Most investors wouldn’t give a fund described as “relatively prosaic, dull and conservative” a second glance. That, however, is exactly how John Neff described the Windsor Fund that he headed for more than three decades. And, while his style may not have been flashy or eye-catching, the returns he generated for clients were dazzling -- so dazzling that Neff’s track record may be the greatest ever for a mutual fund manager.
By focusing on beaten down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards. Over his 31-year tenure (1964-1995), Windsor averaged a 13.7% annual return, beating the market by an average of 3.1 percentage points per year.
Looked at another way, a $10,000 investment in the fund the year Neff took the reins would have been worth more than $564,000 by the time he retired (with dividends reinvested); that same $10,000 invested in the S&P 500 (again with dividends reinvested) would have been worth less than half that after 31 years, about $233,000. That type of track record made the understated, low-key Neff a favorite manager of many other professional fund managers -- an “investor’s investor,” if you will.
Neff's approach forms the basis on one of my Guru Strategies. A 10-stock portfolio picked with the model is off to a strong start in 2011, having gained 9.0% vs. the S&P 500's 6.0% gain. It has outperformed the market by about 2 percentage points annualized since its 2004 inception.
Currently, you can get access to this market-beating model through the Guru Analysis & Guru Stock Screener App in Seeking Alpha's Investing App Store.
The Low-P/E Investor
So, how did Neff do it? By focusing first and foremost on value, and a key part of how he found value involved the Price/Earnings Ratio. While others have called him a “contrarian” or “value investor,” Neff writes in John Neff on Investing (the book on which I based my model):
Personally, I prefer a different label: ‘low price-earnings investor.’ It describes succinctly and accurately the investment style that guided Windsor while I was in charge.
To Neff, the P/E ratio was key because it involved expectations. If investors were willing to buy stocks with high P/E ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share; conversely, if a stock has a low P/E ratio, investors aren’t expecting much from it. Neff found that stocks with lower P/E ratios -- and lower expectations -- tended to outperform, because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high P/Es often flopped, because even strong results couldn’t match investors’ expectations.
To Neff, however, the P/E wasn’t always a lower-is-better ratio. If investors knew that a firm was a dog, they’d rightly avoid its stock, giving it a low P/E ratio but little in the way of future growth prospects. Because of that, he wrote that Windsor targeted stocks with P/E ratios between 40% and 60% of the market average.
While it was at the heart of his investment philosophy, the P/E ratio was also by no means the only metric Neff used to judge stocks. He wanted to see earnings growth, but here again it was not a case of more-is-better. A stock with too high a growth rate -- more than 20 percent -- could have trouble sustaining that growth over the long haul. He thus preferred to see growth between 7% and 20% per year, the kind of steady, unspectacular growth that could be sustained.
Sustainable growth also meant growth that was driven by sales -- not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates. (My Neff-based model interprets this as sales growth needing to be at least 7% per year, or at least 70% of EPS growth.)
One more key aspect of Neff’s strategy involved dividends. He believed that many investors valued stocks strictly on their price appreciation potential, meaning that you can often essentially get their dividend payouts for free. He estimated that about two-thirds of Windsor’s 3% per year market outperformance during his tenure came from dividends.
To make sure that his analysis captured dividend payments, Neff used the Total Return/PE ratio. This measure divides a stock’s total return (that is, its EPS growth rate plus its dividend yield) by its P/E ratio. He looked for stocks whose Total Return/PE ratios doubled either the market average or their industry average.
My Neff-based model is a stringent one, and currently it's only giving two stocks "strong interest" (a score of 90% or better). A number of others get solid scores, however. Here's a look at some of its top picks right now.
China Petroleum & Chemical Corp. (SNP): This Beijing-based giant ($110 billion market cap) is the only stock that currently gets a 100% score from my Neff model. The strategy likes its 8.3 P/E ratio (which is about 55% of the market average of 15), solid long-term sales growth of 17% (I use an average of the three-, four-, and five-year sales growth rates to determine a long-term rate), and 1.37 total return/PE ratio, which more than doubles the market average of 0.55.
Alliant Techsystems Inc. (ATK): Based in Minneapolis, this $2.4-billion-market-cap aerospace & defense firm gets a 98% score from the Neff model. The approach likes its 8.0 P/E ratio, solid long-term EPS growth rate of 18.1% (I use an average of the three-, four-, and five-year historical EPS growth rates to determine a long-term rate), and 2.4 total return/PE ratio, which easily doubles the market average and its industry average (0.83).
Eli Lilly & Co. (LLY): The Indiana-based pharma firm ($41 billion market cap) gets an 81% score from the Neff approach, thanks to its 7.8 P/E, 18.7% long-term EPS growth, and impressive 3.1 total return/PE.
Aetna Inc. (AET): This Connecticut-based health benefit plan company ($14 billion market cap) has an 8.9 P/E, 1.12 total return/PE, and $2.62 in free cash flow per share. That helps it earn an 81% score from the Neff approach.
Disclosure: I am long LLY, SNP.