Bookshelf: John Neff on Investing

John Neff, John Neff on Investing, with S. L. Mintz; John Wiley & Sons; October, 1999, 256 pages.

Value investors, your moment has finally come. At long last, John Neff has delivered a full accounting of the investment philosophy that guided his outstanding performance as manager of Vanguard's (VWNDX)Windsor fund. Although not nearly as famous to investors as his Fidelity colleague Peter Lynch, Neff chalked up a performance record over 31 years at Windsor that would make any fund manager cringe with envy.

How great was Neff's record?

During the 31 years he was at the helm, Vanguard's Windsor fund provided an average annual return of 20.5%, three percentage points better than the S&P's 17.2% return for the same period. Three points may not sound like much to brag about, but add it up over 30 years and you'll see a huge difference, enough to provide longtime Windsor shareholders a cumulative return of (are you sitting down?) 5,546% vs. 2,229% for the S&P. Given that record, you may want to pay attention to what Neff has to say about investing.

In John Neff on Investing, Neff shares with readers what he calls "the enduring principles" that lay at the foundation of his fund's consistent overperformance. "If we shared a compartment on a long train ride, what you read in these pages is what I'd tell you about investing," he writes in a folksy style.

As a value investor, Neff spent 30 years combing "the market's bargain basement" in search of diamonds in the rough, great companies selling at dirt-cheap price-to-earnings ratios, but whose prospects he and his team believed to be bright. Many times Neff pocketed profits by simply waiting for a company's P/E to recover from the financial infirmary.

As he illustrates, an ordinary $16 stock with $2 of earnings sells at a P/E ratio of 8:1, but when the market comes to its senses, the stock's P/E ratio may rise to 11:1, giving the shareholder a great return with little risk. "If you buy stocks when they are out of favor and unloved and sell them into strength when other investors recognize their merits, you'll often go home with handsome gains."

Now you might think that low-P/E investing is about as fun as drinking flat soda, but Neff added plenty of thrills by nonchalantly dismissing prudent asset-allocation models ("you can diversity yourself into mediocrity") and concentrating his holdings wherever he found value opportunity. "When Windsor managed $11 billion, we owned 60 stocks, and the 10 largest accounted for almost 40% of the whole fund." At one time, 25% of the fund's assets were invested in just three oil companies.

These huge bets are rare in professional money-management today, and speak volumes of Neff's confidence in his team's abilities and the latitude granted him by Vanguard's directors. "Windsor's success flowed ultimately from our willingness to step outside the crowd's embrace and be exposed to the risk of embarrassment," which, in the investment world, is career-limiting risk.

Briefly, Neff's "enduring" investment principles are:

• Low P/E ratios
• Fundamental growth over 7%
• Yield protection and enhancement
• Superior relationship of total return to P/E paid
• No cyclical exposure without compensating P/E multiple
• Dominant companies in growing fields
• Strong fundamental case

The fourth principle, "Superior relationship of total return to P/E paid," shows how Neff quickly measured a stock's appeal. The "total return" piece Neff figured by adding the stock's earnings growth rate to its current yield. So if the earnings growth is 12% and the yield is 3.4%, the total return comes to 15.5%. If the stock has a P/E of 6, then dividing total return by the P/E ratio gives a result of 2.6.

"A stock whose total return divided by P/E exceeds .7 matches Windsor's traditional edge. As a way to measure the bang for our investment buck, total return divided by initial P/E could not have been more succinct. We just never found a catch name for it."

In his autobiographical chapters, Neff writes with mild bitterness of a world that quickly recognized his lack of blue-blooded pedigree. His father left home when Neff was young, and this future master of investment supported himself with a variety of odd jobs -- soda jerk, shipping clerk, shoe salesman -- before hitchhiking to New York City one rainy morning in search of a career on Wall Street. In a story that is now legendary, Neff applied for the stock broker training programs at Merrill Lynch, Blyth & Co., Smith Barney and Bache & Co. "Merrill Lynch and Blyth turned me down flat," he recalls, and Smith Barney felt "my voice lacked the requisite authority" for success. Bache offered an analyst's position, a career that Neff began closer to home at the National City Bank of Cleveland.

A book on value investing may seem out of place in today's market, something Neff himself acknowledges in his introduction. But all investors can profit by spending an imaginary long train ride with Neff hearing what he has to say about investing, as he practiced it with great success for over 30 years.

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