SPECIALS
John Neff: An Alternative to Buffett

By Maynard Paton (TMFMayn)
April 11, 2001

Book Review -- John Neff On Investing
by John Neff and Steven Mintz

[Buy this book from the Fool's bookshop]

It's always worth paying attention to anybody with a long-term record of beating the stock market. John Neff is one such investor. After 31 years at the helm of a US mutual fund, Neff beat the market in two out of every three years. During his tenure between 1964 and 1995, he turned $1 invested in his Windsor Fund into $56. The same $1 riding on the S&P 500 over that period would have been worth just $22 in 1995. How he outperformed the US stock market for so long is encapsulated in his book John Neff On Investing

The book is divided into three main chapters, the middle one being by far the most interesting:

• The Road To Windsor;
• Enduring Principles, and;
• A Market Journal.

The first chapter is the least useful to private investors. There isn't much in the way of "how to beat the market" when Neff describes his family, his early career in finance and his move to Philadelphia to become a fund manager. Certainly his tenacity comes through in the chapter, but not the stock picking philosophy his readers are looking for.

Enduring principles

Moving to "Enduring Principles", Neff explains how he followed "one durable investment style, whether the market was up, down or indifferent". Reassuringly, his fund was never "fad-driven".

• The principle elements of Neff's stock picking strategy were:
• Low price to earnings (P/E) ratio;
• Fundamental growth in excess of 7%;
• Yield protection;
• Superior relationship of total return to P/E paid;
• No cyclical exposure without compensating P/E multiple;
• Solid companies in growing fields, and;
• Strong fundamental case.

From the "low P/E" and "yield protection" elements, it's quite clear that Neff comes from the "value investing" mould of stock pickers.

Overall, Neff would seek larger companies where a medium term re-rating opportunity appeared very favourable. He would typically invest in those companies that had P/E ratios 40% to 60% below the market average. He found that the chances for an out-of-favour company's P/E ratio increasing from, say, 8 to 11 times, were always more promising than a growth stock being propelled from a P/E of 40 to 55.

In terms of future profit growth, Neff sought evidence of "reasonable and sustainable earnings growth to catch investors' attention". Between 7% and 20% earnings growth was the favoured rate needed to realise a re-rating. Growth rates beyond 20% entailed "too much risk", apparently.

Alongside low P/E ratios, Neff placed his faith in the dividend yield too. Low P/E investors, explained Neff, can usually bank a meaningful portion of their potential return through dividends alone. Neff is a firm believer of future dividend payments being more stable and predictable than future earnings.

Joining the earnings growth and the yield together is what Neff terms the "total return ratio". Neff added the earnings growth rate to the yield and divided the sum by the company's P/E ratio. Any company that had a "total return divided by P/E" calculation greater than two would spark Neff's interest. Neff cheerfully admits: "I never quite understood why a 15 percent grower with a 1 percent yield usually sold at twice the P/E of an 11 percent grower with a 5 percent yield".

Cyclicals and selling

After some slightly dubious comments about cyclicals ("Timing is critical with cyclicals... The trick is to anticipate increases in the pricing [of a company's product]"), Neff outlines some of the business tenets he looked for. These will be quite familiar to followers of most renowned investors, Neff's criteria covering a company's reputation, industry position, management talent and so on. However, it's quite obvious from the text that Neff puts less emphasis on these subjective qualities than he does on the company's valuation.

While there is plenty of comment about buying stocks, Neff devotes just three pages to his selling technique. A shame really, given that he states that his success "rested equally, if not more, on a firm selling strategy".

He gives the usual two reasons for selling ("1. Fundamentals deteriorating, 2. The price approaching our expectations") and also declares his typical holding timescale was about three years ("but that didn't prevent us from taking profits right away..."). While brief, Neff does give sound advice for selling his shares: "Falling in love with stocks in a portfolio is very easy to do and, I might add, very perilous. Every stock Windsor owned was for sale... When you feel like bragging about a stock, it's probably time to sell."

History lesson

Neff rounds off the book with an epic recount of the US market and his investments between 1970 and 1993. This is a difficult read, as Neff's stock picking recollections are diluted by dreary narrations of what the US stock market and economy were doing at the time. The varying commentary on the stock purchases is also disappointing. The explanations of some are quite vague, which is quite unfortunate given Neff advises readers to keep company detailed fact sheets relating to their stock picks.

Overall though, Neff's book could be deemed required reading for Fools wanting a more achievable investment strategy than that of Warren Buffett's. However, only the middle chapter is of real use to prospective Neff-type investors, where the details of his investment philosophy and techniques are covered. Other gripes include the lack of commentary on the mistakes he made during his career, plus the psychological requirements for his value style. As most value investors know, there's a special mental attitude for buying unloved or troubled companies.

That said, Neff's strategy should appeal to a lot of Fools. His techniques are certainly more straightforward and adaptable to ordinary private investors than Buffett's. Neff's medium-term investments in substantial and traditional businesses strike the middle ground between the philosophies of TMFPyad and the Qualiport. For those Fools hovering between those two investment strategies, and who can live with his US-centric writing, Neff's book provides an excellent compromise.

Ratings (out of five Jester's caps)

Content 4

Readability 3

Foolishness 4

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