Book Review: John Neff on Investing

Investing for over 30 years with a low p/e +growth approach, John Neff consistently beat the market index. Here's how he did it.

I just finished the book "John Neff on Investing." As I have written before, it is helpful to learn from outliers, like those investors who consistently beat the market, and ask how they did it.

John Neff beat the market from June 30 1964 to October 31 1995 he achieved an average total return of 13.7% a year while the S&P 500 achieved 10.6%.

He did it with a simple and consistent strategy. In essence, he simply bought stocks with a low PEG and stuck with it.

About John Neff

John Neff describes his strategy as such:

"We followed one durable investment style whether the market was up, down or indifferent. These were its principal elements:

1. Low price-earnings ratio.

2. Fundamental [business] growth in excess of 7%

3. [dividend] Yield protection (and enhancement in most cases).

4. Superior relationship of total return to p/e paid.

5. No cyclical exposure without compensating p/e multiple.

6. Solid companies in growing fields.

7. Strong fundamental [business] case. "

I think "total return" requires further explanation. Here is how John describes it:

"In Windsor's lexicon, "total return" described our growth expectations: annual earnings growth plus [dividend] yield…total return supplied half of a ratio that summarized, very neatly, Windsor's competitive edge. The other half of the ratio p/e disclosed what we paid to secure the total return. As a way to measure the bang for our investment buck, total return divided by initial p/e could not have been more succinct. We just never found a catchy name for it other than "total return ratio."

I think John Neff combined the concepts of value and growth very well, something that I think many modern value investors still have problems with. That is to say, he didn't just buy low value p/e stocks, he bought those with some growth element. With this strategy he seemed to have devised and heavily used a PEG measure. He looked for a growth element that can be reasonably appraised - notably never investing in technology stocks.

I suppose he took a page out of Ben Graham's Security Analysis:

“The investor can be justified in paying a price premium for expected growth only when the prospects of such growth are both reasonably certain and conservatively appraised.”

Portfolio Management

He had a unique portfolio strategy that he called "measured participation." Essentially, he had 4 categories for the stock he invested in (that passed his previous criteria).

1. Highly recognized growth

2. Less recognized growth

3. Moderate growth

4. Cyclical growth

"Windsor participated in each of these categories, irrespective of industry concentrations. When the best values were available in, say, the moderate growth area, we concentrated our investments there. If financial service providers offered the best values in the moderate growth area we concentrated in financial services. This structure enabled us to flout the constraints that usually condemn mutual funds to ho-hun performance."

I think this added layer is interesting. He didn't just buy a basket of stocks that met his criteria, he sought to balance them across cyclicals, popular growth, unpopular growth and steady growth.

When to Sell

His reasons to sell essentially mirror Graham's (without a specific time limit).

1. Our analysis was wrong

2. Fundamentals deteriorated

3. Price approached our expectations

Screening for Opportunities

His screening process included looking at:

• Stocks at 52 week lows.

• Stocks that are down significantly from yesterday.

• Stock with recent bad news.

He also paid attention to:

• Stocks down from their peak.

• Stocks in beaten down industries.

• Miscategorized companies.

• Companies with free plus. A free option.

Other Tips

Always consider PEG

When you make an investment, build a factsheet of the investment and include the reasons you bought.

Be wary of growth above 20%. If a company grows too fast, it can cause many problems. Especially if it grows too fast via acquisitions.

Conclusion

The philosophy of book is not particularly revolutionary. I suppose when Neff wrote it, pairing growth with value via PEG was a big innovation, but since then Bruce Greenwald and others have written extensively on that subject. And I have enjoyed Greenwald's books on the subject very much.

Throughout the book, John Neff often described himself as a contrarian. In my mind a contrarian is someone who is investing in a stock that appears to be headed for bankruptcy, is facing lawsuits and is heavily shorted. But Neff wasn't that extreme, he just consistently bought low p/e stocks. Surprisingly that alone is contrarian.

Neff taught me that being a contrarian isn't buying stocks that everyone knows and hates, most of the time it's buying boring stocks that no one cares about. History shows us that this is very hard for investors to do. Oftentimes, other investors are involved in some other fad that is taking their attention. But it was not difficult for Neff to tune that out. Throughout the book he doesn't have any problem sticking to a low p/e approach. The alternative doesn't even cross his mind. He just naturally has an attitude of "well that's just how you do it." To paraphrase, he says stuff like, "we had a lot of cash, but that's just because we couldn't find any opportunities that met our criteria. Luckily, in the end that worked out." That is to say, he wasn't holding cash expecting a market crash. He was holding cash because he had no other alternative.

Neff applies his philosophy throughout part three of the book, which alone is be worth the price of admission.

The book is split into three parts. Part one is a short biography "I came to New York, hitchhiking with $20." Part two is his investing philosophy, which is simple and short. Part three is essentially a diary log of his 30 year career, covering the low p/e paradise of the fifties, the 'tronics mania, the Nifty Fifty index bubble, the inflation years, the oil boom of the 80's, the crash of 1987, and the dot-com bubble.

I found his investing diary interesting, because it placed you in Neff's shoes. It made you ask yourself, if I was in that situation facing the same mania or depression, would I be able to keep my head and stick to my investing philosophy? or would I compromise?

History shows us that very few people can stick to a strict investing philosophy throughout all the investment fads that come and go. But if you do, and your philosophy is correct, you set yourself up for excess returns.

Further Reading

Worldly Invest had an article that went over what John Neff might invest in, in today’s market. I thought it was an interesting thought experiment.

If you are interested in learning more about money managers who beat the market. You may be interested in my other post which found 5 currently active money managers who are ‘beating the market’: