**Note**, the excerpt comes from the 2nd book in the “Money Masters”series. John Train interviews and sometimes even invests his clients monies with these masters. This book came out in ‘89.
**Note**: John Neff is often called the Value investors’ investor. He is a low p/e investor and not very well known outside the professional money management industry. He ran the Windsor fund for 31 years and retired in 1995. In that 31 years his performance was 13.7% CAGR over the S&P 500 . John Neff has his own book “John Neff on investing” as well.
The excerpt below is J Train’s description of his techniques, see the similarity to Peter Lynch’s PEG ratio, used in a different way:
————-
**Techniques**
Neff is quite realistic about his own performance, and in some of Windsor's annual reports, particularly when the news is good, issues a "Report Card" on his transactions. They are often remarkably candid and interesting. (See Appendix VI.) One wishes that other managers would assess their own pertormance in the same spirit. Of course, not many managers are as fortunately situated as Neff when it comes to reviewing what they have done.
Not surprisingly, given his conservative techniques, Neffs performance tends to rise more slowly than the market in good times, but it also usually declines less when the market is weak.
He points out the importance of skillful executive work in running large portfolios: The good manager moves faster, particularly in selling on adverse news. In a bank, when something goes sour in a holding, the managers responsible hate to crawl back before the trust committee and say that they were wrong. (Also, you risk trouble with the beneficiaries if you sell a stock at a loss.) Neff has no such committees to deal with, and also, since he is rarely looking for the same developments as other investors, the change in his opinion is unlikely to coincide with a wholesale exit from a stock. He can slip out of a stock almost as inconspicuously as he entered it.
He tolerates a very high concentration in a few industry groups. For instance, in the 1988 annual report the automotive group reached 22.2 percent of the entire portfolio, banks were 16 percent, and insurance had risen to 13.8 percent in the teth of gloomy predictions for the underwriting outlook. Including savings and loans, the lending area represented 20.8 percent of Neff's portfolio. Adding insurance, the whole financial sector came to 37 percent. Airlines reached 7.2 percent of the portfolio in 1987, during a period of grim industry news.
In other words, while he has relatively few ideas, he backs them heavily. Indeed, in his 1988 report the ten largest positions represented over half the assets of the $5.9-billion fund. Thus, we see a third of a billion dollars in Citicorp, which many investors shunned for fear it was going broke, over half a billion in Ford, and about three-quarters of a billion in just three insurance companies. That's real self-confidence!
One justification for these high concentrations is that he isn't taking far-out gambles: Since he buys only the very cheapest merchandise, should something go wrong, it hasn't too far to fall.
**Bargain Hunting**
Neff is considered an outstanding securities analyst. Although in recent years he has not himself ordinarily made company visits, he talks to companies at length. He has a team of analysts working for him, but when a new stock comes into view, he is likely to lead the charge, or, in his own language, to "gang tackle" the problem. By the time he and the team are finished, they should have accumulated the information they require. After almost thirty-five years' experience in his profession, Neff has already bought or studied a high proportion of the companies that he is considering for purchase at any time. In other words, it is often a question of updating his knowledge, rather than starting from scratch.
He is constantly looking at industry groups that are unpopular in the market. He confines his research to stocks with particularly low price-earnings i ratios, and, ordinarily, unusually high yields.
And, in fact, over the many years that Neff has run Windsor Fund, the average price-earnings ratio of his portfolio has been around a third below that of the general market, while it has on average yielded 2 percent more.
He has described himself as a "low-P/E shooter." However, unlike Benjamin Graham, he is concerned with the underlying nature of the company. He wants a good company at a low price.
**Some of the criteria he insists on are:**
1. A sound balance sheet;
2. Satisfactory cash flow;
3. An above average return on equity;
4. Able management;
5. A satisfactory outlook for continued growth;
6. An attractive product or an attractive service;
7. A strong market in which to operate.
This last is a most interesting point. Neff claims that investors tend to pay too much for companies with high growth rates, so they aren't the answer, while no growth means that there is something wrong with the company itself. So the bargains where he does most of his buying often run at about an 8-percent growth rate.
**What You Get for What You Pay**
Neff has an interesting way of comparing stocks, or groups of stocks, with other stocks and with the overall market. Windsor's portfolio overall has an estimated 9.5-percent growth rate together with a 4.9-percent yield, or a 14.4-percent total return.
The average price-earnings ratio of the stocks in the fund is 6. So he divides the 14.4-percent total return by 6, giving 2.3 as what he calls the "what you get for what you pay for it" or "terminal relationship" figure.
In early 1989 the overall market had a growth rate of 8.5 percent and a yield of 3.7 percent, for a total return of 12.2 percent. Dividing this by the market's price-earnings ratio of 11 gives 1.15 as the comparable "what you get for what you pay for it" result. So, by this reckoning Neff's whole portfolio is almost exactly twice as attractive as the market as a whole.
Neff lays out or "arrays" these figures for specific stocks to compare their relative attractiveness. He does find that his earnings estimates for the stocks he buys are usually more optimistic than those of Wall Street in general, or in his term, more "aggressive."
Income in Windsor Fund has grown 17 percent compounded, probably because of Neff's practice of selling stocks that have gone up, and whose yields have therefore fallen, to buy lower-priced stocks with high yields.
**How to Buy**
In determining the price he is prepared to pay for a stock, Neff projects earnings over a number of years.
Then, he determines a reasonable price-earnings ratio that a normal market should put on those future earnings. This, in turn, gives him a target price several years out. He then calculates the current market's percentage discount from that price, from which he derives the indicated percentage-appreciation potential.
Of course, subjective factors have to enter in to some extent.
For instance, if Neff has unusual confidence in the stability of the growth rate, or if he considers management to be exceptionally skillful, then all the figures are adjusted. In reverse, unfavorable factors may reduce the target price.
He calculates the similar consolidated figure for his existing portfolio, which he designates its "hurdle rate."
If the indicated compound growth rate of a stock he wants to buy is not at least as high as the "hurdle rate" of the existing portfolio, then he deters purchase until the stock falls to where it does equal the hurdle rate.
There are, of course, times when he somewhat deforms this method. For instance, if he has raised cash in his portfolio and the market starts up, then he will buy stocks below the hurdle rate in order to get the cash invested. (This is another way of saying that he expects the hurdle rate to rise soon.)
Within the portfolio, Neff weights the holdings according to their calculated appreciation percentage. With seventy to eighty stocks in the portfolio, implying an average size of slightly over 1 percent, he will in practice put 5 percent into one stock if he develops a real conviction; indeed, he will buy several positions of that size within a single group. In other words, if he is confi-dent, he will act with force. And he usually is confident.
Regarding the future, for example, Neff's opinion in early 1989 was that the market should hold in the 1900-2200 range on the Dow until investors become convinced that inflation is going to be contained. At that point, long bonds would come down in price, and the stock market would rise.
Neff's method should, one would think, be highly susceptible to the use of computers, to filter through the stocks of target companies and make value comparisons. In fact, however, Windsor does not use computers. Nor does it use the dividend-discount models and other mechanical devices that are favored by some institutional investors. In that way, Neff is surprisingly old-fashioned.
When it comes to actually executing a purchase, Neff is again extremely disciplined. He has his target price, and he waits for the market to come down to that level. He waits and waits, and if the stock doesn't get there, he simply won't buy it. Neff is ordinarily able to buy stocks below their opening prices of the day. That is, in spite of the size in which he deals, he succeeds in buying on intra-day weakness.
**How to Sell**
Neff's selling discipline has two parts: the market price at which he is willing to sell a stock and the tactics of executing that trade.
As to the target selling price, again it is based on the "hurdle rate" of the whole portfolio. When the market thinks well enough of the prospects of one of his companies so that it rises, in due course the company's further appreciation potential will fall below that of the rest of the portfolio. When it gets down to only 65 percent to 70 percent of the whole portfolio's appreciation potential, Neff starts to sell. He likes to make a substantial sale initially, and then let the rest of the stock go as it moves on up.
If it falls back he will stop selling. If it falls enough, he becomes a buyer again.
When the time comes to execute an actual sale on an exchange, Neff is extremely careful. He almost always wants to sell into market strength that day, and avoids accounting for more than a quarter of the trading in a given issue. Of course, if a stock starts running up, it makes less difference to him what proportion of the trading he is responsible for. Here again, Neff can usually sell a stock higher than its opening price on the day of the trade.
The largest element in trading costs is the impact that the transaction has on the market. So the skill of his traders means that Neff's operations have little impact on the price movements of stocks he is dealing in.
**Patience**
One of Neff's theories is that one should sell a stock before it has achieved its full potential gain. One must leave a sufficient incentive for the next buyer to take the merchandise off your hands.
Still, a feature of Neff's method is that he does not mind waiting almost forever if a stock he owns does not realize its potential. Here he differs from some other "value" buyers, who like to see something happen within a year or two; if it doesn't, they move on. Neff will hold a company for years, as long as its outlook remains satisfactory and it remains cheap relative to the rest of the portfolio.
**Dull and Woebegone**
Since the stock groups that Neff considers to be good value will virtually always be out of favor in the market and viewed with suspicion by investors, they generally partake of a common characteristic: A stockbroker would have trouble selling them to a customer.
For instance, when he made his huge bet in Ford, which I have described, the industry was in deep disfavor among investors. Chrysler's virtual bankruptcy had shaken them, and the news of rising Japanese penetration sounded alarming. So the car companies got down to extremely low prices, and Neff moved in massively. This was true of his commitments in oil, the financial group, and indeed most of his other big conceptions.