One of my favorite contrarian investors is John Neff. His success using a low P/E strategy is best described in an article by Morningstar:
His wager on Ford Motor Company in 1984 was said to be one of his best. When many feared that the company’s sales were due to slow down and analysts began to give a sell call, the P/E sank to 2.5. Neff ignored the noise in the market and saw immense potential – a lean management with good control of costs and a new model, the Taurus. Neff began picking up the stock which had dropped to $12 a share. It climbed to $50 within three years. He made millions on that move. A few years later, when oil prices collapsed in 1986, he plunged into oil stocks and was rewarded once again.
One of my favorite Neff interviews is one he did with The CFA Institute in 2004 in which he discusses his low P/E strategy, Neff says:
If I had to pick one [lesson], I would pick the low-P/E equity strategy. That is certainly the crux of it. There are so many stocks that meet this criterion. 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.
Here’s an excerpt from that interview:
Question: Is the market so efficient that stock picking is dead?
Neff: No. Stock picking is still alive and well. For example, take Crown Holdings (formerly called Crown Cork). It is the biggest container company in the world. Unfortunately, 40 years ago, it acquired Munder, and among Munder’s businesses was an insulation distributor that had asbestos insulation in its product mix. Crown sold the business only three months after the acquisition, but it came back to haunt Crown.
When I first joined the board of directors at Crown, its stock was around $35 per share. It had been as high as $58 and got down to 83 cents in November 2001. The short position was about 20 percent of the stock outstanding, and there was not a significant amount of shares available for shorting (float) either. Within four months, the short sellers got squeezed because Crown did not go belly up. Instead, the stock rose 15 times from 83 cents to $12 and change, and it was simply attributed to the fact that (1) Crown was surviving and (2) the short sellers got squeezed and had to cover their positions, creating a “short sellers’ rally.” So, a lot of Crown-type companies are out there, which, of course, creates opportunities. But it takes hard work and patience to find and stick with those companies.
Question: Over the course of 31 years, you must have seen a lot of market fluctuations.
Neff: Periods of outperformance for us often followed “difficult” inflection points. For instance, the Nifty Fifty was the craze in the early 1970s. We underperformed significantly in that run-up, but as the market finally started caving, we got more aggressive and bought lesser recognized growth stocks out of the ashes in 1973 and 1974. We more than recouped our 1971–73 short falls in 1974 through 1976. But it was not always so straightforward. For instance, in 1980, oil was supposedly going to rise to $60 a barrel, and everything electronic was a hot item in the market. We did not do well that year. Those sectors, however, got killed in 1981, and we did very well in the ensuing years. But then, of course, came 1987. Equity market prices rose to 22–23 times earnings, and we built a 20 percent liquidity position in 1987; we simply could not find reasonably priced stocks to buy, so we fell behind in the first three quarters of that year. Following the famous crash in October 1987, we more than recouped our underperformance through 1988.
Then, in the early 1990s, the financial intermediaries went bust. Thirty percent or more of our portfolio was positioned in financial intermediaries—thrifts, banks, and insurance companies. Shareholders complained that these financial intermediaries were all going to fail. Some did, but obviously they all did not, and they were eventually good investments. So, you have those inflection points when sometimes performance suffers. But you have got to stick to your guns. We were a low P/E fund, and that strategy was in the mutual fund charter so that the shareholders knew what they were getting. All we had to do was execute our strategy well.
Question: Can you offer some advice, some thoughts, or some enduring principles that have worked for you that are still relevant?
Neff: Well, certainly, the low-P/E strategy that I have been discussing continues to provide excellent odds. 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. I thought this advantage was gone three years ago, but it is coming back. You can buy Citigroup with a 3 percent yield, which is 50 percent better than the DJIA and about 100 percent better than the S&P 500, with a 13–14 percent growth rate (my calculation).
So, there are still stocks that provide a yield advantage. Keep in mind, however, that not all low-P/E stocks are attractive. Some of them are fundamentally poor companies in poor industries. So, you have to pick the best of the bunch based on your analysis. And you do have to set some targets—your expected growth rate and how you think the market will eventually respond. If the investment is not measuring up to your expectations a year later, you have to readdress your analysis to make sure you do not have a fundamentally deteriorating situation.
Question: What is the difference between a value manager and a low-P/E manager?
Neff: Value is in the eye of the beholder. Low P/E is easily calculated and definitive.
Question: In low-P/E investing, how do you decide when you are right and what is your sell discipline?
Neff: We focus on total return, which, of course, is defined as growth plus dividend yield. In the olden days, we had a lot of 7 percent growers with a 7 percent yield. As a matter of fact, we had a big position (17 percent) in the regional Bells when they first were born in the mid-1980s. NYNEX Corporation, which was the Baby Bell in New York and New England, had a 9 percent yield. So, we could determine total return. It was a 9 percent yielder, with a 7 percent growth rate selling for 60 percent of the market multiple. We were projecting that it would go to an 82 percent market multiple at some point in the future, so we set up an appreciation screen model accordingly. We determined that we were getting two times total return relative to the market multiple.
In other words, NYNEX was trading at 7-8 times earnings with a 9 percent yield and 7 percent growth, and thus 16 percent in total return (or more than twice its market multiple of 7 times). Admittedly, that is kind of hard to find these days. But I just bought an insurance company that is an 11 percent grower (in my view), with a 2.5 percent yield (13.5 percent total return) and a 7.3 market multiple—not quite double but pretty close. And all the homebuilders, of course, have virtually no yield, but some are 10–12 percent growers with multiples of 5–6 times earnings. And actually, I underestimated the growth rates on the homebuilders: They have not been 10–12 percent; they have been more like 25 percent!
So, we would have a portfolio that maybe had 100 percent appreciation potential in it. 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.
Question: What was your process for finding a stock and deciding to buy it?
Neff: My research team consisted of three analysts (in addition to myself). It was not a big team, but we would really chase down our companies. I would start the process by doing some preliminary analysis. Then, I would ask one of the other analysts to take a day or two to look at the company and then come back to me to see where to go from there. We kind of ganged up on it, and in this way we would chase down good low-P/E opportunities.
Question: How many stocks should a portfolio hold?
Neff: With Windsor, we probably had 60, and the top 10 were about 40 percent of our portfolio.
Question: If you had to pick one important lesson, what would you pick?
Neff: That is a difficult question because there are so many lessons. But if I had to pick one, I would pick the low-P/E equity strategy. That is certainly the crux of it. There are so many stocks that meet this criterion. 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.
You can read the full interview here.
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