With a bit more downtime during the holidays, I recently revisited one of my favorite books on value investing: John Neff on Investing. Legendary investor John Neff left the helm at the Vanguard Windsor
The road to Windsor
Part One of Neff's book covers his childhood and early investment career that eventually led to his taking the helm at Windsor in Philadelphia. Neff's investment career began in January 1955, the year the stock market finally returned to levels last seen in 1929, before the market crash. He first headed to New York City to pursue a stockbroker position but quickly found he was better suited to be an analytical securities analyst, at which point he headed closer to home by taking a position with National City Bank in Cleveland, now known as National City
Neff naturally migrated to a contrarian mentor, but the approach was not widely embraced at National City, which is no surprise, since larger institutions tend to pursue more mainstream approaches to managing money. 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.
Underperformance versus the S&P 500 at Windsor quickly narrowed, and 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." Before long, Neff had beaten the market for three straight years.
The best parts of the opening chapters come when Neff explains how his upbringing formed the backbone for his contrarian, value-investing philosophies. But for the most part, Neff was wired "to flout convention and [had] a penchant for rigorous analysis." He continues, "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."
Part Two consists of the meat of Neff's investment philosophy and the "enduring principles" that he found provided the best odds "in a business with no guarantees":
- 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.
Neff's style allowed him to outperform the market for 22 out of 31 total years and to grow Windsor to one of the largest mutual funds by 1985. Chapters 7 through 9 are chock-full of value-investing goodies; 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.
Dividend yield was another key metric Neff tracked. He noted that Benjamin Graham cited yield as the most assured portion of growth, as a company will likely only cut its dividend under the most adverse of circumstances. Without dividend yield, Neff estimated, his 3.15% annual market outperformance would have fallen to just above 1%.
Other nuggets of wisdom detailed that Neff kept a close focus on earnings growth and dividend yield in relation to the P/E an investor needs to pay to buy a stock. He also believed that return on equity "furnished the best single yardstick of what management has accomplished with money that belongs to shareholders." The book has numerous specific company references that worked for Windsor, from a 63% gain in Home Depot
Part Three consists of Neff's take on stock-market developments during his tenure at Windsor and contains additional stock-market history of the three decades leading up to 1995.
Value-investing books have many similarities, but I always find it interesting to see that most successful investors share common personality traits and subsequent investment styles that eventually lead to market-beating returns. A number of Neff's ideas and terminologies are unique, but 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.
John Neff on Investing is now more than seven years old, but the tenets remain relevant today. When I had the opportunity to see Neff in July, the enduring principles were the same, but the companies had changed. Citigroup
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Citigroup and Home Depot are both Inside Value picks.
Fool contributor Ryan Fuhrmann is long shares of Home Depot but has no financial interest in any other company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.