What ails the truth is that it is mainly uncomfortable, and often dull. The human mind seeks something more amusing, and more caressing. - H.L. Mencken

This article is based on the second section of John Neff on Investing, an autobiography and investment manual by John Neff, written following his retirement in 1995.

There are a number of aspects to Neff's approach. It is not fancy and involves no particular difficulty in implementation. About the only reason why Neff's methods aren't used more often is that this is a fundamentally boring way of picking stocks. It is just plain old value methods and most of the stocks he bought were rather unexciting. One thing that is exciting though, is Neff's results, which beat the market by an average of 3%pa over his entire career lasting more than 30 years. If you think that is unexciting, consider this: he beat the market this much after fees and a 3% return over 30 years amounts to more than doubling your money. This means that a holder of John Neff's fund, the Windsor fund of Wellington management (part of the Vanguard group, (yes, the indexing guys)), from the time Neff started at Windsor in 1964 until his retirement in the 1995 would have had more than twice as much money in their pocket than someone who had invested in an index tracker fund over the same period.

This seems like nothing much to those who believe that merely beating the market by so little is a simple feat for a good trader, but as you embark on your trading career just consider this: there are only a few people in the world who have ever achieved returns of this magnitude, and I include whichever guru you have in mind. The guy selling that futures trading system claiming to achieve miraculous profits has not achieved returns like John Neff did with a particularly ponderous and boring form of fundamental analysis, for if he did he could demand a multi-million dollar salary plus performance bonuses as a trader for a Wall Street fund manager rather than trying to eke out a living selling systems through some little ad in the back of Shares magazine.

Anyway, off my soap box and on to Neff's extremely boring (but effective) system for investment.

Low Price Earnings Ratios

Windsor not only managed to achieve a total return more than twice of the market over Neff's career, but he managed to do this with volatility significantly lower than the indexes. To an efficient market true believer this is of course impossible, but nevertheless Neff did it throughout his career.

Low PERs offer both spectacular upside potential and reduced risk. If a company maintains exactly the same price earnings ratio over a period then the growth rate in the stock price will be equal to the growth rate of profits. This is of course the basis of growth investment, find the companies multiplying their profits and you're there. If a company is truly undervalued though, trading on a very low PER, it will in time come to be recognised as undervalued and the PER will increase. If a company grows its profits at 11%, one with a static PER will appreciate at 11%. If a company grows at 11% but starts out on a PER of 8, increasing this to 11, the stock price will grow by 53%. The trick is of course in differentiating lousy stocks from undervalued ones, Neff was never one to buy every single low PER stock and just sit on them for a couple of years.

Neff regarded his style as one of doing nothing special, but like a tennis player just trying to keep the ball in play and less his opponent make the mistakes. Being able to snap up bargains dumped on the market by a disappointed investing public was how he kept in the game.

The stocks Windsor bought had PERs 40 to 60% below the market average. Neff points out in his book, John Neff on Investing that such bargains became hard to find in the 90s bull market but never disappeared entirely. "The market's boundless capacity for poor judgement ensures a steady supply of out-of-favour candidates".

Fundamental Growth in Excess of 7 Percent

Neff bought low PER companies with a fundamental growth rate in excess of 7%pa. He wasn't particularly interested in really low growth stocks as they had little chance of raising their PERs over time. When something otherwise growing reasonably well, was trading at a low PER, in particular if the dividend yield was attractive he took a much closer look.

Yield protection

It is very difficult to be entirely sure about future earnings, they depend on many things and anything can kill them. Neff values dividends because they pay right here and right now, and only when a company is under extraordinary duress does it usually cut its dividend.

Of the more than three percent market outperformance Windsor showed over time, more than two percent of that was dividends. Furthermore, money paid out to investors is often a bonus, "free" money. If Neff was investing in companies because they were expanding their business and they needed every cent to reinvest, dividends would not be desirable, it would be preferable for the company to hold on to those dividends if it can reinvest at high rates of return. Neff likes dividends because he isn't counting on business growth for profits, he is investing in low PER companies that he believes deserve to be at a higher PER.

When the "correct" PER is recognised by the market the stock price will appreciate even if profits stay the same, so in this case a few extra percent gain because you are getting dividends is a bonus. Neff rarely invested just for the yield, he was a low PER investor as opposed to a high yield investor, but a high yield was a real attention getter.

Yield not essential

Neff reserved the right to buy companies that had no dividend yield at all, if he felt that the company had great growth prospects and was undervalued by a PER measure. As an example he bought Intel long before the .com silliness, purchasing in late 1988 and sold at almost twice the purchase cost in 1989, then bought it back again in 1994 when it was trading at a prospective PER of just 8 times 1995 earnings.

Superior relationship of total return to PER

Neff defined total return as growth plus yield. He used a valuation ratio that he never got around to giving a catchy name apart from "total return ratio". This ratio is easy to calculate, you divide the total return by the PER (or you can flip it around and divide the PER by the total return if you are accustomed to using PEG ratios). Neff looked for stocks with a total return ratio around twice that of the market or the sector. Neff points out in his book that at the time of writing (1999) low PER stocks became much harder to find, the total market had a forecast earnings growth of 8% and a dividend yield of 1.5%, giving a 9.5% total return, with a market PER of 27 the ratio was 0.35. Neff sought at this time to find stocks with a total return ratio exceeding 0.7.

No cyclical exposure without a compensating PE multiple

Cyclical companies made up more than a third of the Windsor portfolio, as individual sectors of the economy didn't necessarily rise and fall in unison this frequently meant Neff was presented with a chain of buying opportunities.

The trick is to buy after a cyclical downturn has decimated the stock price but before improved earnings become apparent to everyone.

Neff's securities analysts attempted to forecast earnings just like everyone else, and bought according to their forecasts. The only real difference between Neff and the major part of Wall Street is that Windsor tended to be among the first to buy while others tended to wait and see earnings develop. Of course if you wait for the earnings to become blindingly obvious you will have missed a large proportion of the price recovery as well.

A typical low-PER strategy makes maximum money six to nine months before cyclical companies start to report better earnings. Predicting that point will tax an investor's understanding of an industry's dynamics and overarching economic considerations.

Solid companies in growing fields

Most Windsor stocks were strong and relatively stable companies that were simply not well known. The top names that attracted the most attention had the greatest stability in market prices because they were instantly recognisable to most investors. Neff's favourites were companies right out of the spotlight, they had solid earnings and occupied a reasonably safe position in their market, but lacking a household name the share price could languish from time to time, which was when Neff bought.

While most opportunities came from less well known stocks, occasionally major names came into view, including ABC television in 1978, which at that time Windsor's analysts rated as one of the great broadcasting companies, yet remarkably only traded at around 5 times earnings at that time. The returns over the next year went as high as an 85% gain.

Strong fundamental support

There is much more to securities analysis than a quick formula like the total returns ratio, in order to make sure that he was buying undervalued strong stocks, Neff employed a full range of fundamental analysis techniques, especially with measures related to earnings and sales.

Earnings growth drives the PER and the stock price, and dividends come from earnings. Ultimately, growing sales create growing earnings. Improving profit margins can improve profits, but there is only a finite amount of cost cutting and margin boosting that is possible, ultimately earnings growth depends on sales growth.

Neff examined quarterly figures finding the relationship between sales in dollars and sales in units, favouring growth in dollars over units. The unit of measurement of earnings is the dollar, not the unit. If the growth of dollar sales out-paces the unit sales growth, rising prices can help fuel momentum and taken along with rising sales, rising prices often flag an opportunity.

Neff also kept an eye on deliveries, recognising a company that is unable to meet demand as being a source of trouble. On the other hand if the product is unique the manufacturer may be able to raise prices to meet a balance between demand and production capacity. Low PER investors must discern if earnings will return to normal and what sort of attention they will draw.

A backlog can indicate trouble, investors must identify if this is because of a shortage of raw materials, too few skilled workers or a technical glitch, to name three obstacles of different and increasing magnitude.

Return on equity (ROE) was another major factor that Neff looked at. ROE is in Neff's opinion the best single yardstick of what management has accomplished with money that belongs to the shareholders. The higher the ROE, the better.

Operating margin was another important consideration. Operating margin is the difference between sales and what is left over after costs related to sales are deducted from sales. A high margin company like a good software manufacturer might have an operating margin of 40%, so if something bad happens and strips 5% off the operating margin the company will still survive and prosper. Other companies providing commodity products and services may have razor thin margins and are less capable of weathering storms that may increase costs or decrease the price they can realise for their product. For low PER stocks a high operating margin is desirable because the higher this is, the more wrong you can be and still walk away without taking a total loss.

New lows

In strong contrast to momentum investors, Neff was quite at home scanning lists of stocks making new lows for the year or hovering just above a low recently established. This isn't everyone's favourite hunting ground, and investors should be very careful because often these stocks are there for a very good reason, but Neff kept an eye on such lists anyway in the search for low PER stocks. Not every stock he bought was from this class, so a stock making a new low is certainly not a mandatory Neff criterion for purchase, but it was a place where Neff looked for likely candidates.

Neff also applied the "hmmmph test". He would scan lists of stocks with the worst performers from the previous day, occasionally he would be surprised by the appearance a familiar name and this would elicit an audible "hmmmph". He read this tone as a question mark from his intuitive self, and frequently went on to further investigate the hmmmph stocks.

Bad press can be very good news

Wall Street has a remarkable propensity for "group think" (aka "herd mentality" as Buffett would put it). Companies receiving lots of bad press and widely discussed in the papers as being about to fail or suffer a massive law suit tend to have collapsing share prices to match. A calmer investor may see through the gloom and realise that the crisis may be exaggerated, or understand that even if the widely accepted worst-case scenario does eventuate, it may not be enough to knock out the company, and the extreme falls in price may go too far.

Some of Neff's best plays were in companies that were widely expected by the investment press to be on the verge of collapse, but according to Windsor's securities analysts were in somewhat better shape than the bulk of investors realised. When sellers are desperate to quit a stock, the price can fall so far that even a company about to take a massive loss will be a good investment. Everything has its value, and no matter how low that value may be, the price is sometimes lower.

Often a stock price may fall because the market doesn't approve of a new merger or thinks management is doing something wrong. While often management is wrong, just as often Wall Street makes the mistake, so a plummeting share price was usually good news to Neff.

A bit of lateral thinking

If you've heard of the guys who made their fortunes selling food, water and mining equipment during the gold rushes, you'll understand this one. Neff used to look around a booming industry to see if he could find value stocks in a related field. For example during a gas boom when various oil and gas companies were sizzling at record high PERs, Windsor invested in companies involved in making steel drill pipes for gas production and casing for the domestic oil industry. As such an obscure sort of industry, and remembering that the stock market is not nearly as efficient and thorough as certain academics tell us, Neff found an excellent value play in the midst of a boom. Soon enough the companies started reporting big gains in sales and profits and finally investors took notice.

Miscategorised companies were also useful lines of enquiry. For example in 1990 Windsor bought Bayer AG, a big chemical company. It's share price suffered from a sector-wide cyclical downturn but Neff realised that about a third of earnings came from pharmaceuticals and health care, 8 percent from agricultural chemicals and 13% from photographic and speciality chemicals. More than half of this company's earnings were not at all related to the cyclical downturn that had affected commodity chemical producers (sulfuric acid etc for industrial use), and Neff saw other favourable factors and only limited exposure to industrial commodity business, so Neff thought the 35% decline in share price was somewhat unjustified, especially since it traded at only 6x earnings. Within a couple of years Bayer AG made substantial above-market gains.

Curbstone opinion

Investing isn't complicated, people just make it so. There are a variety of relatively simple questions that if you can answer them you will be able to make more intelligent estimates of its chances of surviving.

Windsor's portfolio construction: "Measured Participation"

One source of Windsor's phenomenal success was its attitude to diversification, they adopted a flexible strategy they called "measured participation". Windsor eschewed a conventional approach to diversification, involving purchases in every industry and sector, and ignored indexes except as a performance and value benchmark.

Measured Participation established four broad investment categories:

  1. Highly recognised growth
  2. Less recognised growth
  3. Moderate growth
  4. Cyclical growth
Rather than seek to make sure each industry gets into the portfolio, they classified all stocks into one of these four classes, and made sure that each class was represented in the portfolio, concentrating on whichever class was available at the cheapest valuations. With this unorthodox approach Windsor was not hampered by having to buy anything it didn't want to just because everyone else was doing it. Clearly tracking error was not a major concern for Neff, he always stuck to his approach even when the market got frothy and growth stocks leapt ahead, knowing that when value funds came back they would do so forcefully.

Windsor made no attempt to secure a representative portfolio of index stocks, in fact big blue chip companies were rarely part of the portfolio, they would hold only a handful of the top 50 stocks and frequently had none at all. This gave them particular success in the 1970s when the "Nifty Fifty" bubble finally burst. The portfolio was often extremely focused, there were 60 stocks in the portfolio when Windsor had $11 billion under management. They avoided owning prominent blue chips so this frequently meant taking huge positions in some smaller companies. Windsor often owned as much as 8 or 9% of the major companies in their portfolio.

Less recognised growth stocks were featured prominently, but Neff cautions that as many as one in five will fail in any given year, when he says fail he doesn't necessarily mean file for bankruptcy, but a growth stock slackening pace is close enough to failure to form a fall in the share price. When looking at less well recognised growth companies, Neff sought out:

Moderate growers were always an important part of the Windsor portfolio. These included utility stocks, mature blue chip companies and banks. Growth is rarely anything spectacular, seldom more than 8%pa, but dividend yields can be spectacular. When a strong dividend yield is accompanied by a very low PER, revaluations of the company would be enough to lift the stock's price and show solid gains.

Neff looked at cyclical companies bouncing back as well. He tried to identify companies that had average or above average earnings growth during previous booms, and aimed to buy them 6 to 9 months before actual earnings improvements were announced, then sold them into a rising market. This required detailed knowledge of the industry and involved his securities analysts preparing forecasts of industry capacity and market demand.

Neff recognised that frequently the PER would start to retreat before the peak earnings are reached, investors are on the whole reasonably astute at realising that cyclical companies don't usually become genuine growth stocks. It pays to not be too greedy with cyclicals, better to sell early than to ride the next slide down on the other side of the boom.

Top-down and bottom-up

Windsor involved itself in both top-down (strategic plays on industries and economies) and bottom-up (individual stock picks) styles of investing. Both approaches were carried out with the same value approach. Neff would look at industries from a contrarian point of view and figure where a bounce may have been due, going scouting around in the sector for further value, but individual stocks were always bought on individual value merit.

Neff says you can't always get the CEO on the phone, but most companies have an investor relations department. He was attracted to certain industries and groups because of low earnings multiples but while nosing around he would be sure to try to find answers to the following questions:

From a top-down point of view, keep an eye on inflation. When it is quiescent, it's usually a friend of the investor, but when it swoops in with double digit increases, it becomes a bogeyman that can distort all of your bottom-up calculations.

Economic growth is pretty much paired with inflation. It supplies the yardstick that reveals whether the industries in your portfolio actually measure up. In other words, the companies you own should at least match overarching economic growth if you plan to beat the market.

Neff always watches three areas of the economy for excess: capital expenditures, inventories and consumer credit.

Fact sheets

Neff recommends investors should always obtain the following information as a bare minimum.

Selling stock

There were two main reasons for Neff selling: Fundamentals deterioration was assessed on two yardsticks, earnings estimates and five-year growth rates. If Neff lost confidence in these measures he would sell out of the position.

As long as fundamentals were holding up, Windsor would hold stocks for three, four of five years. But on occasion they took profits right away. In some cases they held stocks less than one month.

Cash or bonds

Normally Windsor was quite fully invested, but in later stages of bull markets value stocks can become harder to find, and Neff didn't object to keeping up to 20% of the portfolio in cash. Neff never really tried to forecast the markets, but sometimes value was so hard to find that he thought this an omen, and a 20% cash holding was appropriate if stock prices looked overall a little nutty.