🎙️ TIP747: John Neff: The Value Investor Who Quietly Crushed the S&P 500 with Kyle Grieve

🎙️ TIP747: John Neff: The Value Investor Who Quietly Crushed the S&P 500 with Kyle Grieve

The Unconventional Approach of a Low P/E Pioneer and His Three Decades of Market Outperformance

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John Neff represents one of investing's most remarkable yet under-appreciated success stories. Over his three-decade tenure managing the Windsor Fund from 1964 to 1995, Neff consistently outperformed the S&P 500 by an average of 3% annually. A feat that places him among the investment greats. Unlike many of his contemporaries, Neff achieved this not through flashy growth stocks or complex derivatives, but through a disciplined, straightforward approach focused on low price-to-earnings ratios and solid dividends. Kyle Grieve dives deep into Neff's autobiography "John Neff on Investing" to extract the principles and strategies that powered this extraordinary track record.

The Making of a Contrarian Investor

John Neff's journey to becoming one of investing's most successful practitioners began with his natural inclination toward argument and independent thinking. As Grieve notes, "John loved arguing. His mom told him that he would argue with a signpost. And this is a pretty common trait that I think I've seen in many value investors. Their natural ability to think in a contrarian manner just aligns really well with them being a tried and true value investor."

Neff wasn't a stellar student and saw himself as an outsider, but he learned valuable business lessons working at his father's company, Nef Equipment Co. These early experiences shaped his investment philosophy in profound ways. Grieve explains: "Nef noted a few learnings from his time working with his father. The first one is that you don't need glamour to make a buck. The second is that dull businesses that make money are great and because they're boring, they don't attract competition. And third, bargaining with suppliers was a great way to ensure a business got the best possible terms that could then be passed on to customers."

After serving in the Navy, Neff hitchhiked to New York with just $20 in his pocket, eventually landing a job as a security analyst rather than the stockbroker position he initially sought. This decision proved pivotal, allowing him to focus on analysis rather than sales. At the University of Toledo, he studied under Sidney Robbins, a disciple of Graham and Dodd, who provided his first formal exposure to value investing principles.

The Windsor Fund Transformation

When Neff joined the Windsor Fund in 1964, he inherited a portfolio struggling with poor performance, down 25% in 1962. The fund was filled with overpriced businesses with minimal competitive advantages, typical of the go-go era of the early 1960s. Neff immediately set about transforming the fund's approach.

As Grieve describes, "The first order of business was to get rid of businesses that just didn't belong in the fund. John made things pretty simple here. So, stock prices were a function of just two variables, earnings and earnings multiples." Neff identified three key problems with the existing portfolio: errors in fundamental analysis, overpaying for companies with poor earnings power, and a failure to sell losers and move on.

One of Neff's most important insights was his emphasis on the durability of earnings power under adverse circumstances. Grieve highlights this crucial concept: "Then as now, I assign great weight to judgment about the durability of earnings power under adverse circumstances. This is such a powerful concept and one that I think most investors, myself included, just don't emphasize enough. To avoid losers, consider earnings power during weak macroeconomic environments. You simply do not know when that weakness will happen, but you're nearly guaranteed that it will happen at some point in the future."

By 1964, Neff had established three investing principles that would guide the Windsor Fund: creating impact through concentrated positions, building consensus with committee members individually rather than as a group, and securing dedicated analytical support.

The Seven Pillars of Neff's Investment Philosophy

Neff's investment approach was built on seven core principles that guided his selection process and portfolio management. Unlike traditional value investors in the Graham and Dodd mold, Neff preferred to be known as a "low price-to-earnings investor" rather than a value investor, reflecting his focus on earnings power rather than liquidation value.

The seven principles were:

Neff used P/E ratios as his primary yardstick, believing that cheaper stocks provided more value for less money. However, he understood that growth played a role in determining appropriate multiples. His sweet spot was companies growing between 6-20% that could be purchased at low multiples. As Grieve explains, "Nef mentioned looking for businesses that could expand their PE from something like 8 to 11 rather than, you know, 40 to 55. He also felt that a business trading for that cheap was less likely to go through painful multiple contractions."

The Power of Dividends

One of the most distinctive aspects of Neff's approach was his emphasis on dividend yield. Unlike many investors who view dividends as merely a bonus, Neff made yield a central component of his strategy. The results speak for themselves: "Windsor edged the market by 3.15% per year after expenses while Jon was in charge and 2% of that outperformance was due to the dividend yield that Jon had received."

Neff understood that dividends provided multiple benefits beyond just income. They offered downside protection during market declines and served as a signal of management's confidence in the business's cash flow generation. However, he was flexible in his approach: if a company could deliver double-digit earnings growth, he was willing to invest even with zero yield.

Grieve provides insight into Neff's thinking on dividends: "The concept of a dividend yield is interesting to me. And I think it really matters depending on where you are in your wealth cycle. So, if you're employed full-time and don't require dividend income, then getting yield just doesn't matter that much from your stock picks. But if you're a personal investor managing your own money for a living, then yield becomes much more important as you require cash to live off of."

Measured Participation: A Novel Approach to Portfolio Construction

Neff developed a unique approach to portfolio management he called "measured participation," which allowed him to think differently about diversification and industry allocation. Rather than using traditional industry classifications, Neff categorized investments into four broad groups:

This framework enabled Windsor to concentrate capital where the best values were available, regardless of industry concentrations. As Grieve explains, "Windsor participated in each of these categories irrespective of industry concentrations. When the best values were available in say the moderate growth area, we concentrated our investments there. If financial service providers offered the best values in the moderate growth area, we concentrated in financial services."

Neff believed most investors focused too heavily on highly recognized growth stocks, which often led to underperformance. In contrast, Windsor placed these popular blue-chip stocks on the "lowest rung" of their investment ladder, while most other funds placed them on the highest. This contrarian positioning was a significant factor in Windsor's long-term outperformance.

Hunting in the Bargain Basement

Neff spent much of his time searching for opportunities in what he called the "bargain basement", stocks trading at or near 52-week lows. He understood that many of these stocks deserved their low valuations, but with careful analysis, he could uncover gems that didn't belong there.

As Grieve describes, "In the course of my career, few days have passed when the new low list has not included one or two solid companies worth investigating. The goal is to find earnings growth capable of capturing the market attention once the climate shifts." Neff used a tool he called the "Hymph test" to evaluate whether a depressed stock offered sufficient upside potential.

One of Neff's most successful bargain basement investments was Home Depot in 1985. Although it traded at a high P/E ratio of 20 by Neff's standards, he calculated that on a forward basis, it was trading at only 10 times normalized earnings. As Grieve notes, "So for a business at the beginning of its growth phase, that's simply incredibly cheap on a forward basis." Windsor's investment in Home Depot returned 63% in just nine months.

The Art of Selling

While many investors focus primarily on when to buy, Neff placed equal emphasis on knowing when to sell. His selling discipline was straightforward but effective: "Windsor sold for just two reasons. The first one was if fundamentals deteriorated and the second was when price approached expectations."

Unlike buy-and-hold investors, Neff was willing to sell winners once they reached his price targets, even if their fundamentals remained strong. As Grieve explains, "Since he was very well aware of the price appreciation potential of all of his holdings, he preferred to sell into strength. He was not into the buy and hold strategy seen in investors who focus more on high-quality assets that can compound for a long period."

This approach meant Windsor sometimes held stocks for only a month or less, while other positions might remain in the portfolio for three to five years if the fundamentals continued to improve. Neff didn't try to capture market tops but rather sold when stocks became fully valued, freeing up capital for new opportunities.

Navigating Market Cycles

Neff had a keen understanding of market cycles and what he called "inflection points", times when market sentiment reached excessive levels in either direction. During periods of excessive euphoria, he would sell winners and accumulate cash, while during market panics, he would deploy that capital aggressively.

He recognized that refusing to participate in market euphoria would lead to underperformance during bull markets but provided protection during downturns. As Grieve notes, "He also came to grips with the fact that if you refuse to take part in inflection points during times of excessive euphoria, you're going to underperform in bull markets. And lastly was that inflection points are just impossible to predict. But warning signs will be apparent such as excessive IPOs, cheap debt, a lack of good opportunities, and high amounts of speculation."

Neff illustrated the tendency of investors to repeat mistakes with a memorable joke about hunters who keep crashing their plane by overloading it with moose, despite previous bad experiences. This anecdote, as Grieve explains, "illustrates how investors will just continually chase assets out of greed even after having a bad experience in the past. This is why it's crucial to identify and just learn from your mistakes."

The Cyclicals Conundrum

Cyclical stocks constituted about a third of Windsor's portfolio, and Neff developed a specialized approach for investing in them. He understood that the key to successful cyclical investing was timing: buying 6-9 months before earnings were expected to swing upward and selling into rising demand.

Neff's strategy involved gauging what normalized earnings would be during the upcycle and selling once the business reached that level. While this sometimes meant selling too early, it prevented the need to ride the cycle back down or wait for the next upcycle. As Grieve explains, "He admitted that this did sometimes result in selling out too early, but it also prevented him from having to ride back down when the cycle was over and sell at a loss or locking up capital waiting for the next upcycle."

One of Neff's successful cyclical investments was Newmont Mining in 1981. Despite a 40% price drop after purchase, Windsor held firm as the fundamentals remained intact and eventually sold in 1983 for a 61% return.

Lessons from Mistakes

Despite his remarkable success, Neff was not immune to errors. One notable mistake was missing the long-term potential of Amazon, which he dismissed in 1999 with the remark, "It's the valuation, stupid," when its market cap exceeded the retail sales of all bookstores worldwide. Like most value investors of the time, Neff failed to recognize Amazon's transformative business model and long-term growth potential.

Another example of selling too early was Capital Cities/ABC, which Windsor purchased around 1978 for five times earnings. After selling with gains as high as 85%, Neff missed out on nearly a 5-bagger when ABC was acquired by Capital Cities in 1985. As Grieve reflects, "this example is just an issue that I think I have with some of the really, really good value investors that I've researched. They're so obsessed with price and value that their ability to value quality becomes completely negated."

However, these mistakes were relatively few and far between, and Neff's overall results speak for themselves. His willingness to acknowledge errors and learn from them contributed to his long-term success.

Neff's Enduring Legacy

John Neff retired from the Windsor Fund in 1995 after three decades of exceptional performance. His approach focused on low P/E ratios, solid dividends, and disciplined selling, proved remarkably durable across various market environments.

What made Neff special was his ability to stick to his principles even when they were out of favor. During the go-go years of the late 1960s and the Nifty Fifty era of the early 1970s, Windsor underperformed more aggressive funds. Yet Neff remained true to his value-oriented approach, which ultimately rewarded patient investors with superior long-term returns.

As Grieve concludes, "what he did clearly works. And even though he went through periods where the strategy underperformed, he never lost his way of searching for value. Another thing I really appreciated about Neff was that he wasn't afraid to look at growthier type stocks trading above market multiples if the opportunity was right."

Neff's legacy extends beyond his investment performance. His emphasis on independent thinking, contrarian positioning, and disciplined execution offers valuable lessons for investors of all stripes. In an industry often characterized by complexity and short-term thinking, Neff's straightforward, patient approach remains a powerful reminder of the enduring value of fundamental investing principles.

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