Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the John Neff-inspired strategy, which has beaten the market by more than 3 percentage points per year since its inception more than six years ago. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas based on the Neff investment strategy.
Taken from the May 28, 2010 issue of The Validea Hot List
Guru Spotlight: John Neff
Most investors wouldn’t give a fund described as “relatively prosaic, dull, conservative” a second glance. That, however, is exactly how John Neff described the Windsor Fund that he headed for more than three decades. And, while his style may not have been flashy or eye-catching, the returns he generated for clients were dazzling — so dazzling that Neff’s track record may be the greatest ever for a mutual fund manager.
By focusing on beaten down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards. Over his 31-year tenure (1964-1995), Windsor averaged a 13.7 percent annual return, beating the market by an average of 3.1 percent per year. Looked at another way, a $10,000 investment in the fund the year Neff took the reins would have been worth more than $564,000 by the time he retired (with dividends reinvested); that same $10,000 invested in the S&P 500 (again with dividends reinvested) would have been worth less than half that after 31 years, about $233,000. That type of track record made the understated, low-key Neff a favorite manager of many other professional fund managers — an “investor’s investor”, if you will.
How did Neff do it? By focusing first and foremost on value, and a key part of how he found value involved the Price/Earnings Ratio. While others have called him a “contrarian” or “value investor”, Neff writes in John Neff on Investing that, “Personally, I prefer a different label: ‘low price-earnings investor.’ It describes succinctly and accurately the investment style that guided Windsor while I was in charge.”
To Neff, the P/E ratio was key because it involved expectations. If investors were willing to buy stocks with high P/E ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share; conversely, if a stock has a low P/E ratio, investors aren’t expecting much from it. Much like David Dreman, the great contrarian guru who we examined a few newsletters back, Neff found that stocks with lower P/E ratios — and lower expectations — tended to outperform, because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high P/Es often flopped, because even strong results couldn’t match investors’ expectations.
To Neff, however, the P/E wasn’t always a lower-is-better ratio. If investors knew that a firm was a dog, they’d rightly avoid its stock, giving it a low P/E ratio but little in the way of future growth prospects. Because of that, he wrote that Windsor targeted stocks with P/E ratios between 40 and 60 percent of the market average.
While it was at the heart of his investment philosophy, the P/E ratio was also by no means the only metric Neff used to judge stocks. He wanted to see earnings growth, but here again it was not a case of more-is-better. A stock with too high a growth rate — more than 20 percent — could have trouble sustaining that growth over the long haul. He thus preferred to see growth between 7 and 20 percent per year, the kind of steady, unspectacular growth that could be sustained.
Sustainable growth also meant growth that was driven by sales — not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates. (My Neff-based model interprets this as sales growth needing to be at least 7 percent per year, or at least 70 percent of EPS growth.)
One more key aspect of Neff’s strategy involved dividends. He believed that many investors valued stocks strictly on their price appreciation potential, meaning that you can often essentially get their dividend payouts for free. He estimated that about two-thirds of Windsor’s 3 percent per year market outperformance during his tenure came from dividends.
To make sure that his analysis captured dividend payments, Neff used the Total Return/PE ratio. This measure divides a stock’s total return (that is, its EPS growth rate plus its dividend yield) by its P/E ratio. He looked for stocks whose Total Return/PE ratios doubled either the market average or their industry average.
Now, here’s a look at the stocks that currently make up my 10-stock Neff-based portfolio:
Western Digital Corp. (WDC)
Reinsurance Group of America (RGA)
AstraZeneca PLC (AZN)
Jos. A. Bank Clothiers (JOSB)
Tupperware Brands Corporation (TUP)
Telecom Argentina S.A. (TEO)
AmTrust Financial Services (AFSI)
CVS Caremark Corporation (CVS)
Owens & Minor Inc. (OMI)
Smith & Nephew PLC (SNN)
I began tracking my Neff-based portfolio at the start of 2004. Overall, it has performed substantially better than the broader market, though it’s had an up-and-down ride. From its inception through 2007, the portfolio returned about 67%, about double the S&P 500’s 32.4% return. The 2008 crash was especially hard on value stocks, however, and the Neff portfolio fell more than 48% for the year, about 10 percentage points behind the S&P. But it bounced back strong in 2009, surging 45.4% to put it comfortably ahead of the market over the long haul.
Just like Neff himself, the Neff-based model often treads into the most unloved parts of the market. As you can see above, many of its current holdings come from industries or sectors — healthcare, financial, telecom — that have either been lagging or have substantial fears lingering over them. But by ignoring the crowd and focusing on these firms’ strong financials and fundamentals, I think the Neff model will end up benefiting significantly from many of these picks.
