CFA Institute

John Neff on Investing by John Neff; S. L. MintzReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 56, No. 3 (May - Jun., 2000), pp. 86-87Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480251 .

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Financial Analysts Journal

sense. Many other unique features separate Derivatives from its com- petitors. The option calculators and models, with adjustable 2-D and 3-D graphics, allow the reader to gain a good feel for hedging parameter sensitivities.

Volatility as an input into val- uation receives its own leading section, an unusual approach for a book of this kind but one that gives appropriate emphasis to an important variable. And the final section addresses dynamic strate- gies, with specific emphasis on portfolio insurance. Such focus on this topic is a little surprising, given portfolio insurance's check- ered past; nevertheless, it pro- vides a good example of the application of option replication. Rubinstein was one of the origina- tors of portfolio insurance, and his explanation clearly reinforces the validity of the concept of option replication with traditional assets.

Finally, the bibliography is a delight. Broken down into anno- tated reviews of major works and applications areas, it provides a compendium of all the key research pieces in options. Rubin- stein's timeline of option research and his views on the importance of specific research are innova- tive. Furthermore, the applica- tions portion of the bibliography clearly focuses on how options can be applied to a multitude of problems. This is a section that users will refer to on a regular basis.

Derivatives: A PowerPlus Pic- ture Book has a steep price, which can be justified only if the Web site and calculators are effectively integrated in the learning process. The Web site is a powerful tool in itself, with updates in May and December 1999, including com- puter exercises, numerical exam- ples, more presentation slides, mini-lectures, and live option applications. A second volume that will cover exotic options, alternative pricing models, and

advanced topics is in progress. I look forward to seeing how Rubinstein deals with these more complex topics.

John Neff on Investing. By John Neff with S.L. Mintz. John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 101 58-0012, 212- 850-6336 or 800-225-5945. 267 pages, $27.95.

Reviewed by Martin S. Fridson, CFA.

Like Gaul, John Neff on Investing is divided into three parts-a highly entertaining memoir, a treatise on investment principles, and an exhaustive (114 pages) quarter- by-quarter report to shareholders covering the author's 31-year ten- ure as manager of the Windsor Fund. The volume also contains two appendixes, one of which details Neff's celebrated perfor- mance record.

Over the period June 30,1964, to October 31, 1995, the Windsor Fund produced a cumulative annualized return of 13.7 percent, net of management fees. In terms of relative performance, Neff beat the S&P 500 Index by more than 3 percentage points a year. This was an outstanding achievement in the annals of mutual fund man- agement and one that was demon- strably not attributable to luck. With 95 percent confidence, the mean difference between Neff's annual returns and the S&P 500's was genuinely positive.

A fair question, however, is whether the S&P 500 is a suitable benchmark for someone who is popularly regarded as a value manager. Neff's 1964-95 perfor- mance is less correlated with the large-capitalization stocks that constitute the S&P 500 than with an index of small-cap value stocks, such as the one created by Dimen- sional Fund Advisors (DFA).2 Part of Neff's outperformance of the S&P 500, therefore, may be

attributable to his playing in a dif- ferent universe of securities.

To be sure, Windsor deliv- ered more return for the risk than DFA's small-cap value index, as measured by Sharpe ratios. In cumulative total return, however, the passive approach beat Neff's active strategy hands down: $100 invested in the Windsor Fund on June 30, 1964, grew to $5,662 by October 31, 1995, but the compa- rable figure for the small-cap value index was $15,806.

This sort of comparison would have been purely aca- demic, however, in 1964 when Neff took charge of the Windsor Fund. At the time, mutual fund organizations did not offer small- cap value index funds. Today, such products are marketed to the public with annual expense ratios as low as 0.25 percent. So, even though past performance is not necessarily indicative of future returns, the passive approach's 1964-95 record should give pause to investors who contemplate using Neff's successful but highly labor-intensive methods.

Despite the availability of a comparatively low-effort alterna- tive, many investors will no doubt prefer to seek their fortunes by mimicking Neff's practices. If they attempt to beat the market solely on the basis of the broad strategies outlined in this book, however, they will probably fail. The same emphasis on low P/Es and high dividend yields that wrought miracles at the Windsor Fund produced mediocre results for many less-skilled managers during the same years. Further- more, Neff eschewed such labels as "contrarian" and "bottom-up investor." He used an eclectic array of styles, including sector rotation and market timing. (On occasion, he parked as much as 20 percent of Windsor's assets in cash or took sizable positions in bonds while waiting for better opportunities in equities.) On any

86 ?2000, Association for Investment Management and Research

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Book Reviews

given day, accordingly, two investors can with equal justice claim to be pursuing Neffian strat- egies yet hold radically different portfolios that are bound to pro- duce widely divergent returns. In short, the key to the master's superior performance must lie outside the broad investment phi- losophy outlined in John Neff on Investing.

Close examination of the text discloses several specific tech- niques by which Neff differenti- ated himself from the pack. For one thing, he was obsessive in his search for attractive stocks. "Run- ning Windsor Fund was a 24-hour job," he writes. Charles Ellis notes in the book's foreword that Neff's discipline included secluding himself every Saturday at 1:00 p.m. to reread every word of every edition of the preceding week's Wall Street Journal.

Neff drops another clue to his success by observing, "At Wind- sor, every investment in a cyclical stock entailed an estimate of nor- mal earnings. We were not always right." Finding undervalued securities, in short, is no mere matter of calculating ratios from known (that is, historical) finan- cial statement data. Rather, it requires superior forecasting of future earnings by the use of methods that Neff does not detail. Readers seeking more specific guidance encounter the standard fare of evening courses in securi- ties analysis (e.g., study the new- lows list, read trade magazines,

and look for good products and related investment ideas in shop- ping malls).

To be sure, Neff offers seven specific questions to ask investor relations officers. One wonders, however, how reliable these indi- viduals are as sources of informa- tion. After all, in aggregate, their stories suggest that all stocks will outperform the market average. Moreover, corporate spokesper- sons may be more candid than usual when talking to a latter-day Neff who has several billion dol- lars under management, but that does not help the average investor.

Indeed, Neff may have gained part of his edge by control- ling enough assets to make his voice heard among the corporate chieftains. Concerning one of his most notable coups, Citicorp, Neff writes, "I offered a piece of my mind [to Chairman John Reed] from time to time as Windsor's stock [holdings] mounted." Windsor also scored a triumph with Chrysler, which benefited from Neff's presence on its board.

If some of his pointers are dif- ficult for the average investor to put into practice, Neff at least avoids the pitfall of propagating dangerously inaccurate informa- tion. His most serious error is his claim that the acronym FFO, widely used by analysts of real estate investment trusts, stands for "from financial operations" rather than "funds from opera- tions." In addition, Neff mistak- enly gives 1931 (rather than 1934)

as the publication date of the first edition of Benjamin Graham and David Dodd's Security Analysis. He also repeats the common error about the desirability of moving "up the learning curve." The learning curve plots cumulative units produced against produc- tion hours (or cost) per unit, so the object is clearly to move down the learning curve. Finally, one wishes that the copy editors had deleted the redundant final "s" from "Owens-Corning Fiber- glass" (the correct company name is "Owens-Corning Fiberglas").

John Neff's stature is not diminished by such minor mis- steps. His career stands as a shin- ing example of high professional standards, service to the commu- nity, and above all, integrity. In John Neff on Investing, he argues passionately for incentive-based compensation as a way to ensure that clients' needs come first. Dur- ing his tenure at the Windsor Fund, he reports, he devoted min- imal time to trading his personal account. On the other hand, Neff has given his time generously in service to AIMR. Readers of this book, whether or not they hope to match his investment record, will do well to emulate him.

The reviewer thanks Meir Statman, Marc Reinganum, Martin Gruber, and Cecilia Fok for their advice and assistance.

Notes

1. Rubenstein's work compares favorably with texts I consider excellent: Options, Futures, and Other Derivatives by John Hull (Prentice-Hall, 1999) and Black- Scholes and Beyond by Neil Chriss (Irwin, 1997).

2. The index consists of NYSE stocks ranked in the bottom 45 percent by mar- ket capitalization and in the top 30 per- cent by book-to-market value together with the Amex and Nasdaq National

Market System stocks that would rank similarly if listed on the NYSE.

May/June 2000 87

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