Authors Stephen Horan, Robert R. Johnson and Thomas Robinson in "Strategic Value Investing: Practical Techniques of Leading Value Investors," reported that John Neff grew the Vanguard Windsor Fund from $75 million in 1964 to more than $11 billion by the time he retired in 1995. That worked out to an average annual gain of 13.7%, compared to 10.6% for the S&P 500.
Neff summed up his investing philosophy and strategy with a set of seven principles, which he laid out in his book, “Neff on Investing”, after retiring.
Low price-earnings ratio
The authors of “Strategic Value Investing” called a low price-earnings ratio the “cornerstone” of his investing strategy. As Neff himself put it, he liked to be called a “low price-earnings investor. It describes succinctly and accurately the investment style that guided Windsor while I was in charge.” And, as a contrarian, he was always looking for stocks that were out favor despite having good prospects.
The price-earnings ratio reflects the expectations of the market. For example, a stock will sell at a high price-earnings when the market collectively decides the company will grow rapidly in the future. Conversely, a stock with a low price-earnings means the market doesn’t expect it to grow very much, if at all.
A contrarian value investor likes low price-earnings ratios and low expectations for an important reason beyond price: There is less risk of a downside earnings surprise. That’s unlike the situation when a high-flying price-earnings stock disappoints; as the authors wrote, “the consequences are dramatic” and “You often see a high P/E stock get pummeled after a quarterly earnings shortfall of a couple of pennies.” These dramatic results occur because the market overreacts to earnings news.
When Neff ran Vanguard Windsor, his typical stocks carried price-earnings ratios that were 40% to 60% below the market consensus. Further, he believed that low price-earnings stocks provided the best of both worlds because they had upside potential and downside protection (because of low expectations).
Ă‚ At least 7% in fundamental growth
Neff thought that a stock with a low price-earnings ratio and an annual growth rate of more than 7% was underappreciated (he also avoided stocks growing more than 20% per year). For him, a growth rate of less than 7% meant a company did not have enough promise and if it was growing more than 20%, it was too risky. Such stocks could end up bringing disappointments.
Dividend yields
Companies with a low price-earnings ratio often have high dividend yields (annual dividend divided by price). As the authors reminded us, the return on a stock has two components: dividend yield and change in the stock price (capital gains or losses). Like Benjamin Graham and David Dodd, Neff believed dividend yield was more dependable than changes in the share price, and thus liked stocks with strong yields.
In addition, he thought too many investors valued stocks according to their potential for price growth and neglected dividend payouts. Neff estimated that about two-thirds of his fund’s 3% outperformance (versus the S&P 500) originated with dividends.
Total return ratio
This is a metric Neff developed, with the objective of measuring the attractiveness of a potential investment. He defined "total return" as the sum of the dividend yield and the expected earnings growth rate. Once the total return was calculated, he divided it by the price-earnings ratio (which represented the “richness of the price”).
This is the formula: Total Return Ratio = (Earnings Growth + Dividend Yield) / Price-Earnings Ratio.
In practice, that meant looking for stocks with total return ratios that beat market or industry averages by a two-to-one margin. When he could not find stocks that met this criterion, he assumed the market had become overvalued.
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No cyclical exposure unless…
Neff often invested in cyclical stocks, as much as a third of his portfolio at one point, but their purchase was conditional on having a compensating price-earnings multiple. According to the authors, the key to buying cyclical companies is to avoid paying for peak earnings. They wrote, “In fact, in contrast to the buy-and-hold philosophy advocated by many value investors, including [Warren] Buffett, Neff believed that timing was everything with respect to cyclical stocks.”
Like a good value investor, Neff bought when price-earnings ratios were down and then sold when the market became too optimistic and drove up the price-earnings ratio. In practice, this meant he often bought and sold the same companies multiple times. For example, when he bought Atlantic Richfield in 1994, shortly before he retired, it was the sixth time he had taken a position in it.
Strong companies operating in growing fields
Not surprisingly for a contrarian, Neff usually did not invest in prominent, big companies that were the leaders in their field. He considered them less likely to be mispriced because of investor whims than good, solid companies that received little of the limelight. That was especially true when the markets were pessimistic about them.
A strong fundamentals case
With a chartered financial analyst designation, Neff was a believer in fundamental analysis. He insisted that one or two metrics were not enough to make a buy-sell decision. The numbers behind the numbers are important too, the authors wrote, “The idea is to develop credible estimates of earnings growth rates. Thus, a strong fundamental case must be made to justify estimates used in valuation models.”
Other
Unlike Graham, Neff was not a believer in diversification. Instead, he was prepared to make “exceptionally large bets” when he believed he had found hidden value in neglected stocks.
Like Seth Klarman (Trades, Portfolio), he was prepared to take large cash positions when he thought the market was overvalued.
He watched for bad news, based on his assumption that the markets often overreact because they’re giving too much weight to worst-case scenarios. He saw such news as a buying opportunity.
And unlike Buffett, he was not necessarily a long-term investor. In fact, he would sell holdings after only a few weeks if market valuations were right.
Conclusion
Neff was one of nine value investors profiled in chapter 12 of "Strategic Value Investing: Practical Techniques of Leading Value Investors."
As shown, Neff emphasized low price-earnings ratios of companies that had good growth prospects. In part, that assured him he was getting a good deal, but he also liked them because the market was less likely to overreact to earnings disappointments.
For value investors today, it is worth remembering Neff’s total return ratio, which provides another tool for approaching stock valuations.
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