Unsung Investor: John Neff

Courtesy about.com


Many ordinary folks never heard of John Neff. Yet, within the financial community, he remains one of the most respected, successful, and experienced investors of the 20th Century. Having run the Vanguard Windsor Fund from June of 1964 to December of 1995, he generated a CAGR, or Compound Annual Growth Rate, for his investors of 14.8%. That would have turned an initial $10,000 investment into around $587,000 as compared to only $250,000 for the S&P 500.

His Investment Approach
According to his own book, John Neff on Investing, and other accounts such as John Train’s great interview in The Money Masters of Our Time – John Neff – The Systematic Bargain Hunter, he is a classic value investor. Unlike many of his philosophical and intellectual contemporaries, however, Neff demanded that his stocks generate current income through large cash dividends. He felt that this provided a cushion against market volatility and gave the investor a sense of growth while waiting for Wall Street to recognize the true value of the company.

According to Train, John Neff sought companies with low price to earnings ratios and high dividend yields resulting in a portfolio with an average p/e of 1/3 below the market while averaging 2% more on yield. Train goes on to point out that in addition to looking for a sound balance sheet, satisfactory cash flow, an above-average return on equity, able management, the prospect of continued growth, an attractive product or service, and a strong market in which to operate, John Neff had created a financial metric he called the “terminal relationship” figure. This calculation allows the portfolio manager what he or she is getting for his money when buying a stock.

The calculation itself is easy: John Neff simply took the capital growth rate plus the dividend yield and divided it by the average price to earnings ratio of the entire portfolio. For example, if you had a portfolio you expected to grow earnings at 10% and it generated a 3% cash dividend yield, totaling 13%, and the price to earnings ratio of the whole group of stocks was 10, you would have a terminal relationship of 1.3. If, at the same time, the market had a growth rate of 12% plus a 1.5% dividend yield with a p/e of 17, it would have a terminal relationship of 0.79; far lower than your portfolio. This allows him to see that although the earnings of the market were expected to grow faster, the investor could expect higher returns because he was getting far more future profit for every $1 he spent on a stock. Neff even took this concept further, insisting that each new stock added to the portfolio be at least as attractive as the existing equities he already owned.

Sector and Industry Weightings
John Neff’s Vanguard Windsor Fund was very diversified, typically holding positions that were 1% of assets (although it is reported that he would go as high as 5% in an individual stock if it was extremely attractive.) But as pointed out by my earlier sources, Neff would weight the assets he managed heavily in favor of those areas of the market he thought offered the most value for the money. If, for example, he believed the property and casualty insurance industry was headed for a recovery after a cyclical downturn, he may only take a 1% position in an individual underwriter but he may acquire positions in twenty different enterprising, resulting in 1/5th of assets under management being exposed to that sector of the economy.

Dull and Out of Favor Stocks
Glancing over a portfolio managed by John Neff, you might be surprised to find a list of stocks that are very likely to be highly despised on Wall Street at the time. This disciplined value approach often meant moving into portions of the market for which investors had developed a fear, loathing, and even hatred. A fan of Buying on Bad News, he understood that Price is Paramount – that is, the return you earn is absolutely dictated by the price you paid.

Applying the John Neff Approach to Your Own Portfolio
In addition to the characteristics we already covered, here are some things you might want to look for in a stock if you are trying to invest like John Neff –

* Low Price to Earnings Ratio
* High Returns on Equity
* Management with Disciplined Capital Allocation that Returns Excess Funds to Shareholders
* Above Average Dividend Yield
* Terminal Figure at Least 2x that of the Overall Market
* Out of Favor Industries and Sectors that You Believe Will Turnaround
* Viable Product or Service with Promise