FOOL ON THE HILL
An Investment Opinion

Learning From the Windsor Master

By Warren Gump (TMF Gump)
November 30, 1999

I recently had the good fortune to attend a speech by John Neff, who is on the road promoting his new book, "John Neff on Investing." For those not familiar with Mr. Neff, he managed the Windsor Fund during a 31-year span when it beat the average annual returns of the S&P 500 by over three percentage points. (Finding a mutual fund that can do that for a few years is noteworthy; one that can do that over such a long period is almost mind-boggling.) As an investor with a traditional value orientation, I had been looking forward to hearing one of the strategy's most renowned practitioners for months.

The presentation itself was interesting, with Mr. Neff telling several stories about himself and his investing experience. Not surprisingly, he believed more than ever in the benefits of staying the course, finding the stocks of good companies at reasonable valuations. He pointed out that numerous stocks still fall into this category, given that most of the gains of the past couple of years have been achieved in a small number of stocks. An area Mr. Neff seems particularly interested in at this point is home builders, which are still selling at single-digit price-to-earnings (P/E) ratios.

After hearing Mr. Neff speak, I felt much more confident about my investing strategy, which primarily sticks to value but has some growth and emerging growth interlopers. Hearing one of the value masters extol the virtues of sticking with the strategy was definitely a confidence booster. (It turns out, however, that Mr. Neff has better reason than I to maintain his strategy. His personal portfolio matched the S&P 500's performance last year, beating the returns of the value portion of my own portfolio and value index benchmarks. I obviously have plenty to learn.)

The speech also accomplished its task at hand, inspiring me to pick up his book to see what else he said. Although I haven't yet finished reading the last few pages (the "joy" of painting a couple of rooms in my apartment took up an inordinate amount of my long weekend), the first three-quarters of the book have proven to be an interesting read.

The book is divided into three parts: a mini-biography, a section discussing Neff's enduring investing principles, and an investing journal from three decades in the battlefield. Although it is fun to learn more about the man behind the legend, the real meat of the book is in the last two sections where the thoughts and perspectives of one very successful investor are described.

None of the "principal elements" of Neff's investing style surprised me:

• Low P/E
• Fundamental growth in excess of 7%
• Yield protection (and enhancement, in most cases)
• Superior relationship of total return to P/E paid
• No cyclical exposure without a compensating lower P/E
• Solid companies in growing fields
• Strong fundamental case (cash flow, return on equity)

A couple of points in the book did cause me to pause and reflect.

Neff has no problem selling a security when it reaches his expected price, and has subtitled a section in his book "You Don't Have to Buy and Hold Forever." This directly contradicts a key tenet of Foolishness, which states that the best stock to own is the one you can buy and hold forever. How can these two perspectives be reconciled? I have struggled with this issue for a while. I like to think of myself as being Foolish, but there are a lot of stocks in my portfolio that I'm willing to part with at a certain price. Pondering the topic, I realized that I was mixing tactics from two very different strategies.

The Foolish strategy of buying and holding stocks forever is predicated on finding stocks capable of achieving sustained earnings growth over long periods of time. On the other hand, a traditional value strategy attempts to find companies that are mispriced based on their prospects over the next few years. It makes sense that these two strategies would have different selling rules.

In the former case, the primary avenue for price appreciation should be fundamental growth in a company's business over a number of years. In the latter case, higher valuations and better fundamental performance are both expected to contribute to price gains. If a "value" stock rises and achieves a higher valuation, one of the price thrusters for the stock is removed. In this case, it may make sense to go ahead and sell since one of the key reasons you were in the stock is no longer in place.

Another part of the book that really struck me is the number of times specific sectors had gathered enormous momentum and achieved virtually unthinkable valuations. When talking about speculative market bursts, I have usually referred to overall market euphoria during the period approaching the 1929 crash or the "Nifty Fifty" stocks in 1974. Neff's journal reminds us that periods of particular industry outperformance are regular market phenomena.

Neff talks about the tremendous success of Jerry Tsai in small growth stocks for a few years in the late 1960s. He refers to the Nifty Fifty era and the "one decision" growth stock. (As it turned out, investors who bought and held these stocks did OK if they had lots of patience.) He also points out how oil and oil service stocks have gone in and out of favor over the years. He mentions the market's infatuation with technology stocks in the early 1980s and discusses several other times when investor attention was focused primarily on a limited number of stocks. Most of the time, a large percentage of these "hot" stocks were able to be acquired at lower prices as investor attention shifted elsewhere.

More important than recounting history, though, Neff's journal provides insight into what he was thinking as he invested through various market environments. While markets change and always appear to be entering "new ages," Neff's book makes it abundantly clear that many market patterns are repetitive. If you know and understand this, you should find plenty of opportunities to beat the market.