John Neff on Investing, by John Neff

I came across John Neff on Investing following the recommendation of my uncle, a money manager based in Boston.

John Neff (1931-2019) was an American investor known for his low price-to-earnings (P/E) investment style. During his 31 years heading Vanguard’s Windsor fund, he posted 13.7% annual returns (after fees), compared to 10.6% for the S&P 500 (see John Neff Wikipedia profile).

Below are the key lessons from the book:

Principal elements of Windsor’s style

Low P/E ratio

• P/E is a yardstick, like price per pound in a supermarket.
• It ultimately expresses expected growth in earnings.
• Low P/E stocks won’t create millionaires in a week, but given they have little anticipation built into them, they give both upside participation and downside protection.
• Absent stunning growth rates, they can capture P/E expansion with less risk than skittish growth stocks: an increase in the P/E ratio, combined with improved earnings, turbocharges the appreciation potential.
• For Windsor, low P/E multiples were usually 40-60% below prevailing market multiples.
• Note: Issues around earnings quality began to muddy the waters in the 1990s (slew of M&As, refinancing, restructurings and reengineering). Investors should always corroborate earnings, or other information a company distributes, with a reliable outside source, or at least apply a test of common sense.

Fundamental growth in excess of 7%

• Halfway into the year, stock prices begin to reflect expectations for the following calendar year, which usually boil down to educated guesstimates.
• Forward earnings estimates are exposed to surprises, and the market does not like to be negatively surprised: high P/E stocks have so much expectations built in that any hint of falling short can have punishing results.
• Candidates for Windsor were required to show sturdy track records: except for cyclicals, persistent quarterly earnings increments were preferred.
• Growth rates < 6% or > 20% seldom made the cut.
• The time horizon used for earnings growth was five years.

Yield protection

• Low P/E often results in a superior dividend yield: at Windsor, superior dividend returns contributed 2% out of the 3% outperformance vs. S&P500.
• Low P/E investors usually bank a meaningful portion of combined growth through yield, which is the more assured part of growth.
• Windsor sometimes invested in little or no-yield stocks, typically less recognized growth companies with 12-15% growth.

Superior relationship of total return to P/E paid

• Windsor preferred stocks with a total return ratio (i.e. earnings growth + dividend yield, divided by P/E) exceeding the market average by 2:1.

No cyclical exposure without compensating P/E multiple

• Timing is everything for cyclical stocks, so the trick is to catch them at the right moment (after one cycle has decimated the stock price, but 6-9 months before improved earnings become apparent to everyone).
• But it is difficult to predict tops and bottoms, so cyclicals should be bought with prospective P/E ratios, based on estimated “normal earnings”, that scrape bottom.
• Note that contrary to normal stocks, a ceiling on P/E ratios limits the upside of cyclical stocks as peaks in their cycles approach.
• Cyclical stocks (auto makers, chemicals, aluminum, etc.) normally comprised a third or more of the Windsor Fund, with the same companies being bought repeatedly.

Solid companies in growing fields

• Good companies with solid market positions (enabling premium prices), evidence of room to grow, strategic plans in place and sufficient resources to weather difficult conditions, either operating outside the spotlight or victims of investor malaise.

Strong fundamental case

• Growing earnings drive P/E, stock price and dividends.
• Squeezing greater earnings from each dollar of sales can buttress a case for investing, but margins do not grow to the sky, so eventually attractive companies must demonstrate sales growth.
• Keep an eye on pricing (rising prices can flag an opportunity) and deliveries (companies which can’t deliver goods as fast as they can take orders might spell trouble, with lack of skilled workers taking longer to remedy than shortage of raw materials or a technical glitch).
• Excess cashflow (retained earnings + depreciation – capex – change in WCR) can provide capital for additional dividends, stock repurchases, acquisitions or reinvestment.
• A robust operating margin supplies protection against negative surprises.
• A best-in-class ROE is a good yardstick of what management has accomplished with shareholders’ money.

Where to look for opportunities

Follow stock prices posting new lows

• Many of these companies have more dismal days ahead, but a couple will be worth investigating.
• The goal is to find earnings growth capable of capturing the market’s attention once the climate shifts.

Try the “hmmmph” test

• Whip through the list of 20 worst performers from the previous day.
• You’ll find familiar names you would not have expected to see on this list, eliciting a “hmmmph”.
• Barring evidence of fundamental deficiency, see how these stocks measure up against low P/E criteria.

Look for companies or industries on hard times in the news

• Decide whether the underlying business is actually sound and fears have been overblown.
• Wall Street overreacted on asbestos: the full magnitude of imagined costs never materialized, and affected stocks rebounded.
• With this precedent in mind, Windsor took issue with expert opinion about environmental liabilities that were supposed to swamp P&C insurance company stocks, instead assessing what the impact would be once overreactions melted away.

Find sound companies at steep discounts to higher prices

• In 1985, as Home Depot expanded rapidly from 22 to 50 stores, pre-opening costs and expanding overhead cut into profits, unnerving investors.
• At 10x prospective recovery earnings, down 60% from its high, there was more fear than greed in this 25% grower.

Seek companies in the midst of refashioning themselves

• In 1986, threatened with a takeover, Owens Corning borrowed heavily to buy back stock.
• Investors were spooked by negative equity, sending P/E to 5x, while the company was gaining market share, paying attention to costs, productivity and capacity utilization, and paying down its debt.

Look for companies moving up the quality ladder

• In 1978, Gulf Oil stock traded at 6x P/E, due to a pending uranium litigation.
• Common sense dictated it should prevail, and all the while, the share of domestic earnings had gone from 30% to 80%, and a large exploration program was about to pay off.

Seek backdoor access to investment opportunities

• Royal Dutch owned 60% of Shell and Shell Transport the remaining 40%: this allowed Windsor to go above the regulatory limit for a company trading at 4x earnings, with noticeable yield and cashflow, that seemed tailor-made for institutional acceptance.
• On another occasion, Windsor backdoored an investment in oil field equipment, which was trading at high levels at the time, by buying the stock of a conglomerate with half its earnings in a quality equipment maker, and trading at 5x earnings.

Find miscategorized companies

• In 1990, Bayer was trading at 6x earnings and declined 35% like any basic commodity chemical stock, even though half of its earnings were related to healthcare, agricultural and other specialty chemicals.

Create opportunities for free plus

• If you own a stock where the negatives are largely known, then good news that come as a surprise can have outsized effects.
• Examples can include an unexpected boom in demand, an oil field strike, M&A.

Play to your strengths

• Without a team of professional analysts, emphasize companies or industries you know firsthand.
• But be wary of investing solely in the company that writes your paycheck: if business goes awry, your nest egg will vanish alongside your salary.

Shop around the neighborhood

• It never hurts to visit local retailers or listen to what’s hot with your teenage children.
• But don’t buy a stock just because there is a lot of traffic: while good buzz helps, it is execution that separates good retailers from indifferent ones (buyers with fashion judgement, timing, delivery, friendly prices, good housekeeping).
• Also think about places to eat, where you buy office supplies or the car in your garage.

Develop a curbstone opinion

If you want to sleep well, do your own homework and don’t be hasty:

• What is the company’s reputation?
• Is its business likely to grow?
• Is it a leader in its industry?
• What is the growth outlook in its industry?
• Has management demonstrated sound strategic leadership?

Maintenance of a low P/E portfolio

State of mind is central to the issue

Inflection points abound

• All investing trends go to excesses, which give rise to inflection points, giving low P/E investors the chance to capture extraordinary gains, once out-of-favor stocks regain the market’s attention.
• Warning signs often cry for attention long before inflection points erupt.
• When investors far and wide agree, and the media trumpet that opinion, these are the foothills of inflection points.

Beware of popular wisdom

• The merits of low P/E ratios are most compelling amid the clamor for hot stocks and hot sectors, but that is when investors are least likely to listen.
• Low P/E investors seldom enjoy the luxury of confirmation of their judgement.
• But there is a thin line between being contrarian and being stubborn: eventually, you have to be right on fundamentals to be rewarded.

Classify stocks into 4 categories

Instead of using conventional industry classifications, Windsor established four categories and participated in each of them, irrespective of industry concentrations. While other funds had to own all of the top 50 S&P500 stocks, Windsor seldom owned more than a handful, while dull, ugly stocks found prominence.

• Highly recognized growth: < 8-9% of assets.
• Less recognized growth: < 25% of assets.
• Moderate growth: c.35% of assets.
• Cyclical growth: c.30% of assets.

Don’t chase highly recognized growth stocks

• Everyone wants to own them, as their business is sound and global, they are ordinarily quite safe and seldom embarrass shareholders.
• But this is not a reason to buy them at all times, as illustrated by the “one-decision” Nifty Fifty stocks, which had a hypnotic hold on investors in 1971-1973, before the fever broke in 1974. Some stocks took 7 years to recoup their losses, others 20.

Weigh the virtues of less recognized growth

These companies exhibit earnings growth comparable to or better than big growth stocks, but lack of size and visibility consigns them to the backbench.

• Projectable growth rates of 12-20%.
• Single digit multiples of 6-9 times earnings.
• Dominance or major participation in growth areas.
• Easy industries to understand.
• Unblemished record of double-digit earnings growth.
• Outstanding ROE, signifying management accomplishment and internal capacity to finance growth.
• Capitalization and income qualifying for institutional consideration.
• Some Wall Street coverage.
• 2-3.5% yield.

Moderate growers are solid citizens

• These have low P/Es, earnings that rarely grow faster than 8% a year, and above-average yields.
• They tend to hold their price levels in difficult markets, and supply hefty yields, robust gains from P/E expansion, and dry powder when inflection points spawn more breathtaking opportunities.

Cyclicals will rise again

• Cyclicals usually follow the same pattern.
• As earnings pick up, investors flock to them.
• When earnings begin to peak, investors abandon them.
• Windsor bought cyclicals 6-9 months before earnings swung upwards, then sold into rising demand.
• The trick was to anticipate increases in pricing, with knowledge of capacity and judgements about sources and timing of demand increases.

The market doesn’t capitalize peak earnings

• Investors should not be too greedy on the upside, as peak cyclicals never command peak p/e ratios.
• At Windsor, every investment in a cyclical entailed an estimate of normal earnings.

All cyclicals may not be so cyclical

• Some stocks progressively become less cyclical, e.g. auto stocks thanks to tighter and more cost-conscious management and a less cyclical economy, or homebuilders during a prolonged period of low interest rates.

Don’t sweat market weighting

Assets should be concentrated where they are likely to produce the most bang, i.e. in undervalued areas. Out of 60 stocks, the top 10 at Windsor accounted for almost 40% of the fund.

Top-down or bottom-up

• The author attacked stock picking from both directions.
• At times, broad economic themes highlighted certain industries, and he would burrow down to determine the fundamentals of each candidate.
• On other occasions, a particular stock wandered onto his radar scope when its p/e ratio came into range.

Learn what makes an industry tick

• Wise investors study the industry, its products and its economic structure.
• Industry trade magazines supply valuable information.
• Kick an industry’s tires, try some goods, visit distributors, tour the plant, ask questions (Are prices headed up or down? What about costs? Who are the market leaders? Do any competitors dominate the market? Can industry capacity meed demand? Are new plants under construction? What will be the effect on profitability?).
• Keep tabs on inflation (double-digit inflation ravages fixed-income and equity markets).
• Companies you own should at least match oaerwrching economic growth.
• Watch three areas of the economy for signs of excess: (1) capital expenditures, (2) inventories, and (3) consumer credit.

Build fact sheets

Use concise fact sheets to summarize your outlook for stocks you own, grouped by industry:

• Shares owned.
• Average cost.
• Current price.
• Historical and projected EPS.
• Historical and projected growth rate.
• Historical and projected p/e ratio.
• Yield.
• ROE.
• Price projection based on earnings expectations and resulting p/e ratio.
• Appreciation potential.

Reasons to sell

Windsor sold shares for either of two reasons:

• Fundamentals deteriorated. This becomes obvious on two yardsticks: estimates of earnings, and 5-year growth rates. Each stock owned needs a clearly visualized potential for growth. If the best thing one can say is “It probably won’t go down”, the stock becomes a candidate for sale. Windsor did not hesitate to sell or cut the position importantly after a few weeks or at a loss after indications of slower growth or weaker unit economics (customer count, average ticket).
• Price approached expectations. Falling on love with stocks in a portfolio is easy to do but perilous. Instead of groping for the last dollar and trying to catch market tops, Windsor left some upside on the table for buyers. Expectations for a stock in terms of appreciation potential reflect overall expectations for the portfolio.

Circumstances that call for cash or bonds

• Ordinarily, sales proceeds are recycled into stocks with brighter prospects.
• In overpriced markets, when the market was nutty and there were no stocks to buy that made sense, Windsor went as much as 20% in cash or in government bonds if they offered real returns as attractive or more attractive than overextended equity markets.
• Windsor also prospected in the junk bond market: while the market was generally efficient, some bonds promised 20% or better yield-to-maturity with an overboard assessment of risks by the market.

Times are changing

• While much as changed, low p/e stocks still offer opportunities to investors.
• The main difference is the flood of information (which runs the risk of distracting attention from the few variables that really matter) and the large number of investors who fail to perform rigorous, fundamental analyses and instead chase gold where everyone else is already looking.

Market journal

1970-1976

• During the Nifty Fifty era, investors, hypnotized by rising market levels, emphasized a handful of glamour stocks, losing sight of fundamentals (prices reached such high levels that earnings could not live up to them), at the expense of the wider market.
• This was followed by a market plunge.
• During this period, Windsor seized opportunities in conglomerates (that had risen to fame during the 1960s go-go era but fallen out of favor in 1970), avoided the Nifty Fifty stocks (outstanding growth companies bought irrespective of price) in favor of less recognized growth, modest growers, and cyclicals (e.g., commodities in short supply).

1977-1981

• While the market’s attention was focused on interest rates, oil prices, and commodity shortages, and while less recognized growth stocks surged, Windsor relied on a wider assortment of companies and industries, including banks, conglomerates, consumer durables (autos), transportation, retail, restaurants, multiline insurance, and electric utilities.

1982-1988

• This period started by a bull market (declining interest rates, Reagan tax cuts, devastation in oil stocks) but was punctured by a sharp one-day decline on October 19, 1987 (“Black Monday”).
• Windsor remained faithful to out-of-favor, overlooked, misunderstood stocks with low p/e ratios such as depressed energy and cyclical stocks (natural gas, oil service, banks).
• After the crash, it returned to specialty retailers, commodities (paper and forest products, oil, copper).

1989-1993

• This period was marked by adrenaline and harsh unpredictability, with sharp moves in real estate, banks, high yield, basic commodity cyclicals and consumer cyclicals. Windsor took profits in some stocks in demand (airlines, auto), bought banks (concerns of troubled real estate and construction loans) and the occasional quality stock marked down due to a bad quarter.

1999

• At 28 times earnings and 1% yield, the market at the time of writing the book was the most expensive the author had experienced, resembling two previous markets that exceeded 20 times earnings and folded dramatically: 1986-1987 and 1971-1973.
• The author points out the ludicrous valuations of Internet stocks, with no earnings, potential competition from non-Internet companies, and legions of stockholders planning to get out as soon as possible.