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Book Summary: John Neff On Investing

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John Neff on Investing
by John Neff
with Steven L. Mintz
Published in 1999

John Neff is one of the best mutual fund investors in the last 40 years. I was interested in reading this book because John Neff is considered to be a contrarian. His Vanguard Windosr fund was the best performing mutual fund during his tenure. It became the largest fund before being closed to new investors back in the 80's (John Neff retired in 1995). During his watch from 1964 to 1995, Windsor returned 13.7% annualized vs 10.6% for the S&P 500 (this translates to cumulative percents of 5,546.4% vs 2,229.7%).

Given his long investing career, John Neff went through diverse periods of booms and busts. Through the go-go years of the 60's, to the brutal inflation in the 70's, Savings & Loan crisis in 1990, to the huge bull market in the 80's and 90's, he has performed well. Good performance through all those differing conditions essentially establishes John Neff as one of the best fund managers of all time.

The book essentially has three portions. One is John Neff's biography; while another deals with his investing strategies; and the third one is a journal that describes his investments at particular points in time.

Investing Style

John Neff likes to call his investing style low p/e investing. He is generally considered to be a prominent contrarian investor. After reading the book, and learning a bit about him, I would say he is a tactical contrarian investor who laces high prominence on security analysis. In contrast to someone like David Dreman, who is more of a statistical contrarian investor (i.e. he buys a boatload of stocks satisfying his low P/E or other criteria), John Neff digs deep into a company and analyzes the books. John Neff's strategies seem to have high turnover (his average holding period is around 3 years).

(Numbers in square brackets are page numbers in the book. All errors in quotes are mine (I'm typing them out by hand :( so hope you guys & gals find it useful)).

It is critical to understand that a stock's price reflects two underlying variables: (1) earnings per share and (2) the multiple of earnings per share that the market attaches to it. [p47]

Pretty basic but thought I would quote it to point out that P/E expansion and contraction (captured by item 2) is something one needs to pay attention to. Contrarian and value investors generally try to buy at low P/Es to profit from any P/E expansion while hoping that P/E doesn't contract further.

Then, as now, I assigned great weight to a judgment about the durability of earnings power under adverse circumstances. [p48]

Extremely critical point that is repeated many times by Benjamin Graham. Earnings can be good for a business but what happens when things aren't so rosy?

John Neff Investing in a Nutshell

The key principles that John Neff followed were [p61]:

  1. Low P/E ratio
  2. Fundamental growth in excess of 7 percent: If the P/E is low, you don't need high earnings growth to get the same upside. The multiple expansion on the low P/E stock (towards a more normal P/E) will provide a big chunk of the return.
  3. Yield protection (and enhancement, in most cases)
  4. Superior relationship of total return [annual earnings growth + dividend yield] to P/E paid: John looked for this ratio to exceed the market average by 2 to 1. Ideally a P/E of half the total return is nice (eg. if earning growth is 10% and dividend yield is 5%, then a P/E of 7.5)
  5. No cyclical exposure without compensating P/E multiple: Maximum money is made 6 months to 9 months before better earnings are reported. Instead of using 5yr earnings growth or peak earnings, normal earnings should be used.
  6. Solid companies in growing fields
  7. Strong fundamental case: see below for my detailed thoughts

The above points sum up John Neff's strategy.

When it comes to fundamental analysis,

No solitary measure or pair of measures should govern a decision to buy a stock. You need to probe a whole raft of numbers and facts, searching for confirmation or contradiction. The goal is to develop credible growth expectations for a low p/e company or industry.

One of the big things John looks for is P/E expansion for the low P/E security. Therefore, he says to look for growth fundamentals to justify why that P/E will expand.

My style of security analysis examines earnings and sales: (1) earnings growth drives the p/e and the stock price, and (2) dividends come from earnings. Ultimately, growing sales create growing earnings. Squeezing greater earnings from each dollar of sales (called margin improvement) can buttress a case for investing, but margins do not grow to the sky. Eventually, attractive companies must demonstrate sales growth.

John emphasizes the point that sales need to grow for a successful company. He says looking at sales in dollar value is better than unit value. However, sales increasing in dollars faster than units implies pricing power, and that is something to look for. He also suggests that one pay attention to deliveries and see why there is an order backlog. If the problem can be rectified, it suggest opportunity.

As far as cash flow is concerned, John likes the simple method of using retained earnings plus depreciation as a measure of cash flow. One needs to compare that against working capital and capital expenditures. Anything aboe those two items is extra cash flow available for various uses.

Similar to Buffett, John Neff also likes to look at ROE (return on equity). He says that is the single best measure of management effectiveness.

To cushion any mistakes, John says the following:

The operating margin gives and indication of a company's earnings margin of error to untoward events...In the low p/e spectrum (where going against the grain may invite bad news), a robust operating margin supplies hefty protection against negative surprises.

The pretax margin goes a step further. It highlights the relationship between sales and all costs other than taxes--a more telling source than the operating margin because it reveals whether costs unrelated to sales are hindering the overall business prospects. As an investor, that's a more refined indication of your tolerance for being wrong.

In my limited newbie experience, finding a low P/E stock with decent operating margin is tough. I think I should start paying more attention to this figure in the future since, as John Neff mentions, it is the cushion in case one is wrong.

Search Strategies

The book lists a bunch of search strategies and most of them are common sense:
  1. New lows: Watch for companies hitting 52 week lows
  2. Prior day's worst perfomers
  3. Bad press: look for companies with bad stories
  4. Big price drops: look at companies that have had big price drops
  5. Companies on the "squash": look for actions taken by companies eg. spin-offs, takeover battles. Some investors don't want to be involved in these situations.
  6. Companies moving up the quality ladder
  7. Backdoor entry: eg. participate in some trend by being a supplier (an example is cited where profits off the oil&gas boom was via a manufacturer that supplies drill pipes and casings
  8. Miscategorized companies: eg. Bayer AG being considered as a chemical company with cyclical earnings even though almost 50% of its earnings aren't tied to the economy
  9. Need critical mass: companies need to be dominant in their field
  10. Capitalize on your strenghts: individuals have their own knowledge of some things in life
  11. Look at opportunities in shopping malls, restaurants, and other places you visit
  12. Ask questions

Windsor's Core Philosophy

John Neff breaks down his investments into the following categories:
  1. Highly recognized growth
  2. Less recognized growth
  3. Moderate growth
  4. Cyclical growth

The categories are exactly what they sound like. Those four categories encompass everything that he invested in. John Neff's investing style basically consisted of switching between those 4 categories based on low P/E valuations. Over the decades the percentage in each of those 4 categories has changed.

My Opinion of John Neff's Strategies

I like John Neff's strategies. This doesn't mean it's right for you but I personally find it useful. John calls his strategy 'low p/e investing' and this meshes nicely with contrarian investing, where I typically look at companies with low P/Es. I think this book goes nicely with one of the best books on low P/E strategies, and from another master contrarian, Contrarian Investment Strategies by David Dreman (I'll comment on this book in the future).

Some of John Neff's emphasis in his strategies are different from that of value investors. A lot of emphasis is placed on predicting the economy and projecting future earnings. Most value investors place less emphasis on economics, as well as trying to predict earnings. I'm not saying value investors don't predict earnings but they are not as important. If a value investor is off by a bit, it doesn't really matter. John Neff's strategies seem to be highly sensitive to earnings estimates. Reading about his investment decisions at various points in time, it almost looks like he makes the call based on how earnings will turn out 1 or 2 years from now. John Neff had a research staff working for him so I'm not sure how easy it will be for small investors to predit future earnings. I would have to say that the emphasis on the economy and earnings prediction is something I will not utilize.

True to a mutual fund, Windsor held a large amount of securities. I do not think small investors should--or will have the ability--to hold such a diverse set of stocks. If you want to hold such a large number, you may as well go and invest in an index fund. I personally am trying to master my skill in focus investing so I won't be holding a large number of diverse securities.

Final Thoughts

I found the biographical sketch interesting and lively. It is quite neat to see someone who is a nobody (in school or in career) all of a sudden take up investing and become one of the best fund managers in the last few decades.

His explanation of low P/E investing is also quite benefitial. Although I was familiar with quite a bit of it, there were some things I wasn't familiar with.

However, on the downside, the explanation of John Neff's picks throughout the years left a lot to be desired. I liked how he went into great detail with many of his picks and gave his justification for picking them. Unfortunately, it is highly confusing given that the returns weren't annualized. The reader has to explicitly try to calculate in his head what the annual returns were. Furthermore, I would have preferred it if John Neff had provided some commentary on the prevailing economic situation and mood. He did mention it at times but it was inconsistent and not clear enough to those who either did not live at that time or didn't pay attention. For example, his "journal" of 1989-1992 would be more useful compared to present day, given the housing collapse. But without providing the economic backdrop it's hard to say what was happening back then when he invested in particular securities.

People looking for a pure investment book may find the biographical discussion distracting but I thought it added a wonderful backdrop to John Neff's investing style. I wouldn't consider this an essential book but contrarians or those interested in low P/E investing should check it out. At least the chapters on low P/E investing strategies is worth reading.

Rating: 65%

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