversification and in identifying stocks using the price-to-earnings ratio, stocks with P/Es that were between 40 to 60% of the market average.
He would rather purchase these stocks that seem to be sinking but possess a steady and sustainable growth driven by sales to stocks in popular industries.
His detailed analytical techniques and principles for investing, as summarized in his book “John Neff on Investing,” have made him successful and an example for investors.
Some of these strategies include:
1- Low Price Earnings Ratio
This could be said to be the bedrock of Neff's investing strategies. This was the investing style that brought him so much success at Windsor.
His idea was to separate the “good” stocks that were out of favor despite having quite good prospects from the “bad” ones.
Many investors are quick to discard such stocks, not because they are necessarily bad investment options, but because their P/E ratio is not attractive.
This strategy was important because it involved expectations on the part of the investor.
If investors could buy stocks with high P/E ratios, they naturally would expect it to do well. On the contrary, if the stock has a low P/E ratio, there will not be much expectation from it.
Hence, stocks with lower P/E ratios and lower expectations tend to do better and, in most cases, yield better because whatever sort of improvement it made would exceed the expectations of the investors.
The ones with high P/E often did not meet those high expectations, even with strong results.
Neff, being the contrarian investor that he is, takes his time to do in-depth research and analysis of industries and individual company financial statements.
He prefers these low price-earnings ratios because there is less risk of a surprise downside earnings outcome.
He believes low price-earnings stocks posed fewer risks of downside earnings because of low expectations, and at the same time, it had upside potentials.
In his time at Vanguard Windsor, he was known for stocks that had 40-60% price-earnings ratios below market concord.
2- Dividend Yield
Low price-earnings ratios normally go hand in hand with high dividend yields (annual dividend divided by price), with each serving as the flip side of the other.
In Neff's quest for low price-earnings ratio stocks, he realized that high dividend yields could make for the protection of price.
So, dividends are advantageous for the investor, meaning that when a dividend-paying stock is purchased, the investor will not pay so much for that dividend payment.
Dividend yield proves to be more dependable than changes in the share price. This was the reason Neff liked stocks with strong yields.
3- Total Return Ratio
Neff measures potential investments based on their attractiveness using this metric.
The total return could be defined as the total sum of the dividend yield and the expected earnings growth rate, divided by the price-earnings ratio.
Hence, Total Return Ratio = (Earnings growth + Dividend Yield) / Price-Earnings Ratio.
Practically, this was demonstrated by Neff by looking for and investing in those stocks with total return ratios that are above market averages by a two to one margin.
4- Estimated Growth
Neff advises that when seeking the right stocks, it's not enough to focus on low price-earnings ratios. The presence of strong earnings growth estimates in the stock will further validate the fact that the company does not deserve its low ratio.
Neff warns, however, that there are no specific rules guiding how to know a company's growth rate; in his words, they are just guesses.
But investors must learn to visualize and predict prospects for the company in order to confirm or oppose the market's views on the potentials of the company.
This strategy helps investors in establishing credible growth rates and monitoring published and consensus earnings estimates. The market, in most cases, tends to overreact if a company misses an earnings estimate target.
The presence of strong fundamentals increases the buying chances of low price-earnings stocks for investors. Hence, Neff believed that focusing on these estimates would require growth forecasts and predictions.
5- The Dividend-Adjusted PEG
This is another method Neff suggests investors can use to verify the attractiveness of stocks and to make informed investments.
He simply named it the dividend-adjusted price-earnings relative to growth (PEG) ratio.
The method is employed to calculate the standard PEG ratio adjusted to reflect the dividend yield, and it is calculated by dividing the price-earnings ratio by the total sum of the estimated earnings growth rate and the dividend yield.
An example of how to calculate this is: A stock with a P/E ratio of 10, growing at 11% accompanied with a dividend yield of 2.0%, has a dividend-adjusted PEG ratio of 0.77 [10 ÷ (11 + 2)].
This method inculcates all the key components of the other value investing styles employed by Neff. The price-earnings ratio, earnings growth estimates, and the dividend yield.
6- Measured Participation
Another of Neff's master strategies was what he referred to as the measured participation.
This plan was put in place to rid funds of old and conventional practices of industry representation.
It placed the focus of funds on new and modern ideas in portfolio management and diversification. Measured participation established four investment categories: highly recognized growth, less recognized growth, moderate growth, and cyclical growth.
Neff advises against chasing solely the highly recognized growth but instead to focus and research on the less and moderately recognized ones. He believes that these growth areas are better because earnings growth is comparable to the ones published by the highly recognized ones.
The moderate growth stocks, on the other hand, tend to cling to prices when the market is experiencing difficulties due to their good dividend yields.
Neff often preferred to make investments in cyclical stocks, although he always made sure they had a compensating price-earnings multiple.
Cyclical growth stocks operate in industries that are strongly impacted by the strength of the economy, some of these industries, such as jewelry, clothing, and electronics industries, are good options, but you will need to anticipate and visualize the increase in demand of market forces, relying on your knowledge of these industries.
7- Sales Growth
Sales are one of the most difficult to manipulate in a company's financial statement. Neff sets out some other principles to support low-cost strategies.
One of these can be referred to as growth in sales. He believed that growing sales would lead to an increase in earnings, and any measure of improvement in the margin would highlight the need to invest first.
Truly attractive stocks should be able to build on this by showing significant sales growth.
Investors have to keep their focus also on deliveries; the inability of a company to deliver as fast as it takes orders is a red flag.
When demand surpasses supplies, companies most times raise prices, and so those investors that invested in low P/E ratios must ascertain whether earnings will come back to normal and what kind of attention they will generate.
The same parameters for estimated earnings growth are applied for sales growth.
8- Fundamental growth in excess of 7%
Neff believed that a stock with a low price-earnings ratio and an annual growth rate of just above 7% was underappreciated. He identifies two types of earnings, historical and forward earnings.
Both of them reflect different investor expectations; a smart investor will, of course, use both in finding out the growth for a company.
For him, a growth rate of less than 7% only meant that a company did not have enough prospects, and if it was growing more than 20%, it was too risky. Such stocks could end up bringing disappointments, and he dissociated himself with them.
9- Cash Flow
Another of Neff's strategies was free cash flow. He believed that cash flow has become highly important, especially with increasing doubts about earnings calculations.
Cash gives investors better ideas of how companies manage their assets and makes expenses.
Cash flow is the cash that is left after capital expenditures have been made or net profits that have not been distributed through dividends.
A company that can boast of this is worth investing in. Investors should look out for companies such as these that can use this excess cash flow judiciously to make more earnings. They could repurchase stock, acquire funds, or reinvest back into the company.
Whatever the case, Neff encourages investors to be more focused on investing in these companies.
When did he sell his stocks?
- Deterioration in the fundamentals or
- The price approached expectations.
Neff, during his time at Vanguard, the appreciation potential and expected gain of each stock was calculated based on earnings expectations and estimated P/E expansion before acquiring the stock.
A failure of fundamentals was typically determined by analyzing earnings estimates and five-year earnings growth rates.
Though one would not know a specific decline in earnings growth that could initiate a sale, Neff looked out for historical and estimated earnings growth between 7% and 20% when picking stocks.
While Neff generally had a longer investment period of over 5 years in his time as the manager of Vanguard Windsor, he was always brave enough and took risks to take profits right away; some stocks were sold after a few short months.
He cautioned investors about holding a stock too long and/or fall in love with a stock.
In his words, “Falling in love with stocks in a portfolio is very easy to do and, I might add, very perilous. Every stock Windsor owned was for sale”. He also advised that “When you feel like bragging about a stock, it's probably time to sell.”
Neff also challenged investors to form a “curbstone opinion” of a prospective investment by asking and answering five questions:
- What is the company's reputation?
- Is its business likely to grow?
- Is it a leader in its industry?
- What is the growth outlook for the industry?
- Has management demonstrated sound strategic leadership?
While Neff acknowledged the importance of diversification in portfolio management, he also advised that too much diversification can hinder performance and cripple growth.
He said,
“Why own, for instance, forest products companies if the market has embraced them and you can reap exceptional returns by selling them?
Worse, some portfolio managers whose portfolios are underweighted in a hot sector chase high prices, just to secure sufficient representation.“
His Other Pieces Of Advice For The Investors
Other pieces of investment advice Neff had for investors as contained in his book are:
- “Sufficiently removed from Wall Street's hullabaloo Windsor applied our low P/E sometimes boring principles in a consistent fashion. We weren't fancy, just prudent and consistent. We always took note of prevailing opinion, but we never let it sway our investment decisions“.
- “I can't think of a better way to start to understand a company's performance than by poring over its results with pencil and paper.“
- “My motto has not changed: keep it simple.”
- “Playing the technical or momentum game has always seemed misguided to me.”
- “We never sought to own market weighting. We concentrated assets in undervalued areas.“
- “Rather than load up on hot stocks along with the crowd, we took the opposite approach. Our strength always depended on coaxing overlooked, out-of-favor stocks to move from undervalued to fairly valued. We left ‘greater-fool' investing to others.”
- “A wise investor studies the industry, its products, and its economic structure. Industry trade magazines supply very valuable information long before it finds its way into the general consensus. Prudent investors always stay abreast of developments, which is why casual investors usually get wind of change after the stock price adjusts.”
Conclusion
Neff practiced a style that most investors would not consider or even give a second thought.
Famously described as “relatively prosaic, dull and conservative” by the man himself, Neff, however, saw a goldmine where others saw dirt.
With a proven track record at the helm of the Windsor Fund, where he generated massive returns for clients and pulled a feat that could be the greatest ever for any mutual fund manager, his strategies should be considered worth emulating by investors.
Neff compiled these strategies in his famous book, “John Neff on Investing.”
