Admit it. You would indulge in a discreet guffaw if an asset manager exemplified his fund’s investing style as “relatively prosaic, dull and conservative” and courted “unloved stocks”.
So what would be your reaction if told that that very asset manager delivered a CAGR of 13.7% over 31 years spanning 1964 to 1995, outpacing the S&P 500's 10.6% return during that time?
That’s John Neff for you. He 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.
In his book On Investing, he makes this brilliant observation.
"...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. To us, ugly stocks were often beautiful. If Windsor's portfolio looked good, we weren't doing our job."
His bet on Citibank epitomized this investment strategy.
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. Not Neff. He carefully weighed Citibank’s situation and decided that it was a good time to buy.
Neff gravitated towards out-of-favour and misunderstood shares that had earnings growth potential that the market missed. He was of the opinion that if you buy shares where all the negatives were chiefly known, resulting in a depressed share price, then any good news would have an overwhelmingly positive effect.
To fearlessly court battered stocks requires daring. 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”.
Ditto with his wager on Ford Motor Company in 1984, which he described as one of his best. When many feared that the company’s sales were due to a 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.
Though Neff liked to be known as the “low price-earnings investor”, as it was at the heart of his investment philosophy, not for a moment did he believe that it should be the solitary parameter in governing a buy decision. He believed that one has to probe a whole raft of numbers and facts. This would either reinforce the virtue of the low P/E stock, or expose the factors that could cripple prospects for P/E expansion.
Low P/E ratio.
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.
The Windsor Fund usually bought shares with PERs 40-60% below those of the typical share. Neff believed that if these shares also had the promise of steady earnings growth, then there was the potential for the appreciation to be “turbocharged”. Low P/E shares could get two boosts. One is when the market recognizes that it had previously overreacted to the bad news. The second is due to higher reported earnings per share.
Earnings growth.
Earnings growth is what ultimately drives P/E ratios and stock prices. He looked for fundamental earnings growth above 7%, but not exceptionally high. Why? Because a stock with too high a growth rate (above 20%) could have trouble sustaining that over the long haul. In other words, he wanted steady, unspectacular growth that could be sustained. Sustainable growth also meant sturdy sales growth -- not one-time gains or cost-cutting measures.
When it came to cyclical stocks, Neff noted that while with growth stocks, earnings are expected to increase steadily, the trick with cyclical stocks is to catch them at just the right moment—after one economic cycle has decimated the stock price, but before improved earnings become apparent to everyone.
As a cyclical company’s earnings nears peak levels, the P/E ratio will begin to retreat as investors begin to expect a trough is on the horizon. Once a trough is reached, prices begin to strengthen as investors anticipate a turnaround in earnings. Investor expectations can lead a cyclical stock’s P/E ratio to be extremely inflated during a trough, as earnings fall to negative or very low territory. (If the denominator (earnings) shrinks at a faster rate than the numerator, the overall ratio will rise). Neff protected himself by purchasing cyclicals only with prospective P/E ratios that scraped bottom.
Solid dividends.
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.
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.
A legend, and a ‘star’ fund manager, John Neff passed away earlier this month, June 4. He was 87. The infographic below encapsulates his investing style and has been sourced from The Great Investors.
