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The Successful Investor: John Neff

John Neff might be an unfamiliar name to people who are far away from the investment and financial world, but he is one of the financial luminaries whose name is associated with expertise, success and respect towards his innovations and accomplishments. He is famous for his 31-year management period of Vanguard Windsor Fund, during which he managed to beat the market twenty-two times and successfully achieved an average annual total return of 13.7% against the S&P500 return of 10.6%. This means that an initial investment of $10,000 would be turned to the amazing half a million by the end.

John Neff's Investment Style

Neff's investment style defines him as a value investor. According to Neff himself, the large income generation of the stocks he acquired for his investors was due to cash dividends of large amounts. He bought companies with moderate growth and high dividends while they were out of favour, and sold them when they rose to fair value.

In order to evaluate whether a company is appropriate for investment Neff followed several simple criteria: 

  • Low price to earnings ratios (P/E)
  • High dividend yields
  • Fundamental earnings growth above 7%
  • An appropriate compensatory low P/E on cyclical companies to account for their volatility
  • Better than the average return on equity
  • Companies in growing fields
  • Strong market in which to operate

The list continues with sound cash flow, stable balance sheet, qualified management, and attractive products or services.

Combining all the factors stated above, John Neff created the so called by him "terminal relationship" figure. Its calculation helps the manager determine what he gets on behalf of his/her investor's portfolio. For example, what Neff looked for in a stock was terminal figure at least twice that of the overall market.

How the Terminal Relationship Calculations Are Done?

Terminal Relationship = (capital growth + dividend yield) / average price to earnings ratio

To make a better sense of how the calculations are exactly applied, consider the following example: Tom has a portfolio with an expected growth earnings rate of 7%, which yielded 4% dividends. The average price to earnings ratio for this particular portfolio was 10. Therefore, the terminal relationship will amount to 1.1. Now let's consider the terminal relationship of the market as a whole. Let's assume that at the time period under consideration the market growth was expected at 14% rate and a dividend yield of 2% with a p/e of 23, the terminal relationship (0.69) will be far smaller then that of Tom's portfolio. By making these calculations and comparisons, Neff succeeds in determining that the investor is likely to generate higher returns, despite the higher rate of the market's earnings. This is so, since every additional dollar spent on a stock, generates to the investor future profits. Furthermore, Neff stated that the attractiveness of every additional stock increases as compared to the existing in the portfolio equities.

Industry and Sector Weightings Applied by Neff

Neff investment strategies heavily depended on diversification. For example, while managing Vanguard Windsor Fund, the fund included positions that held less than 1% of asset. An exception is made only if the stock was extremely attractive. In such cases the holding may go up to no more than 5%. Neff concentrated on investing in stocks of markets that offered the highest value for the money invested. After close examination of industries that are under a critical downturn and the possibility of a recovery exists, Neff will chose a stock in which as little as 1% will be invested, but this will be repeated for twenty different businesses. As a result, 1/5th of the assets of the fund will be under the influence of the occurring in the market changes.

Not "Hot" Stocks Preference

John Neff is famous for his inclination of purchasing stocks that are considered out of favor by the other investors on the Wall Street. Taking a quick look at one of the portfolios that has been managed by Neff, one will clearly notice his disciplined value approach illustrated in the purchase of stocks that are avoided by other investors. He was completely supportive of the maxim that the price you pay definitely determines the return you will get later.

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