Some thoughts on the book John Neff on Investing, his portfolio style, and some thoughts on value vs growth investments
I have three or four investment ideas that I’ll be sharing here over the coming weeks. A couple of these stocks might fall into the classic “value” bucket. Great investments can come in all shapes and sizes, but I’m always looking for the same general criteria: a durable business with good economics (high returns on capital), capital allocation that makes sense to me, and an undervalued price.
Ideally, we want all three engines working in our favor: buybacks/dividends (cash now), earnings growth (cash later), and P/E multiple expansion. The net contribution from those three factors is what drives a stock price over the long term.
So, there is no “growth vs value” in my book — it’s all included in that simple equation. I’ve always found it interesting how certain investments get categorized and certain investors get labeled. There are certainly style differences, but sometimes these labels take on a life of their own and begin to transcend reality.
Today, I wanted to share some thoughts on a book I read about an investment manager who is considered by many to be a classic value investor. He is often bucketed into the “value” camp, and while I certainly would agree that he’s a value investor, I got to thinking how similar his style was to Peter Lynch, who is labeled a growth investor (I wrote a post many years ago about the Misunderstanding of Peter Lynch’s investment approach).
In fact, I think both investors are more similar in their strategy than they are different. They tried to market their funds using particular language (just as Buffett tries to simply explain his philosophy), but the simple reality is I think they simply were looking for the most common sense and lowest risk ways to compound their capital.
John Neff on Investing is a great read. He is not a household name like Peter Lynch, but he had great success running the Windsor Fund, compounding at 13.7% for 31 years.
My favorite aspect of this book is how it’s filled with mini-case studies, one after another. It reads like a multi-decade investment journal that spans the course of Neff’s career.
Here are some notes on the book, in “ugly first draft” form.
John Neff on Investing: My Comments
I loved the book. Perhaps the two main points of the book:
- Low P/E investing puts the odds in your favor
- Growth above 20% is risky
It’s interesting that there are similarities in Neff’s approach to Peter Lynch, but that one is considered a value investor and the other considered a growth investor.
But John Neff and Peter Lynch are more similar than they are different:
- Both wanted good companies
- Both wanted value (they both talk about low P/E stocks)
- Both wanted steady and stable growth
- Both employ simple common sense analysis when evaluating companies: is this a good business? What are the prospects?
- Both investors seemed to place value on the near term trajectory of a business: Neff bought stocks that were low P/E’s that had temporary problems but where he could see somewhat near term solutions to those problems
- Both seemed to have fairly rapid turnover; Neff has case study after case study in the book where he describes selling a stock after a 50 or 100% gain in just a year or so. Example: he bought Newmont Mining in 1981, sold it mere months later after a 50% gain, bought it again in 1982, and sold it again in 1983. He did this over and over. One stock he bought and sold 6 different times in his fund.
- I question whether it was an optimal strategy or whether he would have just been better off holding the stock for many years and not trying to catch the wiggles.
- Neff placed a lot of importance on business momentum (not stock momentum, but the momentum of earning power within a business cycle).
- Peter Lynch was similar: he’d notice oil prices heading up and he’d buy oil stocks knowing that their earnings would respond; I think this type of investing today would not be effective: all of that price adjustment in an oil stock happens instantaneously today. They rise and fall with the price of oil daily.
- In general, I think aspects of Neff’s strategy are very replicable and worth considering (more below on growth traps) and other parts are probably more difficult.
- I didn’t see any data on his turnover, but it appeared to me that he rarely held a stock for more than two years, and often held stocks for a year or even less. We know Peter Lynch had rapid turnover (often 300% or more in the early years, which means he held stocks for just a few months on average).
- My note: This is not to my personal liking. I really prefer finding the businesses that I believe can compound value for a long period of time.
Turnover: Grocery Store vs Luxury Goods Portfolio Strategy
- I wrote about how turnover in and of itself isn’t necessarily good or bad; just as a low margin and high asset turnover business like a grocery store can earn great returns on capital (see Costco, turning its inventory 13 times per year) and a high margin, low turnover company (see LVMH, turning its inventory just once per year) can achieve those same returns on capital in an opposite manner; similar to this, an investment approach can be smaller profit on each average position if the portfolio finds a lot of these smaller profit investments; so too can a portfolio like Ted Weschler, which held its two big winners for the entire duration of his fund; both became 100-baggers: the latter is high profit margin low turnover; the former (Lynch and Neff) are more like the grocery store: lower profit margin per average stock but many more investments. My personal preference tends to be the lower turnover approach, but both strategies can lead to high rates of return on investment.
- More thoughts on the grocery store vs luxury good portfolio style:
- Lynch is famous for 10-baggers, but reading through his early Magellan years, it’s clear that these were both small positions and very rare; he owned hundreds of stocks and turned his portfolio over very rapidly
- Lynch and Neff seem to resemble the grocery store; Weschler (and investors like the late great Charlie Munger) are more like the luxury brand; they hold stocks Berkshire and Costco for decades
- Warren Buffett himself has been in both categories: I think he was more in the grocery store style in his partnership years and migrated to longer-term investing as his capital grew and opportunities shrunk
- I personally prefer the longer term, lower turnover style of investing. It suits my personality better and I’m not as comfortable with higher turnover. I like latching onto businesses that can do the heavy lifting for me for years. But I also have a portion of my portfolio that I call the “Value Coffee Can” which consists of workouts, special situation and cheap stocks that is more akin to the grocery store
- Both can be effective for some investors: Walter Schloss is another one who I would put into the grocery store camp. I just had a conversation with a good friend of mine who has had great success with a higher turnover
Their styles were remarkably similar, despite popular narrative that Neff was “value” and Lynch was “growth”. I think that was more of their mutual fund parent companies’ marketing push and less the investor’s own labeling.
Growth Traps: Growth Above 20% is Risky
Here is another similarity, and a point that I found to be the most interesting nugget of the book. Neff had a rule where he wanted growth stocks that had at least 6% growth but not more than 20%. I recall in the Lynch books that Lynch also suggested that fast growth was great, but growth over 20% was risky. I’m paraphrasing from memory here, but I believe Lynch once told a company with a certain growth ceiling that if you have a choice to get there in 5 years vs 15 years, choose 15 years.
This has been an observation I’ve had, especially over the past few years. Last year I did a post-mortem on all of Saber’s past investments, and noticed that my biggest winners coincidentally were in this 6-20% sales growth range (in fact, mine were more in the 6-12% range). A great stock that grows at 8% can lead to terrific results over a multi-year period thanks to capital returns (buybacks and dividends) and a low P/E ratio (see AZO, AAPL, and NVR as just a few examples of stocks with single digit growth rates that all compounded at 20% for a decade or longer, thanks to the consistent buyback engine and a low valuation).
My least successful stocks were the ones that had growth exceeding this range. I’ve actually had more success in companies growing under 6% than companies growing over 20%. Low growth does not equal low quality, and there are plenty of very high quality, durable businesses that earn high returns without a place to reinvest (which leads to high payout ratios and attractive returns even without growth).
It’s true that the low growth realm is filled with value traps, and I try hard to avoid those by focusing on high returns on capital. But, John Neff points out that there are growth traps as well — faster than 20% growth is a danger zone here.
The book Built From Scratch about Home Depot talks about a near death experience the company had in the 1980’s when they tried growing too fast. They opened too many stores, made an ill-advised acquisition, and this stretched both the balance sheet and the operating structure of the business to a breaking point. They realized that growing too fast was a bad idea and the founders actually had the board implement a rule that said they could no longer grow store count faster than 20% per year.
Companies with physical assets that need funding — stores, warehouses, real estate, inventory; banks and insurers whose inventory is capital — these companies obviously can create risk they grow too fast. Technology or software companies often don’t have the same physical constraints — the risk of fast growth are probably less obvious. In a world of “zero-marginal costs”, this makes sense in theory: if there are no supply constraints, then sales growth can match demand growth, which can be rapid. Google grew 100% per year for a while when users were rapidly growing and incremental clicks cost them very little. Facebook grew as fast as users published content and advertisers published ads. Etsy could grow as fast as buyers and sellers came onto their network. However, countless companies over the past few years have made poor capital allocation decisions that can probably be traced to a desire to keep growth rates high, from Etsy to Shopify to Salesforce to many others… I made a note of this growth risk in my John Neff folder and this is something I will always keep in mind.
I’ve noticed that even these digital companies struggle to keep up with fast growth that lasts more than a few years.
There are a few issues even for these capital-light fast growers:
The biggest issue is companies that grow too fast are often tempted to do dumb things to try to keep up a past rate of growth:
- They hire too many people
- They spend too much on R&D and projects unrelated to their core business
- They lose discipline with their cost structure
- And at worst, as a last resort to keep revenue growth high, they begin buying other companies that usually results in diworsification
After thinking a lot about this concept of growth traps, I actually think that capital light businesses are more likely to cause damage through growing too fast, because growth for these companies naturally comes easier in the short term. But growth for growth’s sake creates lots of risk and can destroy value even in capital light businesses.
The core lesson here: a bloated staff or an expensive cost structure from an unrelated business might not require much capex but it does saddle the company with operating costs that dilute the value of the core business and can be just as value destructive as Home Depot trying to open too many stores too quickly in the 1980’s.
These are all risks that even the fast growth great companies can suffer from if management is too focused on growth.
Beware of these “growth traps”.
Neff and Lynch had a lot of success in investing by trying to avoid poor quality businesses (seems obvious), but also by not chasing the companies with 20%+ growth (seems less obvious). They avoided the value traps and the growth traps.
It’s worth remembering that only 1 of 15 stocks grew sales at over 10% in the decade ending in 2019. Growth of 10% is very rare, growth of 15-20% is exceedingly rare and often comes with either business risk (growth traps) or valuation risk (paying too much for future earnings).
I touched on a few general takeaways here, but I recommend reading the book as it has a lot of practical discussion of various stocks and individual case studies that I found interesting.
I’ll be discussing some more specific investments in upcoming posts. Thanks for reading!
Article by John Huber, Base Hit Investing
About the Author
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at john@sabercapitalmgt.com.
