Do you want to learn how to invest – the John Neff way? You can now follow his strategy in a few easy steps:

• Earnings growth of 7 percent or better but not above 20 per cent.
• Total Return Ratio of 2 or above.

For over 30 years, John Neff outperformed the S&P by an average of 3.1%. Neff’s funds earned a compounded annualized return of 13.7% vs. 10.6% for the S&P during the period of 1964 until his retirement in 1995 when he managed the Vanguard Windsor Fund. Neff beat the market 22 out of 31 years turning each dollar invested in Windsor in the first year to $56 during that period. The average return of the Windsor fund was 13.7% a year, versus 210.6% for the S&P500. Neff liked to categorize himself as a low P/E investor rather than a value investor and his style emphasized that concept. Additionally, he felt proper selling was just as important as proper buying in regard to equities. Neff’s investment style resembled a cross between the concepts of Sir John Templeton and Peter Lynch; sort of an eclectic merger between value and growth held together by one common thread. That common thread was represented by Neff’s quote: “I’ve never bought a stock unless, in my view, it was on sale.” Similar to Walter Schloss, Neff liked to comb through the list of 52-week lows to find potential bargains. Similar to Warren Buffett and Charlie Munger, Neff was a voracious reader. His idea of weekend entertainment was a second round of reading of the Wall Street Journal in case he missed something on the first go around. He put in long hours at the office and meticulously studied the industries and companies which he purchased. Rather than purchasing the expensive high fliers in popular sectors, Neff preferred to identify the suppliers to the hot sectors which offered greater value. The practice resembled a “picks and shovels” approach which frequently provided Neff with lower P/E companies with equal growth prospects. For instance, if oil stocks were running, Neff found better value in the service and equipment companies which provided essential services necessary to extract and transport the oil.

Buy on the Cannons, Sell on the Trumpets

Similar to John Templeton, Neff loved to purchase stocks following bad news or during periods of excessive pessimism. Conversely, Neff preferred to sell equities during periods when volume and optimism were at their highest point. Neff started managing the Windsor Fund during the height of the “Nifty-Fifty” era when fund managers tended to concentrate their holding on a few extremely popular large-cap stocks with extremely high P/E ratios. Nifty-Fifty stocks were high-growth companies which were viewed as stocks which should never be sold regardless of their price. In the early 1970s stocks such as Xerox, Polaroid and Avon traded as high as 90 times their P/E multiples. By 1974 these companies had lost 70 to 90% of their market value. Neff never bought into the notion of buying into these extremely expensive companies even though their lofty multiples held up for many years. The idea of buying a stock with an earnings multiple in excess of 40 times the price of the stock seemed absurd to Neff, although few other fund managers seemed to agree. Neff felt that expensive high-fliers were living on borrowed time. He understood the risk to these lofty multiples should their earnings growth suddenly cease or if overall market sentiment suddenly turned pessimistic. By 1974 Neff was vindicated when a bear market in equities drove down the prices of the overpriced Nifty-Fifty stocks by as much as 90%.

Total Return Ratio

Neff provided investors with a formula which he referred to as the Total Return Ratio (TRR). The ratio is very similar to the PEG formula which was popularized by Peter Lynch in the 1990s. The main difference is that TRR added back dividends into the ratio and generally emphasized low-growth stocks with favourable P/E ratios. Further, TRR is the reciprocal of PEG, where higher rather than lower numbers indicate value. TRR is calculated as follows: Earnings Growth + Dividend Yield / PE Ratio. Neff’s aim was to identify stocks which were trading at approximately twice the market average in terms of TRR. The idea was to purchase the discounted stocks and subsequently hold them until they approached their full market value. In other words, if the S&P average TRR was around .7x, Neff looked for stocks which traded at about 1.4x their TRR value. For instance, say XYZ Ball and Roller has a projected earnings growth ratio of 12%, yields a 2% dividend and currently trades at a P/E ratio of 10 (12+2= 14 / 10 = 1.4 TRR). Neff would consider such a stock as a prospective purchase. Neff looked for steady but not excessive projectable growth in the companies which he purchased and he was willing to purchase shares of companies with smaller capitalizations. It was not uncommon for Windsor to own 8 to 9 percentage positions in some of the smaller companies which the fund purchased. About one-third of the companies which Neff purchased could be considered cyclical in nature. It appears that Neff deviated from his normal TRR standards when dealing with companies which exhibited highly volatile earnings. In such cases Neff would rely upon industry and company analysis to project the forward earnings of such companies. Neff was among the first to document that cyclical stocks must be purchased six to nine months before their earnings begin to up tick. In other words, an investor must anticipate the earnings improvement in advance of the up tick. If an investor waits until the earnings have improved the stock will already have increased to a level where it offers little value. Neff noted that cyclical companies should never be confused with growth companies. In such cases it seems that the concept of TRR would not apply.

Conclusion

Similar to most successful value investors, John Neff could be considered a contrarian. He made his living by sifting through companies which were trading near their 52-week lows and identifying the ones which were being unduly punished. The key to such an approach is understanding the industry and the nature of the company which is trading nears its lows. If the market has made an error in its appraisal of the future prospects of the company then the stock will eventually recover and the contrarian approach will be rewarded. On the other hand, if the market has correctly ascertained that the future prospects of the business materially changed to the negative; the stock is a value trap. Like all successful value investors, Neff was an avid reader and focused upon businesses and industries which he understood. It is also important to note that Neff actively sought small companies which were unfamiliar to the average investor. Such companies might be bedrocks of their industry although they remained obscure to most mutual funds and investors. Frequently such companies supplied the “picks and shovels” to a sector which was on the rise; even though they were being overlooked by Wall Street.