WHAT JOHN NEFF AVOIDS
John Neff was in charge of the Windsor Fund for 31 years. It beat the market for 25 of those 31 years. He took control in 1964, and retired in 1995. Windsor was the largest equity mutual fund in the United States when it closed its doors to new investors in 1985. Each dollar invested in 1964 had returned $56 by 1995, compared with $22 for the S&P 500. The total return for Windsor, at 5,547% outpaced the S&P 500 by more than two-to-one. In this article, instead of focusing on what stocks Neff purchased, let us focus on what he avoided, most of which relate to bull-markets.
1. High Transaction Costs
Few mutual funds can claim to have such low expenses as the Windsor had-- a mere 0.35% per year. The portfolio's turnover was kept to unusually low levels. This saving on dealing costs is complemented by the low level of operating expenses for activities such as information gathering and analysis. One of Neff's guiding rules is to keep things simple. The most important element determining stock value can be understood without the need for expensive sophisticated equipment or people. By holding for the medium term and not going for short-term profits he reduced both transaction costs and taxes.
2. Excessive Diversification
While all would agree that 'some' degree of diversification is necessary, if this is taken too far investment performance is hobbled. Neff said: 'Why own, for instance, forest products companies if the market has embraced them and you can reap exceptional returns by selling them?' He generally ignored market weightings and bought in areas of the market where under valuation was evident. Some sectors would be unrepresented in the portfolio, whereas others would be 'over-represented' (according to conventional logic). Normally the vast majority of the S&P 500 were not held, at any one time, by Windsor. Generally a mere four or five of these well known stocks fulfilled his requirements for inclusion. When the fund was valued at US$11 billion it still only had 60 stocks. Furthermore, the largest ten accounted for almost 40% of the fund. Windsor would often have 8 or 9% of the outstanding shares of companies. 'By playing it safe, you can make a portfolio so pablum-like that you don't get any sizzle. You can diversify yourself into mediocrity', he said.
3. Technology Stocks
These were generally avoided for three reasons: (1) they are too risky; (2) they do not pass the total return to PE ratio test employed by Neff; (3) Neff admitted that he had no 'discernable edge' versus other people in the market place (Buffett's circle of competence lesson). Neff believed it is essential to have some informational and analytical advantage.
4. Forgetting the Lessons of the Past
The memory of stock market participants is notoriously short. Markets are continually foolish, being condemned to invite catastrophe by forgetting the past. A knowledge of history is essential to give the required perspective. Neff, writing in 1999, believed that speculators in 1998 and 1999 were merely the latest in a long line of amnesiacs. In the late 1990s anything ending in a .com generated great excitement. In the 1950s firms merely had to put 'tronics' on the end of their name to attract attention and to drive their share prices higher. In the 1960s it was the go-go stocks. In the late 1960s and early 1970s to be labelled one of the Nifty Fifty was to see your stock prices soar. In the 1980s oil companies were in vogue. Before these bubbles you had the new era stocks of the 1920s, and so on.
Each generation believes that a few magical companies have an almost infinite capacity to grow, that the rules of economics have been rewritten and that you have to jump aboard before it is too late. The 1990s fervour was more dangerous than most because many, if not the majority, of the companies which lured the speculative dollar had no profits. They could not be called growth stocks in the traditional sense of the term. Speculators were premature in conferring growth status on companies that had good prospects only if you made massive assumptions regarding the likelihood of the entry of competitors, or the prospect for another change in technology, and, the willingness of consumers to join the revolution rather than continue to do things without the new technology. 'Windsor's critical edge was nothing more mysterious than remembering the lessons of the past and how they tend to repeat themselves,' said Neff.
5. Getting carried away with Bull Market Hype
Markets go through cycles over time. There are occasions when investors are very risk averse. There is a phase when the emphasis is on quality. Later as confidence grows, investors look for stocks with a more speculative taint. After a period of growth the speculators fall over each other in their buying panic as the market runs well ahead of its fundamentals. 'The capacity of investors to believe in something too good to be true seems almost infinitive at times,' quips Neff. As the fad gathers pace, people who have little familiarity with stocks get swept along with the drumbeat of the prevailing wisdom. People find the urge to 'hop on the line that moves fastest' as they try to take short cuts to riches. The siren song of positive beliefs in the future drowns out the argument for a rational investment strategy based on a fundamental evaluation of stocks. Traders buy and sell on the basis of tips and superficial knowledge. The visions of overnight fortunes blind them to the logicality of investing without sound information and calm reflective thought.
People come to believe that there is gold enough for all in the same streams that earlier adventurers panned. Most of these followers go home empty handed as the wild expectations of the individual members of the mob one by one receive a slap in the face with a dose of reality. Eventually, it dawns on the masses that some players have already taken their money, as they figured things had already gone too far. Group panic begins, as everyone tries to exit at once. Predicting when these inflection points will occur is impossible so the best advice is to stay clear of stocks and markets that have lost touch with fundamentals. Don't try to play the greater-fool game -- you might just end up being the biggest fool.
6. The Technical or Momentum Game
Neff considered it ill-advised to try and predict market movements. His approach: 'amounts to hitting behind the ball instead of anticipating market climaxes six to eighteen months ahead of the investment crowd. Poor performance often occurred as a consequence of a technical orientation that tried to predict peaks and troughs in stock charts. It assumed that where a stock has been implies where its going.'
7. Growth Stocks with High PE Ratios
The problem with stocks showing fast earnings growth is that their potential is likely to be well recognized. Indeed, on too many occasions, stocks that have attracted a market buzz have their price driven up to unrealistic heights as investors get carried away. This was clearly evident in the mania for business-to-consumer internet stocks in the late 1990s. A combination of over excitement, small free-float and the obligation of index tracker funds to purchase high capitalization stocks drove prices to ridiculous levels, especially for those with an untested business model, no profits and without enough time having passed to be able to analyze the possibility of market entry, competition and the introduction of substitute products.
Even well established growth companies such as General Electric, Gillette, Coca-Cola and Procter and Gamble can be poor investments. Yes, they are good companies with excellent financial performances based on strong competitive positions and good management. Yes, their businesses are broadly-based, sound and global. Yes, they are safe and, almost inevitably, will be around in 20 years' time. But, no, they will not produce good returns to the stock buyer if they are purchased at a time when everyone knows these are great companies and the price is bid up to reflect this common belief. The slightest hiccup in growth or expectation of growth for these companies will see the stock sent reeling as the crowd becomes disillusioned. The lesson is that even great companies have a price ceiling. Neff says, 'You can't up the ante forever. Eventually, even great stocks run out of gas.' Believing that Coca-Cola is a buy at a PE of 55, because it might go to 70 times earnings is battling against the odds. Value investors always keep the odds in their favor.
8. Being a Simple Contrarian
Neff is an individual who makes up his own mind about a situation or a stock. His willingness to argue with a signpost has paid off handsomely when it comes to going against the whims and fancies of the stock market. And yet, he was never obstinate, ego-driven or simple minded in his opposition. He did not assume that the market was always wrong. He was prepared to listen to the views of others. Most importantly he did not unthinkingly and automatically take a contrarian line.
Neff says, 'Do not bask in the warmth of just being different. There is a thin line between being contrarian, and being just plain stubborn. I revel in opportunities to buy stocks, but I will also concede that at times the crowd is right. Eventually you have to be right on fundamentals to be rewarded... Stubborn, knee-jerk contrarians follow a recipe for catastrophe. Savvy contrarians keep their minds open, leavened by a sense of history and a sense of humor. Almost anything in the investment field can go too far, including a contrarian theme.'
Credits: This article is modified from a summary of Neff's investing style provided by Glen Arnold in Valuegrowth Investing, 2002.
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