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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP747: John Neff: The Value Investor Who Quietly CRUSHED the S&P 500 w/ Kyle Grieve
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Kyle discusses legendary value investor John Neff, one of the most underrated investors in value investing, who quietly outperformed the S&P 500 for decades.
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You're listening to tip.
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Today we're going to cover a value investing legend who is rarely discussed among the greats, but most definitely belongs there. That's John neff, a low PE investor who outperformed the S&P 500 by 3% per year for nearly three decades. My favorite part about Neff was the vast array of ways that he won. Yes, he was best known as a low PE investor who gobbled up cheap shares in businesses that were unloved by the market. But that wasn't the single investing strategy I think that really defined him. Instead of looking exclusively for cheap stocks, he ventured into cyclicals, moderate growers, and my personal favorite, misunderstood growth. While the majority of his contemporaries chased well known growth stocks, John chose a road less traveled. And like many value investors, he was forced to endure some pretty tough times of underperformance. However, he never abandoned his value investing roots and continued to invest wherever he could find value. It didn't matter if the Stock had a PE of 4 or 25. If it was undervalued and had the characteristics of a winner, he was fair game. I have a deep admiration for investors who own a diverse amount of stocks at wide ranges of valuation metrics and can still outperform the market. Neff was someone who excelled at investing and did a great job of sharing his investing strategy, which I'm going to cover with you today. So whether you're in value investor looking at cigar butts or a growth investor looking for hidden growth, going to enjoy this episode. Now let's get right into this week's episode on John Neff.
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Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Kyle Grieve.
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Welcome to the Investors Podcast. I'm your host Kyle Grieve and today we're going to be discussing one of the most underrated legends of the value investing world and that's John Neff. So I'll be citing his autobiography here, which is called John Neff on Investing. The book provides a very, very good illustration of his long and successful career and a lot of details on his strategy, which is what I'm going to be focusing on. So John Neff's investing career ran about three decades and during that time he outperformed the S&P 500 by 3%. Ann is one of the most impressive investing feats I've ever seen. One thing I really Admire about John was his steadfast ability to just maintain his strategy when other strategies were working better for a time. Now, he ran the Windsor fund from 1964 to 1995, meaning he was around during the Go go years where investors who chased momentum were very well rewarded until they weren't. But let's start with John's early life before we transition to some of his primary principles here. So 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, you know, think in a contrarian manner just aligns really well with them being a tried and true value investor. Additionally, Neff wasn't really a great student and saw himself as a bit of an outsider in school. So John learned a lot about investing, kind of indirectly from his father. So his father owned this business called Neff Equipment Company which sold items such as air compressors, drive lubrication equipment, lifts, and pneumatic tools to other businesses, including automobile dealers, service stations, auto repair shops, and even farmers. Now, his father bid on and won a contract with a US defense company that did very, very well during the Korean War. Neff 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 a 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. Knapp then moved on and joined the Navy for a two year stint before leaving to join his father. Introduced him to his first stock and that was a stock called Arrow Equipment. The terms for him buying the stock were great as his father basically told him that he would cover any losses that he incurred from investing in that stock. Now, once John joined the Navy, he went to Toledo and just crushed it there. So I mentioned he wasn't a very, very good student, but at Toledo he rarely got anything below an A. And it was in Toledo that John met his first mentor in the world of investing. This was a disciple of Graham and Dodd named Sidney Robbins. So Dr. Robbins was a professor of two investment courses that he took while at Toledo. And even though those were the only two investing related courses that John ever took, he actually ended up winning the school's Outstanding Student Finance award. Robbins taught John a ton about value investing and just thinking broadly. So at the age of 23. John hitchhiked to New York with $20 in his pocket to take part in a series of interviews. Neff originally wanted to be a stockbroker. But after being offered a job not as a stockbroker, but as a security analyst with Bosch, a Cleveland based firm, he came around to the idea that he was probably better suited to just actually analyze stocks rather than sell them. He also figured that avoiding the constant hand holding that comes with being a broker would be a welcome feature of being an analyst rather than a stockbroker. So he ended up taking that job in Cleveland with another firm called National City Bank. So as a security analyst there, he focused on several industries. Chemicals, pharmaceuticals, automotive, automotive parts, rubber, and banking and finance. So industries that he really resonated with included auto and auto parts. He wasn't really crazy about chemical and pharmaceutical industries. Now, keep in mind, this was back in the 1950s, and just like today, we have all sorts of businesses that are mentioning, you know, AI to create buzz and hopefully prop up their share price. So at this time, that buzzword was Tronics. So during this time, Russia had launched its Sputnik into space, creating a frenzy for tech stocks. So any hint of being an electronics goods manufacturer could boost your stock price, which is why companies were using this Tronics buzzword. So the bank that he was at had this investing committee, and it was often at odds with how John wanted to invest. So while at National City Bank, John met his second mentor, Art Bowanus. Bowanus hadn't been educated by Graham and Dodd like Robbins had, but his thought processes were very similar. Art also had a problem with the investing committee. He would find very interesting ideas, but the committee just wouldn't go for it. Instead, they sought well known names that their customers could hold onto forever, but offered pretty low returns. But at this time, Neff was just doing very, very well in his personal account. So money from his Aero Equipment investment that his father suggested he had grown to about $3,000. And by the time he arrived at Windsor, the fund that he would spend the rest of his career at, he periodically added cash to his personal account and had accumulated about $100,000. However, he also lost his desire to work for that bank due to their lack of creativity in buying some of the new ideas that he was coming up with. So as a result, John joined the Wellington equity fund in 1963. So inside Wellington was another fund, the one that I just mentioned, which was called the Windsor Fund, for which John had been hired specifically to work. Now picture this. So the Wellington Fund had a long history of success, being launched way back in 1928, and was originally quite conservative. But the times had changed before John had joined. The fund had this diverse portfolio of just unfortunately overpriced businesses with minimal competitive advantages. So during the early 1960s, these were the type of businesses that were actually getting really good returns. But these were also the times when, you know, Buffett was no longer seeing bargains in the market. So buying overpriced tech names was kind of par for the course for many funds during that time. Now, once John joined, he began scrutinizing just why Windsor had fared so poorly. So, in 1962, the fund had negative 25% returns. So 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. So since the fund had a bunch of growth names with high multiples attached to them, once the market got any hint of declining earnings growth, it would be followed by some pretty severe multiple contractions. And this was a crucial lesson for John, as you'll see. So, while looking at the Windsor fund specifically, John kind of came up with these three generalizations regarding some of the losers that the fund held. So, the first one was that there were just too many errors in fundamental analysis. The second one was that they were overpaying for companies with poor earnings power. Many of the businesses saw significant declines in earnings power after Windsor had purchased them. And third, this was more of a strategic shift, but it was to sell losers and then just move on from them. So regarding point three here, it sounds like John didn't make too many mistakes of omission at this time. You know, he was liquidating a lot of the portfolio. While he doesn't discuss mistakes of omission in the book, I have views on it that I'm going to share a little later when we start diving into a strategy. Now, one part of the book that I thought was really worth highlighting was this quote. 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. So by 1964, Neff had three investing principles that he wanted to instill into the Windsor Fund that he'd learned from his previous experiences at First National Bank. So the first here was to create impact. You know, this is doing things like increasing position sizes in positions that really offered tremendous returns. The second one was to avoid the issue with the investing committee. So John approached each member separately to gain a consensus on some of his newer ideas. And this worked a lot better than approaching the three as a complete group. And the third here was that Windsor was a $75 million fund inside of Wellington which had 2 billion in AUM. So Neff unfortunately had problems getting the analysts to help him on specific positions that he wanted to learn more about. And as a result, he requested just one full time analyst to work for him at the Windsor fund. So in 1964, Neff was promoted to the head of the Windsor Fund. Now, interestingly, at this time, mutual funds weren't nearly as competitive as they are now. But Neff was running a mutual fund and he was very competitive and he definitely cared about performance. So In October of 1964, Windsor Fund was lagging the S&P 500 by about 3%. Now, that was actually pretty good progress compared to when Neff had or first joined the fund. At this time, Neff was beginning to really solidify his investing strategy that would make him into this legend. And much of that strategy was based just purely on simplicity. He started by bucketing investments into two potential areas, growth stocks and basic industry stocks. So growth stocks were established businesses with above average long term prospects in earnings and dividends. Basic industry stocks would track the growth of the US Economy. These also included special situations. While they had inherent growth potential in some of these areas, they might be closer to market averages. If you bought them at a low price or time to cycle correctly, you could make a great return. However, another interesting concept that Neff came up with was what he called measured participation. So measured participation meant evaluating each stock based on its relative risk and reward and comparing those opportunities to other opportunities in other sectors, rather than becoming overly focused on any one specific industry. Instead of using traditional industry classification, Windsor assessed stocks, particularly growth and basic industry stocks, based on their quality, marketability, growth and economic characteristics. And the strategy really began to work. So in 1965, Windsor had an excellent year of returns, crushing the S&P 500 by 17%. However, the late 1960s was a very challenging period for Windsor when compared to some of the other mutual funds. So keep in mind, this was the Go Go era and the years in which people like, you know, Jerry Tsai became infamous for buying very expensive Growth stocks. So even though the Windsor fund was doing well, it wasn't performing as well as someone like Jerry Tsai's fund with Fidelity. Now, when referencing Windsor Fund, one bank went as far as to say Windsor fund was just not with it. Looking back, that was probably a good call for the top. When others are saying your results aren't good because they're succumbing to something like contrast misreaction tendency, it's probably a good signal that things are getting frothy. So the contrast misreaction tendency occurs when we compare things rather than using absolutes. Windsor was still beating the S&P 500, but it was losing the funds that were buying a large number of these high flying tech stocks which were being overbought by speculators that were just seeking a very quick return. If you are comparing two funds and one is outperforming the other, the question should be why? And often you'll conclude it's because they're taking more risk by buying more expensive stocks with a very, very minimal margin of safety or none. So by 1970, investors had changed their tune towards Neff. Neff writes, after having been eclipsed by this adrenaline funds for several years running, we persevered in the very testy 1969 market. Amid this wreckage came one of my better moments. I was in New York attending a popular annual mutual fund conference. And the very salesman who, 12 months earlier or ready to give Windsor up for lost, instead initiated a spontaneous and glowing ovation when I was introduced. Windsor's demise, Mark Twain would have said, has been greatly exaggerated. We are now going to move on from some of Neff's early life and then just dig into Neff's investing strategy into a lot of detail here. So his investing strategy was predicated on seven primary principles. So the first one here is low price to earnings ratios. Second, fundamental growth over 7%. Third is yield protection. Fourth, a superior relationship of total return to the price to earnings paid. Fifth, no cyclical exposure without a compensating PE multiple. Sixth, solid companies in growing fields. And seventh, strong fundamentals. Now let's go over each of these principles in a little more detail. Very interestingly, John Neff didn't think of himself as a traditional value investor. Like Graham and Dodd, he prefers to be known as a low price to earnings investor. Now, part of the distinction is likely because Neff doesn't mention anything about things like, you know, liquidation values in his principles. He certainly looked for a deal, but he also sought businesses that paid a dividend, meaning they were profitable and growing at a moderate rate. Neff liked to use PE ratios as a yardstick. So the cheaper the business meant, you got more for less, and it's just that simple. Neff also understood that growth plays a role in a PE ratio of a stock. A business with high growth rates demands a higher PE ratio. But from what I took from reading this book, I don't think Neff was necessarily looking for long term compounders either. Since he looked for businesses trading in the doldrums. Many of the companies he bought were largely unloved and he would buy them at those points because he knew that sentiment would eventually shift and he'd make his profit. Then he preferred looking for businesses that could still grow earnings, but not necessarily high flyers. The high flyers rarely traded cheap enough for him. And even with, you know, 10% growth in earnings per share, you wouldn't need much expansion in PE to generate 50 to 100% returns. Neff 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. Neff also mentioned in his book that he avoided windfall opportunities. Businesses that I own, like Topicus or Lumine, would just not be on his radar. For Neff, windfall opportunities were also the ones that could obliterate your gains. So let's look at some of the growth that Neff really did look for. His bar wasn't very high at 7% and I think having that low bar worked very well for him, given that he just wanted things to be cheap. Businesses with a history of growing at 20% or higher rarely trade for single digit P E multiples. It's worth mentioning that Neff's sweet spot was in this 6 to 20% growth range. So Neff makes a great point that Wall street tends to obsess over trailing twelve month earnings, but doesn't put enough emphasis on where earnings will be 12 to 18 months from now. So a business with slow trailing 12 months earnings growth might be primed for regression to the mean, meaning they may make a massive jump in EPS over the next year. However, since they experienced a slowdown, the market doesn't always factor in these future improvements as you'll see in some of the examples we'll be going over. John absolutely loved these types of opportunities. The next tenet is yield production, and this is a principle that I think really differentiated John Neff. Because while many investors enjoy yields, I haven't seen another investor have as much success as John, who made yield a very, very high priority. So Windsor edged the market by 3.15% per year after expenses while John was in charge. And 2% of that outperformance was due to the dividend yield that John had received, meaning the outperformance in capital gains was approximately 1%. While he liked a dividend yield, if a business was growing earnings in the double digits, he was okay investing in them even if they had 0% yields. 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. And if you don't have dividend yielding companies in your portfolio and the market dies, then you're going to be selling stocks at a pretty big discount to fund your lifestyle. One thing I've never really liked about dividends is how they are sometimes abused in terms of capital allocation. Some businesses appear to be able to invest 100% of their earnings back into their business at high rates of return. So when I see a company like that that pays a pretty hefty dividend, you have to actually challenge management's capital allocation decisions. If they can get 20% returns on capital, then why are they intentionally deploying less capital? I always consider this when analyzing a company that pays a dividend. Now, alternatively, another way of looking at it, kind of the Peter lynch way, is that companies that pay a dividend can actually be a good thing. So this is how lynch looked at it, and his reasoning was that, okay, if a company has cash on its balance sheet, what can often happen is that they just want action and they want action for the sake of having action. So in his opinion, one of the functions of having the dividend was to kind of slow down the action that a company would need to do. And instead of making, let's say, a poor acquisition, they would just pay a dividend. So, you know, I think that's actually a pretty decent way of looking at why a company might pay a dividend as well. Let's take a quick break and hear from today's sponsors.
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Limited time all right, back to the show. So let's go back to the Windsor Fund here. So Windsor Fund used an interesting metric to observe the total returns that it received compared to the PE that it paid. So they refer to it as their total return ratio. Now this was the sum of per share, earnings growth and yield divided by the initial PE paid. So he had an example here of a business called Yellow Freight that he compared to the 1999 S&P 500. So Yellow Freight had a total return ratio of 2.6 and the S&P 500 had a total return of just 0.4. So the point here is that Yellow Freight was a better investment compared to the index. Generally, Neff sought businesses that had a ratio of 2 to 1 compared to the index. So Neff also just absolutely loved cyclicals. He said they made up about a third of Windsor's portfolio. Neff ensured that he would only buy cyclicals when the market was employing a wait and see approach. So this would allow Neff to enter when earnings were depressed, but he had a very good chance of making money when those earnings normalized back to the upside. The last two principles resonate very strongly with me, as I prefer businesses that are growing and high quality. So John typically looked for businesses in healthy industries that were trading at a discount to peers. For instance, he discussed abc, which he felt was in a growing industry, had better prospects than his competitors, but was actually trading at a discount to the industry in general. So in terms of Fundamentals. John looked at a few things. The first thing was that he demanded some sales growth. Even if a company was improving margins and therefore improving earnings, at some point, margins can't expand anymore and sales are actually vital to growing those earnings. The second one was to look at cash flow. John's definition of cash flow was retained earnings plus depreciation. Many businesses would have experienced depressed cash flows due to the nature of their operations and incurred larger depreciation expenses which can mask the actual cash flow of a company. And third was return on equity. He liked it because it showed how skilled management was at delivering returns to the owners of a company's equity. And fourth was margins. He mentioned operating and pre tax margins and he used this to help ensure that a business had resilient earning streams. So the next chapter I want to look at is titled the Bargain Basement. And I think it's aptly named as that is where John really played his entire game. The beautiful part about investing in the bargain basement is that it's not hard to find new opportunities. Today we can look at apps to find stocks, you know, trading at 52 week lows. Now, in John's day, he would have to look at things like public stock tables. John writes, 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. Now it's vital to understand that the 52 week low list isn't some giant gold mine. Many of the stocks are at the bottom of the basement because they deserve to be down there. Maybe, you know, earnings have gone negative, maybe they've lost a large contract, maybe their IP is becoming public domain, or maybe they just can't service their debt. These are all pretty bad situations for a business to be in. But if you look close enough, there may be a handful of companies that don't quite belong there. Those are the ones that you want because those businesses can really turn on a dime once the market understands that things maybe aren't as bleak as what's embedded in the stock price. For many of the examples that John gave in the book, that was what he was looking for. You know, 50 to 200% returns over a reasonable period of time. Many of these names were boring, misunderstood and cheap. He'd made his returns based on increases in earnings and accompanying multiple expansion. Neff used what he called the test to see whether a stock was worth looking into when it was down big. So if there was a big name down big that he was aware of. He might use his total return ratio to see if the business was offering unacceptable upside. Outside of looking at things like 52 week low list, he also just read a lot. Like all good investors, reading opens up just so many opportunities. And similar to someone like a John Templeton or a Warren Buffett, the news would often signal the market's perception of the market as a whole. Neff gives an example here in 1991 when Windsor was featured in Forbes under a story called Tarnished Glory. A few months later, signaling a rebound in the market, another story was written called Stock Picker Returns to Success. Now in the 1980s, Neff observed the gloom around the property and casualty insurance industry. So one company that had come on Windsor's radar was called cignacorp. Regarding the industry, nearly every analyst on Wall street predicted high liabilities in the range of half a trillion dollars. Neff adds Wall Street's propensity for groupthink fans these dire expectations. Too many sell side analysts whisper in each other's ears and few wanna stick his or her neck out too far. There's not much of a reason to be a hero if being wrong can cost you your job. You can sum up the street psychology this hope for the best, expect the worst. Meantime, don't stick your neck out now. Cigna had some exposure to this area, but it wasn't the entire business. One of the best parts of the business was its managed care operations. Neff didn't really elaborate on what the segment was, but from some of the research that I did, it appears to be an insurance on services such as medical, dental and behavioral health, vision, pharmacy and supplemental benefits. So even with the environmental liabilities looming over Cigna, it didn't actually affect the profits of this part of the business. So Windsor bought shares and as the environmental consequences abated, Cigna's share advanced about 54% while other insurers gained about 45% on average. And John noted at this time The S&P 500 logged about a 29% gain. So one thing I liked about Neff was that even though he enjoyed his single digit P E types, he would stray outside that range if the right opportunity arose. Even a high growth company that was hit hard by the market can still present a very good opportunity. So one such example was Home depot. So in 1985, Neff found this business trading at a high PE by his standards of 20 times earnings. But in his modeling, looking forward to 1986, the business was trading at only 10 times normalized earnings. So for a business at the beginning of its growth phase, that's simply incredibly cheap on a forward basis. He noted that the business had gone from about 22 to 50 stores in 1985 and that the costs involved with opening that many new locations had momentarily depressed normalized earnings. After only nine months, they were up 63% on their home Depot investment. One of my favorite John neffisms is what he calls the silly season. So this occurred at times when the market was selling at exorbitant prices. In John's case, this would be the time when he would just sell some of his winners to increase his cash position. When it wasn't silly season, John was often buying and he enjoyed quality stocks about as much as I do. One quality cyclical that he liked was Gulf oil back in 1978. So Gulf oil was undergoing an improvement in its quality as it was increasing its concentration of revenue from US and Canada. So in 1973, earnings from North America were just about 30%. By 1978 they moved up to 85%. So Gulf had been involved in some litigation and John had a view that they would eventually prevail. While he waited, the business paid a beautiful 8% yield and was trading at only 5.8 times earnings. He ended up selling over the next two years posting returns between 42 and 86%. One category of companies that Windsor Fund liked to look at was those that were miscategorized. So I like this investment category because you can really find some exceptionally high quality businesses that are just often overlooked. One of my favorite examples of this is a business that I own called Terravest Industries. I started researching the business in Q1 of 2024. After speaking with some great investors who had passed on it, I realized that investors were looking at the business the wrong way. If you look at their ticker on Yahoo. Finance, they are categorized as an oil and gas equipment and services company. Now while that is technically true, when you dig a little deeper into Teravest, the actual exposure to the highly volatile oil and gas industry is a lot less than what you might expect. Currently the segment is about 24% of revenue. But Teravest has been incredible at smoothing out revenues based on the demand of the industry. Now, while Terravas is often incorrectly categorized as a pure play oil and gas service company, it generates the majority of its revenue from more stable segments including H Vac and containment and compressed gas. As a result, I got shares at a decent multiple and now shares trade at what I consider a pretty Expensive multiple. One mental model that John Neff used was called Critical Mass. I like to think of it as a small sum, an ingredient, an idea, wealth, anything really that can create a self sustaining entity. So one example he gave of a business that didn't fit this mental model was a business called US Industries. The company experienced impressive growth of about 24% per year over a five year period. And yet it was only trading at eight times earnings. John believed they could continue to compound earnings at about 15% per year going forward. Unfortunately, it wasn't able to create that self sustenance that critical mass dictates. U.S. industries was unable to dominate its industry and command any pricing power and its fundamentals quickly deteriorated. This caused Windsor Fund to lose about half of that investment. Now as I've alluded to, John loved yield as a bonus to waiting around for a business's stock to re rate. But in the absence of yield, John looked for another type of opportunity he titled Free plus. This is basically looking for an opportunity with a free call option on additional upside optionality. Or you can think of it as a business where management is just so good that they often outperform expectations. This works very well in low PE world that John was fishing in. Since he searched primarily for low PE businesses. The businesses already had a lot of potential downside priced directly into the stock. So this meant that if there was some minor positive event that were to happen, you know, something like maybe a nice new contract or maybe cutting costs that could increase margins, or maybe an unexpected boom in the company's industry could mean very fast and fierce improvements in the company's fundamentals which would ultimately be shown in the stock price. So similar to Peter Lynch, Neff liked finding ideas outside of referring to just his stock broker. I think this might be more of a problem for investors during his time as it's much easier to find ideas today. I personally have never gotten one idea from speaking with a stockbroker. But the point is you don't have to peruse professional investors tips to find ideas. Neft used the example from retailers for instance, which are an easy category to search for when you just go shopping. He made a few good points here which was that execution separates the best retailers from the average. And don't confuse buzz for a company's products for good execution as a retailer can actually ride momentum for short bursts before just fizzling out. Now a notable win for Windsor Funday specifically inside of retail was a business called Pier 1 Imports which was a specialty retailer of home furnishings. So in the mid-1980s, a new management team took over which improved their marketing product mix and improved the attractiveness of some of their stores. This resulted in improvements in the company's volumes and prospects. But it was just too expensive for Neff at that time. So he waited to see if an opportunity might arise in the future. And Black Friday in October of 1987 was just the opportunity that he was looking for. So on that day, the market plunged about 20%. Pier 1 imports, which John thought could increase EPS by 47% in 1988, was only trading at eight times earnings. He gobbled up shares and doubled his investment within a few months. This is an area that most investors should probably try to take more advantage of. And it's also a good reason to keep some cash on hand. For instance, in early April, the tariff threats caused the market some extreme levels of anxiety. The S&P 500 dropped nearly 11% over just a two day period. If you had cash on the sidelines, there's a very good chance that either one a company that was on your watch list reduce in price enough to become attractive, or or 2 a company that you already own, which you've wanted more of, becomes attractive to add to. It's important to remember that you don't always need a market sell off for a good opportunity to present itself. Nearly all companies have just some degree of cyclicality. If you find one that you think has great long term prospects, but is maybe going through some headwinds that you believe to be temporary in nature, you can make off like an absolute bandit. You just need to have conviction that you're correct. Now I find getting this conviction a lot more often in businesses that I already own versus businesses that I'm just starting to research. When I own a business, I become much more attuned to how the business runs and how the market perceives it. Since I'm generally looking for wonderful businesses I can hold for a multi year time period, it means that I'll have a very good chance that my businesses may undergo some temporary headwinds. And since I know the business so well and have a high level of conviction in the idea, it's a lot easier for me to have a variant perception. Now, the final interesting lesson here that I took from this chapter was based on a concept known as developing a curbstone opinion. So Neff writes, investing is not a very complicated business. People just make it complicated. You have to learn to go from the general to the particular in a logical, sequential and rational manner. Curbstone opinions entail informed observations about the general condition of a company or an industry or aspects of the economy that are likely to affect the first two. Ask and get answers to these questions. What is the company's reputation? Is the business likely to grow? Is it a leader in its industry? What is the growth outlook for that industry? Has management demonstrated sound strategic leadership? So one thing that you learn pretty fast reading this book is just how much attention Neff gives to looking at the economy with his knowledge and time he spent studying different industries and the economy. In some ways he was a top down investor, but in other ways he was more of a bottoms up investor, pouring over resources like Value Line each week looking for specific stocks trading on the cheap. So the questions posed above help when evaluating an individual business. If you can answer those five questions, you know probably more about that business than 99% of investors out there. And if you can maintain your curbstone opinion and update it quarterly, you'll be very well prepared to pounce on the business when it goes through some sort of temporary headwind. Speaking of maintenance, the next theme that I want to cover is a chapter on the care and maintenance of a low PE portfolio. I loved this chapter because it deals specifically with how to manage a low PE portfolio, which may differ from other investors who have a medium or high PE portfolio. If John, for instance, were to review my portfolio, he'd probably consider me to be a high PE investor as I have multiple companies that trade at price earnings ratios of more than 30 times. Nonetheless, I think his principles still stand here. A notable excerpt that he has written discusses the psychological aspects of investing. His point is that many investors claim to adopt a low PE strategy, but when reality sets in, they tend to just sit on their hands waiting for the price to recover before deploying capital into an idea that has already lost its ability to re rate its multiple, he writes. When shares of a stock change hands for 30 times earnings, who doesn't recall the day when shares fetched only 12 times earnings? But where were the buyers then? Most were cowering in fear of the latest news reports or piling into the speediest growth stock bandwagon even if its wheels were about to fall off. This is a great reminder to evaluate just how brave you really are. A straightforward exercise is to just review some of the trades during periods of significant market turmoil. Are you a net buyer or net seller of stocks? You can look up your trades during such times as you know the COVID 19 crash in March of 2020, the inflation and interest rate fears in the first half of 2022 or the regional bank crisis in March of 2023, or maybe even the most recent tariff sell off in April of 2025. If you're a net seller during these times, you're actually in accordance with human psychology, which tends to be risk averse. But unfortunately, this is not the way to win in the market. What the best investors do during these times is really deploy as much capital as possible, because the upside and the margin of safety during these sell offs provide them the best possible opportunities. And in today's market, you often need to act very fast or that opportunity vanishes. Speaking of opportunities, let's look at a term that Neff used extensively throughout the book, which is inflection points. So inflection points to Neff are times in the market when there is an excessive sentiment to the highs or to the lows. When an inflection point happened, he viewed it as a signal that the trend had gone too far and he would take appropriate action. In NEF's case, that meant searching for inflection points to the downside, which allowed him to deploy capital on inflection points to the upside. John would usually sell off some of his portfolio to free up cash once the market turned. A few other ways that Neff used inflection points to his advantage included being aware that inflection points can be short lived, such as, you know, Black Monday on October 19, 1987, when the market declined there by over 20%. Being aware that inflection points can be long duration, episode lasting years, such as the Nifty 50 era of 1971-1973. 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, you know, excessive IPOs, cheap debt, a lack of good opportunities, and high amounts of speculation. This type of rhetoric always reminds me of Howard Marx and cycles. We don't know when a cycle will turn, but at least we can observe where we are inside of a cycle. You can use that information to help you with decision making. Whenever I read about cycles, I always get a degree of cognitive dissonance. I can see what value investors like, you know, a John Neff or Howard Marks are saying act per the cycle. But how I really act is actually a lot lazier. What many value investors do during exuberant times is to sell stocks that have approached or exceeded intrinsic value. However, this is actually not a strategy that I employ that often and the reason is simple. I'm not looking for stocks that I can hold for 6 to 12 months which will quickly re rate and then never grow again. I'm looking for businesses that can continually improve their intrinsic value and I don't think I'm smart enough to time when I should be in and out of these names. So my general strategy is to just hold these names even when the market is euphoric. When there is a market wide sell off, or if one of my businesses goes through headwinds is when I'm most likely to add to my current positions, which I'm generally more apt to do than pile into new positions that I probably don't understand as well as something that I already own. One area I think I can improve is allowing cash to accumulate more in my brokerage account, which would give me a higher buffer during periods of excess euphoria. Once that euphoria ends, I just deploy capital. It sounds easy, but since I tend to stay fully invested, I often have that feeling where excessive amounts of cash doing nothing is just a waste of my capital. Let's take a quick break and hear from today's sponsors.
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All right, back to the show. So Neff devised a novel approach to investing that I think avoids standard industry classifications that I discussed earlier. He called this measured participation, which I mentioned briefly earlier in this episode. This allowed Windsor to think differently about diversification and portfolio management. Instead, they categorized businesses into four broad investing categories. The first one was highly recognized growth, the second was less recognized growth, third moderate growth, and fourth, cyclical growth. Neff writes, 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. This structure enabled us to flout the constraints that usually condemn mutual funds to ho hum performance. So Neff believed that most investors tend to focus just on that first category, which is highly recognized growth. This was because since they attempted to, you know, copy an index, they actually had to ensure that they had adequate representation. But this act alone is why many funds chronically underperformed. They are actively buying stocks that they should probably be trying to sell instead. For Windsor, the well known blue chip growth stocks were on the lowest rung. The majority of other funds placed these investments on the highest rung. As a result, Windsor constantly held out of favor in less popular stocks, which was a significant reason for their long term outperformance. Now, as a retail investor myself, I've never actually thought much about having a specific representation of an index. I prefer to have none actually. And as a matter of fact, I've never owned a stock that was in the S&P 500. While I wouldn't say that my portfolio is made of maybe ugly ducklings like Neff's was, I definitely have businesses that are less known to the average person compared to a business inside of the S&P 500, such as, you know, Amazon, Tesla, Microsoft. If I had to say where my focus on it's on probably number two, which is less recognized growth. While I love businesses that can grow 25% or more per year and are trading at single digit forward multiples, they're pretty tough to find. I see them now and then. But I think another strategy that many investors employ is to search for businesses that have a high likelihood of growth at a higher rate and for a longer time than the market gives them credit for. These are businesses that are misunderstood which can hide some potential upside in the opportunity. Businesses that I own like Topicus, Lumine, Aritzia and Dinopolska I think are really good examples of this. They just never appear cheap. But the market always seems to assume growth rates that are below what these companies are capable of producing. This is why having a variant perception is so important. You can buy an optically expensive business, but if you have a view on the growth trajectory of the company that the market just doesn't share with you, then you're buying it at a discount to intrinsic value. This is something that I think Bill Miller really excelled at. His investment in Amazon was a great example. He knew the business didn't look attractive on a GAAP basis, but if you made the necessary adjustments, the company was growing incredibly fast. And he felt that Amazon had the DNA to continue doing so for many years into the future. And of course he was correct. Now the mention of Amazon is a good transition into another one of Neff's points regarding growth stocks. Don't chase highly recognized growth stocks. This is an area that I mostly agree with Neff, but I think investors like, you know, Terry Smith would probably disagree with him. So Terry Smith would say that the right growth stock that is also of high quality can be bought and held for an extended period of time and provide tremendous returns. For instance, in his book Investing for Growth, he mentions two businesses that are highly recognized growth stocks, Coca Cola and Palm Olive. He examined the returns of these businesses over a 30 year period spanning from 1979 to 2009. So in 1979 these businesses were trading actually pretty cheaply at a market multiple of 10 times. However, if you had bought them then you would have earned a much higher return than the market. So his question was, okay, how much could you have paid for these businesses and made market like returns? And the answer is 40 times earnings, which is, you know, an absurdly high number. But if you have even a well known company of just superior quality, they can do things that most businesses can't and they can provide value at a much higher rate for a lot longer than investors can imagine. So while I do think that Neff is mostly right that you probably shouldn't chase highly recognized growth stocks, it's more of a product of long term thinking. One of his worst experiences of underperformance was during the nifty 50 years. And this was when Windsor underperformed the index because it didn't own many of the high flying stocks that were driving a significant portion of outperformance at that time. And while Neff did not enjoy the 25% loss that his fund had in 1973, which coincided with the end of the Nifty 50, he also realized that that was the time that was about to breed just enormous opportunity. So in his 1973 letter to shareholders he wrote, it is my view as Windsor Fund's portfolio manager that there is a period of outstanding potential appreciation on the horizon. As a shareholder with a substantial portion of my family's resources invested into the fund, and one who has personally and financially lived and breathed each good day and each bad day within the fund since mid-1964, I hope you await the inevitable eye catching appreciation of our fund with the same solid confidence and eager anticipation as I do. But even during the nifty 50 days. Windsor actually did own a couple more well known growing businesses. They owned things like IBM, Home Depot, McDonald's, Xerox and Intel. However, since these businesses tended to trade on expensive multiples, Windsor Fund never really achieved meaningful levels of concentration in those positions inside of the fund. So nevs had a highly amusing joke here on how investors tend to flock to expensive investments. Even though they usually end with people losing a lot of money once, they tend to re rate downwards. So here's a joke. Two hunters hire a plane to take them to a remote destination to hunt for moose. Once at their destination, the pilot warns the hunters that the aircraft can only accommodate one moose per hunter and any more weight could cause a crash. So the pilot arrives two days later to pick up the hunters who have each killed two moose apiece. The pilot tells them that they can't take two mooses each because of the added risk. The hunters say, but last year we did the same thing. Remember, we each paid an extra thousand dollars and you took off with all four moose. Reluctantly, the pilot agrees and takes off. After an hour, the plane sputters under the unsafe weight and safely crash lands. The hunters exit the plane and one asks, do you know where we are? The other responds with not sure, but it sure looks a lot like the place we crashed last year. This anecdote 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. If you just identify mistakes, but continue to make them, then you're making a very grave error. The sad fact is that most investors just don't learn from their mistakes. Which is why if you go back four centuries, you can see bubbles forming repeatedly and they will again into the future. You can try to protect yourself from participating by adopting a value investing mindset. If something is now trading at, you know, two times its average multiple over the last decade, the multiple is probably unsustainable. Let's get back to the importance that Neff put on less recognized growth stocks because it's a segment of his portfolio that was pretty large at about 25% of his career at Windsor Fund. So one advantage he saw in these lesser known names was that the well known names would receive most of the attention. This meant that certain businesses which might have been too small would or maybe lacked visibility wouldn't receive that same amount of attention. An example in the book was a business that was called Edison Brothers. So Edison Brothers was a specialty retailer of women's Shoes. Earnings had improved in the industry at a steady rate in 1974, but since the market was obsessed with just these larger growth companies, it just didn't pay that much attention to the improvements that were being made at Edison. One year after the Windsor Fund purchased it, Edison's share price increased by 137%. The process of discovery in stocks is truly powerful. So Neff had some very interesting warnings for investors. Looking at the less recognized bargain bin, he noted that one in five of these businesses tended to fail each year. Now, by failure, he's not saying that they file for, you know, chapter 11, but rather that they will see things like their growth rates decline along with a corresponding PE contraction. So here are some of the specific attributes that he looked 12 to 20% growth rate with high visibility, high single digit P E multiples of six to nine, dominant or large market share in well defined growth areas in an easy to understand industry, an unblemished record of double digit historical earnings growth, a high roe, high enough market cap and profitability to qualify for institutional ownership, a minimal but present Wall street coverage, and a 2 to 3.5% yield. Next is the third part of measured participation in which Windsor Fund invested, which was moderate growers. So these are your blue chip companies, which are relatively boring investments but offer high yields that Neff really loved. Think of businesses you know, like phone companies, electric utilities and banks. These businesses have dividend yields that often exceed 7% and are expected to grow at rates similar to GDP growth. Add that all up along with the fact that they generally trade for, you know, mid single digit P E multiples, and John felt that he could get a very good return from some of those names. Another bonus was that since these names were boring, they would often remain attractive even in heated markets. So he mentions a few names from the tech bubble of 1999 that were still trading at yields of 4 to 8%. The other interesting trade that he noted about moderate growers was that they provided liquidity during inflection points. For instance, during the tech bubble, it would have been challenging to find good opportunities where you weren't taking part in speculation. However, since the bubble would eventually burst at some point, these moderate growers allowed Windsor Fund to accumulate extra cash through the yields which could then be deployed during any potential market sell offs. Now, the final category of measured participation was in cyclicals. Ness meant a significant amount of time on cyclicals and frequently mentions them in his investing career. He understood cyclicals very well, especially the timing part. Here's how he breaks down cyclicals. So earnings pick up and investors flock to them. Earnings peak and investors abandon them. Next strategy was just to buy cyclicals six to nine months before earnings would swing upwards and then sell them into rising demand. The key was to understand and anticipate the fluctuations in commodity pricing. So he presents an interesting case study in the book on a business called Newmont Mining. So this was a company that was very well diversified across, you know, copper, gold, oil and gas and coal. But he bought it specifically due to the copper part of the business. So in 1981, Windsor's view on copper was that it was due for a rebound in pricing from current depressed levels. The copper capacity wasn't really growing very fast at a rate of only 3%. So Neff like Newmont because they were a low cost provider and their customers were all domestic. So here's what happened. After Windsor purchased it, there was a quick run up in price. The price then slid by 40%, dropping 15% below windows initial buy price. But the fundamentals held. So they ended up buying more shares a year later. And in 1983 they made about a 61% return and sold into strength. So I personally find cyclicals to be just too complicated. My one obvious cyclical play that I no longer own is a business called Natural Resource Partners. I actually still love the business and if you want my full pitch, I'll have it linked in the show notes below. So NRP is simply just a royalty play on a commodity. In this case the commodity is coal. So they own land that mines use to extract thermal and coal from. Then they have another piece of a mine that deals with soda ash. So their customers pay a percentage of revenues back to NRP for use of their land. The thing I liked most about NRP was that I didn't have to worry much about cycles. The business just gushed cash. Whether the cycle was up, whether it was down, they're always cash flow positive. But it's a different story at the mines where when supply is highest, it then lowers the price that they can charge for their commodity. Yet input prices remain the exact same. So the reason NRP was interesting was that it was inexpensive and had a very high pro forma cash flow yield. In the high teens, it had paid down a ton of debt to get near debt free. And since it was seen as a coal business, many hedge funds just weren't interested in the name. If I had to bet, Neff would have been all over a company like this. So even though NRP was involved in cyclical businesses, they didn't participate in the margin compression that plagued cyclical industries. I liked that because it meant that I could lazily just hold onto my position. For those wondering, I sold purely based on non investing reasons. The business is a master limited partnership, meaning that I would have to hire someone to handle all my taxes. And it just became a little bit too much of a headache. If I didn't have to worry about any of that, I would still gladly be a shareholder of the company. Now back to cyclicals. Neff noted that the market is knowledgeable about one aspect of cyclicals, specifically the application of non peak PE ratios. When these businesses are at the top of their cycle, the typical growth stock will have a PE that generally expands as earnings growth expands. But this is a death sentence in a cyclical business. So what happens typically in cyclicals is that the PE will decline as the cycle moves towards a day. Packs Windsor strategy was to gauge what normalized earnings would be at some point during the up cycle. That way he knew that when the business reached that normalized earnings number. 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. Now one twist on cyclicals is just to find a business that is becoming less cyclical. One business I think that has executed on this flawlessly is Apple. So Apple up until 2015 was primarily engaged in hardware sales. However, the sales numbers and margins were somewhat volatile depending on consumer demand and peak cycles of Apple's specific products such as the ipod. As a result, Apple's operating margins fluctuated wildly between, you know, 2 and 10% in the early 2000s. However, as the business scaled and diversified its products, its cyclicality decreased and and now Apple boasts rising operating margins all the way up in the low 30s. I mentioned a little earlier that Neff was both a top down and bottoms up investor. So let's expand a little bit on that. While Neff liked looking at individual businesses, I think he got a lot of his ideas from a top down approach as well. When you understand just an industry and its various subtleties, you begin to really separate yourself from others. If you know that a positive or negative catalyst is likely to happen in an industry, by understanding it, you can find a business inside of that particular industry that might benefit the most that the market isn't pricing properly. So if you want to understand an industry better, Neff mentions a few simple questions to ask. Are the industry's prices headed up or down? What about costs? Who are the market leaders? Do any competitors dominate the market? Can the industry capacity meet demand? Are new plants under construction? What will be the effect on profitability? And when it comes to macro, which Neff paid very close attention to, he was looking at just three signs of capital expenditures, inventories and consumer credit. Since Windsor Fund was pretty widely diversified into, you know, 50 plus stocks, Neff built fact sheets for all of his businesses to keep track of them. They had pertinent information like, you know, the number of shares owned, their average cost basis, the current price, historical and projected price to earnings ratios, historical and projected earnings per share, historical and projected growth rates, historical and projected PE ratios, yield returns on equity price projections based on, you know, earnings expectations and upside potential. I think this is a really good idea to hold onto even if you keep a more concentrated portfolio. It's nice to have this information handy in case you want to share some of this information with others so you can quickly provide them with important numbers. Next, I want to discuss an area that I always enjoy breaking down in different investors that I get to examine and that's their selling framework. So NEFS was pretty simple. Windsor sold for just two reasons. The first one was if fundamentals deteriorated and the second one was when price approached expectations. So the first point is pretty simple. I think any half decent investor is likely to sell once they realize that the business's fundamentals have deteriorated. Unless investors are short a stock, there is just no money to be made holding a stock that is likely to drop in value. What I always find interesting is why investors sell their winners. And in true value investor fashion, Neff's strategy didn't really surprise me. He would hold on to some winners for, you know, three, four, five years if the fundamentals remained intact or they improved. However, he also mentioned that Windsor Fund had periods where they hold stocks for a month or less. So similar to this strategy of selling on the way up with cyclicals, he employed the same approach with non cyclicals. 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. He also admitted to not trying to capture market tops. If a company became fully valued, then there was a good chance it would not stay in the portfolio. The final thing I want to discuss today is some of Neff's blunders. We all make them and the beauty of being A good investor like Neff is that when you make a blunder or commit an error of omission, it doesn't harm your investing results. For instance, in a 1999 roundtable discussion with Barron's, Neff said, it's the valuation stupid when referring to Amazon. He warned investors of the perils of Amazon since its market cap exceeded the retail sales of all bookstores in the entire world. It's easy to look back now and see that this remark clearly shows a misunderstanding of the business. But when you hear most of the stories surrounding Amazon at this time, there was no value investors outside of, you know, Bill Miller or Nick Sleep, in case Akaria that thought that Amazon was a value stock. Then there are other stocks where when I was reading this book, I just thought, you know, why don't you just hold onto these for a longer period of time? For instance, ABC. So Windsor bought the stock around 1978 for five times earnings. This was a business that he believed could grow earnings at about 11% and offer about a 4% yield, resulting in a total return of about 15%. Now, over the next year, he ended up selling and his gains ranged as high as 85%. Now, that's great, but I decided that I wanted to dig a little deeper. So I asked myself, okay, what would have happened if he just held ABC from then until ABC was acquired by cap cities in 1985? The numbers were hard to come by, but I used perplexity to look them up. So it shows an EPS of about $4.89 in 1978, which was approximately when Windsor purchased it. By 1974, before merging with Cap Cities, ABC grew EPS to $6.71. Now, at a PE of five times, Windsor would have purchased ABC for about $25. Had they held onto it until the merger in 1985, they would have sold their shares for about $118 a share, or nearly a 5x. So, full disclosure, I couldn't find any data on share splits, so my assumption is that there weren't any during this time. But 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 just. They're so obsessed with price and value that their ability to value quality becomes completely negated. However, as with many things, this could very well be a result of my own biases. A part of me truly appreciates the Nomad Partnership style of investing, which involves just finding a few incredible compounders to hold onto and ride off into the sunset with. But when it comes to Neff, the results just speak for themselves. 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 growth year type stocks trading above market multiples if the opportunity was right, even though it was a smaller part of the investing strategy. He knew that growth, even when priced where he wasn't typically comfortable, could provide value if he had high conviction in the company's abilities to continue growing at high rates. That's all I have for you today on John Neff, a no nonsense, dividend loving, PE skeptical investor who quietly beat the market for 30 years. Want to keep the conversation going? Follow me on Twitter Rational Mrks or connect with me on LinkedIn. Just search for Kyle Grieve. I'm always open to feedback, so feel free to share how I can make this podcast even better for you. Thanks for listening and see you next time.
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