John Neff on the merits of betting on low P/E investing

The most important prerequisites for investment success are judgement and fortitude, according to legendary investor John B. Neff, and investors do not require the help of glamour stocks or bull markets to attain their investment goals.

“Judgement singles out opportunities, fortitude enables you to live with them while the rest of the world scrambles in another direction. To us, ugly stocks were often beautiful,” he said in his book “John Neff on Investing.”

Neff, who died in 2019, was an American investor, mutual fund manager and a philanthropist who had an impeccable investment track record. His portfolio and value investing style deserved a lot more attention than it got. Under his leadership, Windsor Fund became the largest mutual fund of that time. However, it was closed to new investors in the 1980s. In his three-decade-long career at Windsor Fund, the returns increased from 13.7% annually. Neff eventually retired from Vanguard, the investment manager that runs Windsor, in 1995.

Investment strategy
Neff’s investment strategy may not have been eye-catching. Nevertheless, the returns he generated were outstanding, due to which he was considered as one of the greatest mutual fund managers. He himself described Windsor Fund as “relatively prosaic, dull, conservative” which many investors would not even look at. But 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 discovered these gems, he and his clients reaped the rewards.

During his illustrious career as a money manager, Neff often passed over the opportunity to invest in big growth stocks of that moment. Instead, he chose inexpensive, under performing ones. During his 31 years as a portfolio manager for Vanguard’s Windsor and Gemini II Funds, he beat the market 22 times.

Neff shared his investment wisdom in his book, which earned him international recognition as the “investor’s investor”. Here are some of his core principles that can help investors achieve investment success in the long run.

1. Be Disciplined

Investors need self-discipline and a curious mind if they want to achieve success in the long run, said the mutual fund manager. Also, he said, having a disciplined investment approach is extremely crucial for investors to navigate through capital market volatility. “Lack of discipline can lead to high failure in trading. Discipline in the stock market involves the will and dedication to stay focused and hardworking, along with the discipline to stick to your trading plan. When it comes to stock market investment, you get the opportunity to be your own boss. You decide how to invest and where to invest. In order to keep yourself aligned to get the best returns, high-level self-discipline is important,” he said.

2. Take Risks

Neff said it was important to keep one’s mind open and take the risk as and when required. Not taking risks for profitable returns could cause losses. “It is important to note that the risk you are taking should not be out of an emotional and irrational decision. Do your research and calculate the risk before delving any forward. Even if the view is unpopular, do your research about it and have the willingness to step outside of your comfort zone,” he said.

3. Look for value

Neff always looked for beaten-down or unloved stocks to find value. He had the ability to see value in a stock when others couldn’t. Neff firmly believed in low P/E (low price earnings ratio) investing and attributed Windsor Fund’s success to low P/E investing, the most reliable investment method. “Carloads of research statistics demonstrate that low P/E investing works, but no evidence I have seen speaks more convincingly than Windsor’s track record. The challenge is to foster opportunities for a free plus, and low P/E investing is the most reliable method I know. If you own a stock where negatives are largely known, then good news that comes as a surprise can have outsized effects,” he said.

4. Study industry properly

A wise investor always studied the industry, the products and its economic structure before investing, he said. Wise investors were active and always looked for opportunities that helped them get the best deal with high returns. “Prudent investors always stay abreast of developments, which is why casual investors usually get wind of change after the stock price adjusts. The ones who snooze are bound to lose. Don’t follow the crowd or be fooled by the market slips. Make sure to always stay on foot to be able to make the right investments,” he said.

5. Look for low P/E stocks

Neff said investors should consider companies with low price-earnings ratios as good starting points when constructing a portfolio. “Low P/E stocks usually get less attention and people expect less from it. But investment in low P/E stocks brings the benefit of no penalty. You can improve your financial performance with these stocks. The crowd usually falls for the trending news and gives up on investing in low P/E stocks. But that is unwise to do,” he said.

He believed that investors should have a contrarian approach and look for beaten down businesses that had fallen out of favor, and stay away from the popular glamour stocks.

“My whole career I have argued with the stock market. Windsor’s success ultimately flowed from our willingness to step outside the crowd’s embrace and be exposed to the risk of embarrassment. Taking the unpopular view was how we made our money. Savvy contrarians keep their minds open, leavened by a sense of history and a sense of humour,” he said.

6. Spot companies with strong growth

The investment guru believed investors should only be invested in boring cyclical stocks and should pick companies that have underlying earnings growth above 7%. “The trick is in finding companies that are both cheap on a price-earning basis and which also have strong earnings growth. One generally precludes the other,” he said.

7. Investing is not for the faint hearted

Investors shouldn’t excessively diversify, he said, adding that people should invest only in companies they really understand after spending a lot of time and resources studying these. “If you have 100 companies in your portfolio, it’s hard to realistically be an expert on all of them. Better to put your money where your mouth is than to sit on the fence and get nowhere,” he said.

8. Look forwards not backwards

Neff believed that it was essential for investors to adapt to changing circumstances and they should try not to be intimidated by their own lack of success.

“It would be nice to be able to invest yesterday, but investors don’t have that option. You can spend your time regretting that you didn’t buy Cisco before a tenfold rise, or you can organise for future performance. That’s the nature of the daily investment challenge,” he said.

9. Avoid predicting the market

Neff was of the view that no one was skilled enough to predict the path of the market so investors should avoid making predictions. “It is always hard to be too penetrating or too precise about the outlook for the market in general,” he said.

10. Don’t fall in love with stocks

Falling in love with stocks in a portfolio was very easy to do but investors should avoid doing so as they might incur losses by following this approach.

11. Watch out for these three areas of the economy

Neff advised investors to always watch three areas of the economy for signs of excess of (1) capital expenditures, (2) inventories and (3) consumer credit.

His lessons remain timeless as history has a tendency to repeat itself. While most investors forget the lessons of the past, Neff’s lessons are a great reminder of how to navigate through the challenges of today’s momentum-driven market.

“I attribute success not to genius or blinding insights, but to a frugal nature and lessons well learned. Therein rest my enduring principles, stamped indelibly with the merits of low P/E investing,” he added.

(Disclaimer: This article is based on John B. Neff’s book “John Neff on Investing”.)

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