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, up 19.0% year-to-date vs. 8.9% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Neff-based investment strategy.
Taken from the November 7, 2014 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 Investingthat, “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.
In recent years, very few companies have passed all of my Neff-inspired model’s tests. In fact, only one stock in the U.S. market currently gets a 100% score on the model. Here’s a look at the stocks that currently make up my 10-stock Neff-based portfolio:
United Insurance Holdings Corp. (UIHC)
Banco Bradesco SA (BBD)
Itau Unibanco Holding SA (ITUB)
Home Loan Servicing Solutions (HLSS)
Starwood Property Trust (STWD)
Canadian Imperial Bank of Commerce (CM)
ResMed Inc. (RMD)
Franklin Resources (BEN)
Valero Energy Corporation (VLO)
AXIS Capital Holdings Limited (AXS)
I began tracking my Neff-based portfolio at the start of 2004, and it’s had some significant ups and downs. In the past few years it was mostly downs, but it’s started to rebound — it’s my top performer this year, returning 19.0% vs. 8.9% for the S&P 500. All in all, it is averaging annualized returns of 5.7% since inception, just ahead of the S&P 500’s 5.6% annualized return (through Nov. 4). Keep in mind that while Neff believed dividends were very important (as do we), our system only can track returns without dividends.
Just like Neff himself, the Neff-based model often treads into the most unloved parts of the market. As it was when we last checked in on it in January, the portfolio is heavily concentrated in the financial sector, with seven of its ten holdings being financials. Most of them are dirt-cheap thanks to lingering fears about the economy and financial sector. By treading into such unloved areas, a value-focused strategy can languish for lengthy periods of time, and the Neff-based portfolio has indeed struggled in recent years. But Neff succeeded by staying disciplined, focusing on value, and having the patience to wait for others to recognize the value in his picks. That’s what we’ve tried to do, and in 2014 it has paid off, as investors have begun to recognize the value in the Neff portfolio. Over the long term, I expect the strategy’s picks will continue to demonstrate their value.