The Forlorn, the Unloved, and the Out-of-Favor

The Forlorn, the Unloved, and the Out-of-Favor

In an age when large mutual funds struggle to even keep pace with broader market averages, how did Neff, who at one point was managing the nation’s largest mutual fund, manage to achieve such impressive results?

As my dad explained in a recent investment strategy report, Neff had a unique investing style.

John Neff, in his Vanguard Windsor Fund days, was an outstanding proponent of investing in the forlorn, the unloved, and the out-of-favor. John was noted for his patience and willingness to be out of synch for extended periods. During my institutional brokerage days, I loved working with Wellington Management, Windsor Fund’s management company. I knew many managers and analysts at Wellington and fondly remember, when I was the new kid on the block with a lot to learn, the helpful, informative lunches and analyst sessions. These learning sessions still serve me well today. And the contrary-opinion, out-of-phase success of John Neff played a big part in the learning curve I share with you over four decades later.

My dad goes on to explain:

… It is during a Neffian cycle that the dividend-paying stocks I favor tend to have their worst relative performance versus the stock market in general. Over long periods, Windsor Fund’s John Neff found himself wildly out of synch. John invested primarily in low P/E stocks, which is quite different from what I do. John’s low P/E stocks often fell out of favor. Neff simply did not care and stuck to his guns through thick and thin, often taking a beating in the “what’s hot today” financial media. I remember critical articles about John’s out-of-synch performance—each more misguided than the previous. John was not investing to outpace his neighbor. Rather, he was investing client funds entrusted to him with diligence, care and prudence, as if he were investing his own family fortune.

In his latest quarterly letter, Ben Inker, the co-head of Asset Allocation at Jeremy Grantham’s GMO (a firm with serious contrarian bona fides) offered readers some insight and counsel on the toll the Neffian cycle has taken on his own firm’s value-based approach.

Inker explains:

It’s no secret that the last half decade has been a rough one for value-based asset allocation. With central bankers pushing interest rates down to unimagined lows, ongoing disappointment from the emerging markets that have looked cheaper than the rest of the world, and the continuing outperformance from the U.S. stock market and growth stocks generally, it’s enough to cause even committed long-term value investors to question their faith. Over the past several years, we at GMO have questioned a lot of things, including assumptions that we had held without much question for decades, but we have not wavered in our belief that taking the long-term view in investing is the right path and that in the long run no factor is as important to investment returns as valuations.

The drivers of mean reversion [Editor’s note: the heart of GMO’s value strategy] are not hugely powerful at any given time, meaning asset prices and even the underlying fundamentals can move in unexpected ways for disappointingly long periods. It is a little glib to say that without this risk, it would be difficult for asset prices to get meaningfully out of line in the first place, but the reality is that the only way you can get really exciting opportunities for mean reversion is to have misvalued assets become even more misvalued before they revert to fair value. This is the catch-22 of value-driven investing. Your best opportunities will almost always come just at the time your clients are least interested in hearing from you, and might possibly come at the times when you are most likely to be doubting yourself. [Emphasis mine.]

In our view, an appreciation and understanding of what my dad refers to as the “Neffian cycle” is important to long-term investment success.

Diversification and Patience

We of course do not pursue a low P/E strategy like Neff, or a value-based asset allocation strategy like GMO. Diversification and patience form the foundation of our strategy. We craft portfolios that are diversified across asset classes and countries. In equities, we take a value-conscious approach focused on companies with a record of making regular dividend payments and regular dividend increases.

Like at GMO, the last few years have not always been kind to some of our favored asset classes. The relative performance of international shares has been especially challenged during this period. Our chart shows the performance of the MSCI All-Country World Index, excluding the United States in relation to the performance of the S&P 500. Over the last five years, international shares, as measured by the MSCI index, have lagged their U.S. counterparts badly.

Despite what some might consider to be a painfully long period of weak relative performance, we continue to own and add to our international holdings. Why? The way we see it, the investment criteria we use for selecting international stocks is largely the same as it is for selecting U.S. stocks. We favor dividend-paying companies which have records of making regular dividend increases. We further favor firms with strong financial positions and those operating in industries with high barriers to entry. The companies we buy may not be household names to all Americans; but, in our view, their investment merits are just as good as the domestic names we own.