Vanguard might be known for its low-cost index funds but it carries a slew of actively managed funds too. In fact, one of the best investors ever managed Vanguard’s Windsor Fund for 31 years.
John Neff’s career at Vanguard began in 1964 until his retirement in 1995. Under his watch, Winsdor Fund outperformed the S&P 500 23 out of 31 years with a 13.7% annual return. That’s 3% better than the S&P 500 over the same period. Even better, he earned a 20% annual return on his own portfolio over the 10 years following his retirement.
More impressive is the fact that Neff believed his pay should be tied to his ability to beat Windsor’s benchmark. He convinced John Bogle to add an incentive-based fee structure to Windsor’s already low fees.
Windsor charged a 0.16% fee with an incentive-based fee that swung up or down 0.10% based on performance. If Windsor beat the S&P 500 the fee bumped up to 0.26% but if it fell short, the fee dropped to 0.06%. It wasn’t a pure beat either. Neff needed to beat the S&P 500’s trailing three average return by 1.2% to hit that incentive.
Neff had a value investing discipline. He was known as a low-P/E investor. It often led him to neglected cyclical stocks where selling was inevitable. However, his perfect stock provided dividend yield plus growth. A high total return at a low P/E multiple was his goal.
He approached it in a somewhat concentrated way. Winsdor Fund held about 60 stocks, on average, with the top 10 making up roughly 40% of the portfolio. Throughout his three-decade-long career, he shared more details on his investment approach.
On His Low-P/E Value Strategy.
Having a low P/E is the primary principle. Then, look for solid companies with strong fundamentals in strong, growing industries and hone your analytical prowess. A company’s prospects should include fundamental growth of 7 percent or better. The company should not have cyclical exposure without a compensating P/E multiple. Seek out companies on the ‘‘squash’’— that is, ones that are making new lows.
To effectively pursue this strategy, however, do not be afraid to take on a stock that is under market attack, but your aim is to buy low P/Es in decent companies in decent industries. There are not too many outstanding ones, but there are some decent ones.
The Nifty Fifty’s, “it’s good enough for Morgan, it’s good enough for me,” growth stocks at 40, 45, 50 times earnings. Or in ’80. Remember when energy was the end-all and be-all, plus technology? In each of those periods, Windsor was woefully behind the averages. Then, in the ensuing period, why, our positive performance was twice as good as our shortfall.
Those are the kinds of stands you have to take. It requires a pretty strong stomach and the loneliness of the long-distance runner. But the real trick is to not lose too much ground…
If a stock doesn’t do anything, you buy more, or if you’ve already got too much, you don’t buy any more, but you keep it — until either America warms up to it and/or the fundamentals change. We try to look out six to eighteen months — and sometimes they’re faster, but most of the time they’re slower. Our average holding period is probably three years.
We almost always have insisted on a good yield on cyclicals. It gives you some kind of bulwark in case you’re wrong.
With Windsor, we were typically 50 – 60 percent of the market P/E. You do not have to be a magician to discover those stocks, but you do have to be pretty good at pursuing and analyzing them. And you have to stay on top of your analysis. Usually, we would have a total return — growth rate plus yield — that was very competitive. About 200 bps of that performance was from a superior yield. In other words, the market would give us that yield, in effect, for nothing. Stocks sell on their growth rate. So, our strategy incorporated a built-in advantage.
Our goal at Windsor was always to earn a total return — growth rate plus yield — of twice the P/E we paid… The lesser-recognized growth stocks typically had a 12 percent growth rate with a yield of 2 – 3 percent, which equaled a 15 percent total return. We bought them for 7.5 times earnings.
It would bother us if a company had a lot of debt, and we would characterize it as a penalty relative to the P/E.
I have continued to play the low-P/E game since I gave up my Windsor responsibilities, but I do it in a much more concentrated form. I typically own 8 to 10 stocks, which, of course, is the opposite of what you are supposed to have in the way of diversification. I buttress that allocation with about 30 percent in fixed income. So, if the wolf comes to the door, at least I have an anchor to windward.
When we go into these programs, at least the way we try to do it is, you buy into weakness and keep ratcheting down. And if it doesn’t keep going down, you don’t get your full position, but you leave something in your hip pocket to try and average down, admitting your own inadequacies in picking the exact price.
On Portfolio Construction.
One of our strategies was that our top 10 holdings were about 40 percent of the portfolio.
We could not have achieved our record without taking big sector bets. For instance, the homebuilder sector recently represented a mere 1/10th of 1 percent of the S&P 500, so an investor does not receive much exposure in that sector… In my own personal portfolio, I recently had as much as 40 percent; now, I have about a 21 percent weighting. So, yes, sector bets are very important in my view.
We don’t forget to sell into strength. A lot of people can’t bear to sell when a stock’s price is going up. They’re convinced that they’ve made a mistake if they don’t hold out for the last dollar.
My attitude is that we’re not that smart. And you don’t run big money that way. The same thing applies to a stock we want to buy that has been hosed. If you find 500,000 shares offered for $39.50 and think the company will do well a couple of quarters down the road, you can bid $39 and maybe get it. When you’re after something nobody else wants, you can sometimes drive good bargains.
Everything we own was bought to be sold. If our predictions come to pass, and the market embraces a stock and it goes up, we start selling. That’s simplistic but essentially the way I operate. If you get a significant price move, you begin selling early and look for something else. One reason the fund’s cash level stays at around 20% is that we are consuming our ideas as we sell stocks.
When an individual stock reached 65 percent of its appreciation potential, we would start to sell the portfolio holding. We also had large portfolio positions that we might want to cash in more aggressively. So, when one of these positions rose to 65 – 70 percent of its potential, we would sell 20 – 25 percent of the position and then sell the rest on a scale down to 40 percent of portfolio appreciation potential.
On Risk Management.
There’s a difference between making judgments that are not highly assured ones at seven times earnings and making them at fifteen or sixteen times. Or, put another way, one of the reasons we have been able to persevere over the years is that we don’t have very many disasters, because we don’t court them. You know, if you’ve got something at fifteen times and you get a big shortfall, well, that stuff can go down 20 percent in a day.
We do hold large positions, and the risk we take is of poor short-term performance. But this is the sort of risk you should take, particularly if the stocks are woebegone, misunderstood and overlooked. You’re not buying a lot of high hopes because investors aren’t expecting much from these companies.
On Holding Cash.
The thought was the shareholder had given us money to be invested in equities, but when you couldn’t find sensible things to buy, we told the shareholder that at the margin we could go as high as 20 percent in cash. We wouldn’t do more than that because, one, we could be wrong and, two, we’d been given the money to invest in equities. But we did that about three or four times and successfully each time.
I am impressed — or maybe one should be depressed, I don’t know — by how many of my brethren, whom I respect, have pretty good cash positions, or think the market’s very high — from Warren Buffett to the guys who run Sequoia. That kind of realistic value school finds it a little tough.
Now, you can turn that around and say, yeah, but you guys are going to have to get back in at some point. But we’ve never had any trouble. When panic runs amok, why, there aren’t so many people on the other side. We’ve closed the loop every time to date, not that we’ve fancied liquidity too many times. But it’s amazing what you can do in those devastated markets.
On Investing Mistakes.
People get used to being fat, dumb, and happy. They go with the flow and don’t fight the trend and big momentum, and all that becomes fixed in the conventional wisdom. That’s when we extract one penalty. And it may go too far, because we still have that inexorable ability in the investment community to overdo a good thing — or a bad thing.
When stocks go down we’re sometimes stupid enough to buy more. That’s what we’ve always done. We do not listen to the marketplace. The only thing worse than being wrong is being whipsawed — you know, caving in at exactly the wrong moment and duplicating on the other side the losses you just suffered.
The Street has this outstanding proclivity to overdo both ways, to go from rampant enthusiasm to abject desperation, devastation. And therein lies price opportunities sometimes.
Inflection points occur in the market, and around them performance can suffer, but you have to stick to your guns.
On Knowing Yourself.
Play to your strengths. Know your good plays and your not-so-great ones. I, for instance, don’t own many technology stocks because of my limited technology knowledge.
Mr. Neff’s Cool View, Barron’s
John Neff, Kiplinger’s
Is It Time to Make a Cyclicals Play?, Institutional Investor
From a Voice of Experience, A Warning of More to Come, New York Times
A Conversation with Legendary Value Investor John B. Neff, CFA, AIMR
John B. Neff, CFA: On Low-P/E Investing
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- The Boneyard Principle: Why the Next Big Thing will Emerge from a Failed Idea – Every
- Why the Past 10 Years of American Life Have Been Uniquely Stupid – The Atlantic