Get a grasp on this scenario.
In 1991, Citibank had made more than $13 billion in commercial real estate loans. Nearly 43% of them were nonperforming. The bank had lent up to 80% or more of the value of the properties, putting Citibank's investment underwater when values plunged 40% or more. Residential mortgages were turning sour. Some of Citicorp debt, which was downgraded by the major rating agencies in 1990, was reduced to junk bond status by 1991.
Around that time, the world's developing countries owed more than $1.3 trillion to industrialised countries. Among the largest problem debtors were Brazil, Mexico and Argentina. Of the total developing-country debt, roughly half was owed to private creditors, mainly commercial banks – Citibank being a prominent one.
Naturally, investors were fearful looking at Citibank’s bleak prospects.
One fund manager thought otherwise. He carefully weighed Citibank’s situation and decided that it was a good time to buy.
In his book On Investing, John Neff explains his stance when he picked up Citibank for his Windsor Fund.
"...investment success does not require glamour stocks or bull markets. Judgement and fortitude were our prerequisites. Judgement singles out opportunities, fortitude enables you to live with them while the rest of the world scrambles in another direction. Citibank exemplified this investment challenge. To us, ugly stocks were often beautiful. If Windsor's portfolio looked good, we weren't doing our job."
Citibank was not a one-off case. His wager on Ford Motor Company in 1984 was said to be one of his best. When many feared that the company’s sales were due to slow down and analysts began to give a sell call, the P/E sank to 2.5. Neff ignored the noise in the market and saw immense potential - a lean management with good control of costs and a new model, the Taurus. Neff began picking up the stock which had dropped to $12 a share. It climbed to $50 within three years. He made millions on that move. A few years later, when oil prices collapsed in 1986, he plunged into oil stocks and was rewarded once again.
So one can have a discreet guffaw when Neff describes the Windsor Fund as “relatively prosaic, dull and conservative”.
By courting unloved stocks, which resulted in numerous letters from irate shareholders and criticism in the press, prosaic was certainly not a word many would use to exemplify the fund’s style.
Neither would the term dull qualify as a description of its returns. On the contrary, the returns were rather sensational. The fund delivered a 13.7% average annual return over 31 years spanning 1964 to 1995, outpacing the S&P 500's 10.6% return during that time. A $10,000 investment in the fund (with dividends reinvested) would have amounted to around $564,000, more than twice what the same investment in the S&P 500 would have yielded (about $233,000).
(Neff managed the Windsor Fund run by Wellington Management in 1964. The fund eventually became part of John Bogle's new Vanguard operation in the early 1970s).
Ironically, though he shunned publicity and opted for a low keyed existence, his returns grabbed the attention of other money managers. In polls, he was often the preferred fund manager to manage their personal money, leading him to be referred to as the “professional’s professional”.
Neff was daring in his convictions and fearlessly courted battered stocks. In the case of the Citibank stock, he confessed to enduring “slings and arrows” which did not faze him but led him to eventually experience “sweet vindication and very handsome returns”.
Neff’s investment process began in the “dusty rag and bone shop of the mart, where the supply of cheap stocks replenishes itself daily”. He would scout the Wall Street Journal for stocks making new lows. He would also look for the worst performers from the previous day’s close – stocks which fell from 8-30% or more.
The one time this was best elucidated was on Black Monday - October 19, 1987. The DJIA crashed over 20% in a single day. In the midst of the panic, Neff went shopping. It is estimated that on that day he spent $118 million purchasing stocks with plans to double his buying the next morning.
Don’t get misled into thinking that all cheap stocks made the cut. Neff once said that "As a low P/E investor, you have to distinguish misunderstood and overlooked stocks selling at bargain prices from many more stocks with lacklustre prospects." He looked for good companies with moderate growth, solid earnings, high dividends and low price-earnings ratios.
For instance, in an interview in 2006, Neff recommended Citigroup. At that time it was trading close to a single-digit P/E level, a return on equity near 20%, a current dividend yield of more than 4%, with yield is growing by about 10% per year. Management was also buying back stock and Neff projected Citigroup's overall growth at about 10% per year -- almost as high as its P/E multiple.
Neff believer that no solitary parameter should govern a buy decision. “You need to probe a whole raft of numbers and facts, searching for confirmation or contradiction. Fundamentals consistent with benchmarks usually reinforce the unrecognised virtues of low P/E stocks; fundamental shortfalls may expose gaps that cripple prospects for P/E expansion”.
1) Low P/E ratio.
Neff did not call himself a contrarian or value investor but preferred to be known as a “low price-earnings investor”.
2) Earnings growth.
Fundamental earnings growth above 7%, but not exceptionally high. A stock with too high a growth rate (above 20%) could have trouble sustaining that over the long haul.
3) Solid, and ideally rising, dividend.
Neff believed that strong dividends were an often overlooked part of how investors could beat the market. If two companies offer a prospective 14% return, but Company A's consists of 14% earnings growth and no dividend, whereas Company B's consists of 7% growth plus a 7% dividend, it is better to choose Company B, because the dividend makes the outcome more certain.
4) A much-better-than-average total return in relation to the P/E ratio.
Neff targeted stocks with P/E ratios between 40 and 60% of the market average.
He hunted for stocks that were cheaply priced in relation to the total return indicated by the sum of their earnings growth plus their dividend yield. He called this the “terminal relationship” or “what you pay for what you get”.
More simply, he would take the estimated growth rate plus the dividend yield and divide it by the P/E.
For example, let’s look at a stock in different scenarios.
Stock in Scenario A: Growth rate = 10% / Yield = 5% / PE = 7.5
Stock in Scenario B: Growth rate = 10% / Yield = 5% / PE = 15
The terminal relationship of the stock in scenario B at 1 is much less attractive.
5) Cyclical stocks.
No exposure to cyclical downturns without a compensatory low P/E to compensate for their volatility.
6) Solid companies making a strong fundamental case for investment.
Sound cash flow, a stable balance sheet, an attractive market for the products or services are some of the other criteria he kept in mind. He once
told a journalist, "
I don't want to do so well that I lose my sense or recognition of how the middle class might react to something like a new retailing concept." In the process of analysing Burlington Coat Factory Warehouse Corp., Neff sent his wife and daughter on a shopping expedition to scout one of the chain's off-price stores. They returned with three coats. By 1988, he held about 500,000 shares of Burlington Coat Factory.
On selling....
Finally, it’s worth ending with a note on how Neff took his selling strategy as seriously. And rightly so, or else you risk losing profits. He cited two basic reasons to sell:
Deteriorating fundamentals: According to him, the main fundamentals to keep an eye on are earnings estimates and 5-year growth rates. If these start to slip, sell at once.
When the stock price matches your expectations: In other words, when the market begins to chase the stock and recognise its value, it’s time to bail out, with a tidy profit of course.
“An awful lot of people keep a stock too long because it gives them warm fuzzies – particularly when a contrarian stance has been vindicated. If they sell it, they lose bragging rights.”
