Global equity markets finished the third quarter up modestly in local currency, but faced a good bit of volatility along the way largely due to ongoing trade tensions with China and increasing evidence of slowing economic growth. In this increasingly volatile environment, the Tweedy, Browne Funds finished the quarter in the red and trailed their respective benchmark indices. However, year-to-date through September 30, our Funds are up between 7.59% and 11.30%. While the quarter was modestly challenging from a stock price perspective, the bulk of our Funds’ portfolio companies continued to make fundamental financial progress, and we remain encouraged by the uptick in idea flow produced by the markets’ recent choppiness.
While overall results for the quarter were quite mixed, there were a number of companies in the Funds that made significant contributions to returns. On the positive side of the ledger, the Funds’ aerospace & defense, food products, insurance, and pharmaceutical holdings produced solid returns. This included good returns in Safran, the French-based civil jet engine manufacturer, which continues to grow its earnings and our estimate of intrinsic value at well above average rates; BAE and Babcock, two U.K.-based defense companies that continue to benefit from a solidifying pipeline of projects that provide future revenue visibility; Nestlé and Unilever, two European food giants that continue to do a good job managing their respective brand portfolios; Zurich Insurance Group and Munich Re, the Swiss and German-based insurers that have had success managing their costs and maintaining strong underwriting results; and Roche and GlaxoSmithKline, two of the Funds’ core pharmaceutical holdings, whose drug pipelines remain strong. Also contributing to the Funds’ returns during the quarter were Henkel, the German household products company; Alphabet (Google); CNH, the European-based agricultural equipment company; Wells Fargo & Co; and Verizon.
In contrast, relative performance comparisons were hurt by the Funds’ underexposure to Japanese equities, which produced solid returns for the benchmarks during the quarter, and market price declines in a few technologyrelated holdings, including two Chinese internet-related holdings, Baidu and Sina. We also had disappointing absolute returns in a number of bank and oil & gas holdings. Despite a serious attack on Saudi Arabia’s oil production facilities during the quarter, oil prices continued their downward volatility, and the stock prices of most oil & gas related enterprises followed suit. This translated into disappointing stock price results for ConocoPhillips, Royal Dutch, Total, and MRC Global, a U.S.-based oil service holding. Tarkett, the French-based commercial flooring company, was also down significantly during the quarter as a result of a poor earnings report and near-term outlook. The flooring industry is going through a rough patch, and Tarkett’s results are not surprising to us in light of the near-term challenges. With the stock price in our view overreacting on the downside, we decided to modestly add to Global Value Fund II’s position, as did the Deconinck family, which owns a controlling interest in the company.
We are encouraged by the fact that increasing market volatility continues to produce pricing opportunities for us, and that is reflected in several new additions to our Fund portfolios: Krones, the German beverage equipment manufacturer; Trelleborg, the Swedish industrial polymer producer; and Fox Corp, the U.S.-based news and sports broadcaster. In Global Value Fund II, we also took advantage of pricing opportunities during the quarter to add to the Fund’s positions in Konishi, the Japanese adhesives and sealant company, and as previously described, Tarkett. On the sell side, we sold the Funds’ remaining shares of Kia, which was up nicely for the year, but had produced only modest returns over the Funds’ full holding periods. We also sold AGCO, the U.S.-based farm equipment company; the Daily Mail, the U.K.-based publishing company; Mastercard, the U.S.-based interchange business; and Lumax, the Taiwanese industrial service company, all of which had reached or exceeded our estimates of their intrinsic value. We also trimmed positions in Baidu, G4S, HSBC and Royal Dutch, among others.
Baidu reported weak operating results in the last two quarters and, after much analysis and discussion, we decided to reduce our position in the stock. The company is currently facing some headwinds due to near-term macroeconomic concerns in China, regulatory/clean-up issues affecting certain segments of advertising revenue, increased management turnover, and more intense market competition. Growth in internet advertising in China has slowed more than expected, and the company is facing increasing competition in advertising, particularly from ByteDance (owner of popular short video app Douyin), which is disrupting the digital advertising industry profit pool. This is impacting Baidu’s expected growth and profitability, and has caused us to reduce our estimate of its underlying intrinsic value. That said, the company continues to maintain a dominant position as a search-engine provider, which we believe should remain quite valuable.
The new additions to our Fund portfolios, Krones and Fox Corp (in the Value Fund only) and Trelleborg (in all four Funds), were all trading at significant discounts to our conservative estimates of their underlying intrinsic values at purchase, and we believe they have the ability to compound their intrinsic values going forward at attractive rates. The Global Value Fund and Global Value Fund II have owned more or less of Krones over the years, depending on its price in relation to our estimate of intrinsic value at various points in time, and we decided to purchase shares in the recent quarter for the Value Fund given that its stock price had nearly halved over the last year. Krones is the dominant competitor in the manufacture of bottling machinery for beverage companies. Its business is somewhat cyclical and its growth has slowed a bit over the last year, and it has also faced cost pressures which have brought down margins. However, we believe these headwinds are temporary and that the market has overreacted, affording us an attractive pricing opportunity in its shares. Krones currently pays a dividend yield just over 3% and, in our view, can continue to compound its intrinsic value over time.
With manufacturing appearing to have already entered a recession, particularly outside the U.S., we have, of late, been uncovering a number of pricing opportunities in niche manufacturers around the globe, of which Trelleborg is one. This mid-size Swedish manufacturer is a leader in the production of polymer (rubber & plastics) solutions that seal, dampen and protect applications. Its Sealing Solutions segment, which accounts for over half of operating profit, is considered one of the best in the Nordic region. The cost to produce a seal is low in relation to the value that it protects, so Trelleborg has had pricing power that has allowed for above-average organic growth, high margins, and high returns on invested capital. Employing a sum of the parts valuation using conservative M&A comps, we believe Trelleborg at purchase was trading at a substantial discount to its underlying intrinsic value. While growth appears to be slowing near term, which could put its stock price under additional pressure, the company has generated growing EBIT, year over year, for 24 straight quarters. They have paid an increasing dividend since 2010 and the current yield is approximately 3.6%.
Following the sale of certain Fox Corp assets to Disney, the “new” Fox Corp consists mostly of its predecessor’s “live” programming assets, particularly news and sports. Fox’s management has chosen to focus on “live” programming because it is less exposed to secular challenges in TV consumption/distribution than scripted content.
Specifically, “new” Fox consists of Fox News, Fox Sports, the Fox Broadcast TV Network, and a local TV station business. Fox News currently accounts for an estimated 70% of the company's total EBITDA. Regardless of one’s opinion about Fox News’ content, it has a very loyal audience and a strong brand. We believe this gives it relatively high pricing power over the cable operators. Wall Street analysts estimate that Fox News earns a 60%+ EBITDA margin, making it amongst the most profitable cable channels around. Fox News also has minimal capital intensity and, in our view, solid growth potential given the current level of its affiliate fees relative to the size and loyalty of its audience.
At initial purchase, we estimate Fox Corp. was trading for roughly 9x its trailing twelve-months EBIT (earnings before interest and taxes) or an owner’s earnings yield (net operating profit after tax/EV) of approximately 8%. We included the benefit or value for Fox’s Roku holding and its production studio in our enterprise value calculation. Fox earns a 20% ROE on a 20% operating margin and, in our view, should generate sufficient free cash flow given its low capital intensity and a tax shield resulting from the Disney transaction. It is also worth noting that there has been material insider buying at Fox as its founder and current co-Chairman has purchased over $36 million of its shares since June.
Since early 2018, there have been periodic bouts of market volatility, which has translated into weakening correlations and improved idea flow for value investors like us. Past experience would suggest that prevailing investor anxiety is, in part, related to above-average risk asset valuations coupled with increasing macroeconomic uncertainty, not the least of which is what appears to be a slowdown in economic growth, both in the U.S. and abroad. Other potential issues currently on the horizon that could pose a threat to market confidence include, but are not limited to: a hard Brexit; escalating trade tensions with China; a long overdue recession; a military confrontation with Iran; a miscalculation by North Korea; continued unrest in Hong Kong; rising debt levels; antitrust scrutiny of some of the FAANG companies; the upcoming U.S. presidential election; and perhaps more importantly, the possibility, however remote, of an uptick in inflation and interest rates. An unexpected outcome with respect to any of these macroeconomic issues could dampen investor enthusiasm, and in turn, negatively impact risk asset valuations, shifting the teeter-totter back in value’s favor. In the interim, we suspect that market volatility is likely to remain with us, and that should bode well for bargain hunting.
Thank you for investing with us, and for your continued confidence.
William H. Browne, Roger R. de Bree, Frank H. Hawrylak, Jay Hill, Thomas H. Shrager, John D. Spears, Robert Q. Wyckoff, Jr.
Investment Committee
Tweedy, Browne Company LLC
October 2019
