The title of this seminar, “The Renaissance of Value,” implies that the concept of value had previously been in eclipse in Wall Street. This eclipse may be identified with the virtual disappearance of the once well-established distinction between investment and speculation. In the last decade everyone became an investor – including buyers of stock options and odd-lot short sellers. In my own thinking the concept of value, along with that of margin of safety, has always lain at the heart of true investment, while price expectations have been at the center of speculation.
– Benjamin Graham,
“The Renaissance of Value” (1974)
To Our Shareholders:
After an unsettling amount of market turbulence at last year-end, albeit brief, global equity markets turned on a dime in early January and headed due north, led once again by U.S. technology stocks. The markets’ resurgence was coincident with Federal Reserve Chairman Jay Powell’s reassurance that the Fed would remain patient and flexible when considering future rate hikes, and early indications that progress was being made in the ongoing trade negotiations between the U.S. and China. Markets became a bit more volatile in the second and third quarters in the face of slowing economic growth, but continued their seemingly inexorable advance on the heels of additional interest rate cuts, reaching record highs in late July. In this rather robust environment, the Tweedy, Browne Funds continued to make fundamental financial progress, but trailed their benchmark indexes.
As we mentioned in one of our previous letters, the last time technology stocks were in such ascendency back in early 2000 (the last time we felt as badly as we do today), Barton Biggs, the renowned equity strategist at Morgan Stanley at the time, provided the following admonishment to investors: “Don’t despair on value, and for goodness sake don’t fire value managers now and hire growth firms. In fact, the rational brave fiduciary with a contrarian bent should be doing just the opposite.” He wrote these words just two weeks before the technology bubble burst in late March of 2000, heralding in a period of significant outperformance for the beleaguered value strategy.
Today we are once again in a period where value investing and, for that matter, active management as a whole have not proven to be as profitable as simply paying up for disruptive technology stocks, particularly the high-flying FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks, which have helped to propel passive indexes to new highs. In fact, many in the financial press have once again declared value investing to be dead or dying. You can understand why the “this time it’s different” gremlins are once again out and about, wreaking havoc with investor psychology. As the chart below illustrates, the MSCI World Value Index peaked out versus its growth counterpart in 2006 and has underperformed cumulatively ever since. However, we believe this underperformance for the MSCI World Value Index is due in part to misplaced emphasis on the price-to-book (also referred to as Price/Book or P/B) value metric used in the construction of style-based indexes such as this one. More on that will follow.
It also doesn’t help that the investment world appears completely upside down today, causing investors to question previous investment norms. It’s simply impossible to adequately explain $15 trillion of negative-yielding debt, which, according to The Financial Times, accounts for roughly a quarter of the debt issued by governments and companies around the world; forward Euro Stoxx 50 Index dividend yields that trump German, Swiss, and French shortterm bond yields by over 400 basis points as of September 30, 2019; junk bonds trading at negative yields; Danish mortgage rates that have recently gone negative; and profitless technology “unicorn” companies that have blitzscaled themselves to stock market riches. It would appear that investors today are buying stocks for yield and bonds for capital appreciation. Why else would someone want to invest in a low-to negative-yielding fixed income security, other than with the expectation that rates were going even lower? A case in point is the 100-year Austrian bond, issued in 2017 and priced to yield 2.1%, which, as of September 30, 2019 (two years later), traded at 192% of par.
If you’ll indulge us, we’d like to take a stab at reassuring you that this time (in our view at least) it is NOT different, but simply a normal period of underperformance for a value investment approach that has handily beaten its growth counterpart for much of the last half century, albeit in a very lumpy manner.
As we mentioned in our annual report earlier this year, whether you view value’s recent underperformance as alarming or simply a normal component of long-term investment success may depend on how you define value. If price-to-book value is your preferred metric for determining value investing’s effectiveness, it has unfortunately been a disappointing relative performer for an uncomfortably long period of time. The price-to-book value metric has had an illustrious history. It has been used in countless academic and empirical studies over the years to prove out a robust return advantage for value stocks over growth stocks. Eugene Fama and Kenneth French gave the metric further credence in 1989 in their seminal paper, Common Risk Factors in the Returns on Stocks and Bonds, in which they confirmed a return advantage for low price-to-book value and small company stocks over the longer term. While we may not be willing to conclude that price-to-book value is dead just yet, it certainly appears to be somewhat compromised. However, if your preferred metrics are earnings-based acquirers’ multiples such as enterprise value in relation to earnings before interest and taxes (EV/EBIT), which are what we generally use in appraising business value, it has been somewhat of a different and more reassuring story for value investors.
As you can see in the chart that follows, since 1995, stocks trading at low enterprise values in relation to EBIT have performed significantly better than stocks trading at low prices in relation to book value, producing over time attractive absolute and, for much of the period, index-besting returns. In fact, these stocks produced 3.6 and 3.5 times the wealth produced by the MSCI World and MSCI World Growth Indexes, respectively, and 1.8 times that produced by low price-to-book value stocks.
Since 1995, stocks trading at low EV/EBIT have significantly outpaced stocks trading at low Price/Book Value, but recent history has proven difficult for both of these value factors relative to growth.
A recent study conducted by the Leuthold Group, which spans the period between 1985 and 2018, found that a combination of stocks trading at low earnings-based multiples, i.e., EV/EBIT, Free Cash Flow Yield, Earnings Yield, and Shareholder Yield (“Combo 4”), performed significantly better than stocks trading at low prices in relation to book value, producing returns that were far in excess of the cumulative capitalization-weighted returns of Leuthold’s proprietary universe of the top 1,000 U.S. stocks. The chart below illustrates that the relative performance of the cheapest quintile of stocks based on price-to-book value peaked in 2006 and, by 2018, had cumulatively produced negative value added in relation to the top 1,000 stocks. In contrast, the relative performance of the cheapest quintile of stocks based on the combination of earnings-based multiples (Combo 4) surged ahead of price-to-book value for most of the period, and did not peak on a relative basis compared to the top 1,000 until early 2018. For the entire period, the earnings-based multiple stocks added over three times the cumulative value achieved by the top 1,000. Price-to-book value has simply not been a very robust value metric over this period.
The world economy has indeed changed. The proliferation of asset light and service-based companies over the last several decades has seemingly decreased the usefulness of book value. There are simply not as many companies today for which book value is a relevant metric for determining intrinsic value – certainly not nearly as many as there were in the post-war industrial economy. While we may use low price-to-book value as an initial screening tool to uncover stocks for further study, particularly when screening for banks, insurance companies and other deeply cyclical businesses, low price-to-book value is almost never the sole reason we purchase a stock. And yet, so many index providers, consultants, and academics continue to accord this metric significant weight in assessing the efficacy of the value approach to investing.
In contrast, at Tweedy, Browne, our determination of intrinsic value consists of comprehensive business appraisals, and the study of cash merger and acquisition deals of comparable businesses in an effort to understand what knowledgeable and informed buyers of entire companies have been willing to pay in arm’s length negotiated transactions. These acquisition prices are often expressed in terms of a multiple of pre-tax income, multiples such as EV/EBIT, EV/ EBITA (enterprise value to earnings before interest, taxes, and amortization), and EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization). These earnings-based enterprise multiples help to inform the multiples we use to value comparable businesses we are studying in the stock market.
Earnings-based multiples such as EV/EBIT have arguably been more effective determinants of value over the last several decades; however, as demonstrated in the above chart, these stocks peaked in January of 2018, causing this value metric’s five-year annualized return through September 30, 2019 to underperform the MSCI World Index and MSCI World Growth Index by a considerable margin. It is an empirical fact that any value metric, including low price-to-book, low price-to-earnings, low price-to-sales, and earnings-based multiples such as earnings before interest and taxes, will at times underperform growth counterparts and passivelymanaged market indexes for uncomfortably long periods of time. However, in our view, such periods are a perfectly normal part of a successful, value-driven performance record. As you can see in the scatterplot chart below, since 1995 (when such data first became available on Bloomberg), stocks trading at low prices in relation to earnings before interest and taxes (bottom quintile) have on a rolling five-year basis underperformed the MSCI World Growth Index roughly 18% of the time. Conversely, this means that stocks trading at low EV/EBIT outperformed the MSCI World Growth Index in 82% of the rolling five-year periods.
If we look back even further in time, there have been other periods that come to mind where value investing underperformed for uncomfortably long periods, including, among others, the period leading up to the dot-com bubble of 2000, and the “nifty fifty” era between 1965 and 1973. We should not lose sight of the fact that both of these challenging periods for value were followed by long periods of outperformance for value. The lumpiness of value’s return stream over time reminds us of Warren Buffett (Trades, Portfolio)’s comment in Berkshire Hathaway’s 1996 Annual Report regarding the “gyrations of Berkshire’s earnings … Charlie and I would rather earn a lumpy 15% over time than a smooth 12%.”
Despite the effectiveness of earnings-based multiples such as low EV/EBIT over the long term, we continue to believe the common practice of characterizing investment managers and their investment styles as either growth or value based solely on a few valuation metrics is inherently flawed. While such metrics can at times provide investors with meaningful clues to potential outperformance, they are by no means the whole story. As we said in our last annual report, it is not uncommon for qualitative considerations that cannot be easily measured to weigh heavily in the determination of value – attributes such as a company’s industry dynamics, prospects for growth, balance sheet strength, corporate culture, management quality, capital allocation record, customer relationships, brand power, and patents, among a host of others.
As to when (or whether) investor sentiment shifts back in favor of value, it’s anyone’s guess, but there have been a number of signs of late that suggest we might be in the early stages of such a change. Since January of 2018, there have been numerous, but brief, pockets of market volatility that in our view reflect an increasing level of investor anxiety. The accompanying price volatility has translated into a better opportunity set for value investors such as ourselves. Economic growth has slowed, and corporate earnings in many industry segments have begun to come under some pressure. Some have argued that the manufacturing sector of the economy is already in recession. Several of the FAANG stocks, which have had a disproportional impact on the market’s advance, are now reportedly under investigation by regulators in the U.S. and abroad for potentially anticompetitive practices, and a number of new technology IPOs have proven to be disappointments. All of this, we believe, may augur well for value stocks.
In addition, there have been a host of macroeconomic canaries in the coal mine of late: the possibility of a hard Brexit; the persistence of trade tensions between the U.S. and China; increasing risk of conflict between the U.S. and Iran; conflict between mainland China and Hong Kong; the uncertainty posed by upcoming U.S. elections; rapidly increasing levels of deficits and non-financial debt both in the U.S. and abroad; depending on political outcomes, the potential for increases in taxes and regulations around the world; 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 macro issues could dampen investor enthusiasm and, in turn, negatively impact risk asset valuations, shifting the teetertotter back in value investing’s favor, as value has tended to hold up better in challenging market environments. In the interim, we suspect that periodic market volatility is likely to remain with us, which should continue to bode well for bargain hunting.
Investment Performance
Global equity markets finished the last six months up solidly 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 continued to make fundamental financial progress and produced positive returns, but trailed their respective benchmark indexes. Year to date through September 30, our Funds are up between 7.59% and 11.30%.
Presented below are performance results for the Tweedy, Browne Funds for various periods with comparisons to their respective benchmark indexes, and a rolling 5-year average annual return history (scatterplot diagram) and Morningstar peer group ranking information for our flagship Global Value Fund. (Note that scatterplot return and peer group ranking information shown for the Global Value Fund should not be considered representative of the ranking or performance of the Global Value Fund II, Value Fund, or Worldwide High Dividend Yield Value Fund.)
Our Fund Portfolios
Please note that the individual companies discussed herein were held in one or more of the Funds during the six months ending September 30, 2019, but were not necessarily held in all four of the Funds. Please refer to footnote 6 at the end of this letter for each Fund’s respective holdings in each of these companies as of September 30, 2019.
While results in all four of our Funds were modestly positive in local currency over the last six months, there were a number of industry groups and companies in the Funds that stood out in terms of their contribution to Fund returns. On the positive side of the ledger, the Funds’ aerospace & defense, food products, insurance, and media holdings produced very solid returns for the period. This included good returns in Safran (XPAR:SAF, Financial), 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 (LSE:BA., Financial) and Babcock (LSE:BAB, Financial), two of our U.K.-based defense companies that continue to benefit from a solidifying pipeline of projects that provide future revenue visibility; Nestlé (XSWX:NESN, Financial) and Unilever (UN, Financial), two European food giants that have done a good job managing their respective brand portfolios; Zurich Insurance Group (XSXW:XURN) and Munich Re, the Swiss-based and German-based insurers that have had success managing their costs and maintaining strong underwriting results; and media companies Axel Springer (XTER:SPR) and WPP (WPP), which benefitted from corporate actions that were announced during the period. We also had nice returns in two of our core pharmaceutical holdings, Roche (XSWX:ROG) and GlaxoSmithKline (GSK), whose drug pipelines remain strong; two of our bank holdings, Standard Chartered and United Overseas Bank; and beverage holdings Diageo (DEO) and Heineken Holding (XAMS:HEIO).
This past summer, Bain Capital (BCSF) agreed to buy 60% of WPP’s market research unit, Kantar, which will bring the U.K.-based global advertising company approximately $3.1 billion in cash proceeds that the company can use to pay down debt and fund share buybacks. Axel Springer, the German publisher and a long-term holding in our Funds, was also the subject of a buyout proposal during the period. The company’s board formally endorsed a deal after quarter end, agreeing to a buyout of Axel Springer’s minority shareholders by KKR & Co. at a price of €63 in cash. This price represents approximately a 40% premium to the stock’s closing price on May 29, 2019, the day prior to the announcement that deal negotiations were underway, and up to a 208% premium to the Funds’ weighted average cost.1 Friede Springer (the widow of the company’s founder) and Mathias Döpfner (the company’s CEO), who together either directly or indirectly control approximately 45% of the company’s shares, will retain their shares and continue to be involved with the company. We expect the deal to close sometime before year end.
In contrast to these positive developments, relative performance comparisons were modestly hurt by the Funds’ underexposure to Japanese equities, which produced solid returns for the benchmarks during the period, and market price declines in a few technology-related holdings, including Chinese internet-related holdings Baidu and Sina. The Funds also faced declines in a number of other emerging market equities, although the Funds maintain relatively low exposure to these markets.2 This included disappointing price results in Bangkok Bank, a Thai-based bank holding; Antofagasta, a Chilean copper mining company; and Coca-Cola Femsa, a Mexican-based Coca-Cola bottler. Despite a serious attack on Saudi Arabia’s oil production facilities during the period, 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 period as a result of a poor earnings report and near-term outlook. The flooring industry is going through a cyclical 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.
Baidu (BIDU) reported weak operating results in the last two quarters and, after much analysis and discussion, we decided to reduce Fund positions in the stock in early September. 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 the 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.
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; BASF, the German chemical giant; Trelleborg, the Swedish industrial polymer producer; and Fox Corp., the U.S.-based news and sports broadcaster. We also took advantage of pricing opportunities during the period to add to Global Value Fund II’s positions in Konishi, the Japanese adhesives and sealant company, and, as previously mentioned, Tarkett.
On the sell side, we sold the Funds’ remaining shares of Kia, which were 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, Roche, Cisco Systems, and Royal Dutch, among others.
New Additions to Our Fund Portfolios
The new additions to our Fund portfolios, Krones and Fox Corp. (in the Value Fund only), Trelleborg (in all four Funds) and BASF (Global Value Fund II), were all trading at significant discounts to our conservative estimates of their underlying intrinsic values at purchase, and we believe have the ability to compound their intrinsic values going forward at attractive rates. In addition, insiders (e.g., corporate officers and directors) have been buying each of these stocks recently. 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 more than 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 of 2.7% 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, damp 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 merger and acquisition comparables, we believe Trelleborg at purchase was trading at a substantial discount to its underlying intrinsic value. While growth is 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 3.0%.
The “new” Fox Corp., following its sale of certain assets to Disney, 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, Fox now 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 or an owner’s earnings yield (net operating profit after tax/EV) of approximately 8%. We included the benefit or value of 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 significant 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.
Founded in 1865, BASF is a global chemicals company with over 118,000 employees operating in over 80 countries around the world, with leading positions in many of its businesses. BASF is a complex company with 13 operating divisions in five segments – one of which is an oil & gas business. In November 2018, the new CEO, Dr. Martin Brudermüller, announced numerous targets to be achieved over the coming years, including: 1) a substantial cost savings program (totalling €2 billion in annual cost savings by 2021); 2) a new simplified segment reporting structure; 3) annual EBITDA growth of 3%-5%; and 4) annual increases in the dividend per share. BASF will also be disposing of its oil & gas business.
While chemicals can be a cyclical business, BASF appears to be somewhat less cyclical than its peers. The company traditionally operates with a conservative balance sheet, and although BASF did add some leverage with the acquisition of an agricultural chemicals business from Bayer, we expect the firm to return to its historically low level of leverage within the next several years.
At purchase, BASF was trading at roughly 12.3x trailing twelve month earnings and 1.8x book value; had an owner earnings yield of approximately 7.3%; and paid an aboveaverage dividend yield of 4.6%. We expect the company to grow its intrinsic value in line with targeted annual EBITDA growth of 3%-5% over the long run. In addition, there was a significant amount of insider buying in late 2018, in May 2019, and in August 2019.
Continue reading here.
