One of the best resources for value investors are the newsletters at Value Investor Insight (VII), they’re full of great interviews with value investing gurus. VII recently interviewed the team at Tweedy, Browne Co. about their value investing strategy, how to find potential opportunities, and their thoughts on the impact of passive investment strategies and algorithmic trading today. It’s a must read for all value investors.
Here’s an excerpt from that newsletter:
For those seeking portfolio managers who “eat their own cooking,” Tweedy, Browne Co. would certainly fit the bill. At year-end 2016, current and retired principals and their families, as well as employees, accounted for $1.1 billion of the firm’s $16.5 billion under management. Investors inside the firm and out have been quite well served. Since its 1993 inception the flagship Tweedy, Browne Global Value Fund has earned a net annualized 9.3%, vs. 4.9% for the MSCI EAFE Index.
Following a tried-and-true process developed over the firm’s 97-year history, principals Thomas Shrager, John Spears and Bob Wyckoff see opportunity today in such diverse areas as auto parts, insurance, IT distribution, agricultural equipment and Chinese real estate.
Your firm’s compendium, What Has Worked in Investing, is a must-read for value investors, young and old. We imagine its findings are a good place to start in talking about your basic strategy.
Bob Wyckoff: We are quite price-driven in our orientation as value investors, so our process often begins with screening across value metrics that allow us to cut a global universe down to what are likely to be more-interesting ideas. Most of our investments have characteristics that have been associated empirically with above-average investment rates of return over long measurement periods: a low stock price in relation to book value, a low price-to-earnings ratio, a low price-to-cash-flow ratio, an above-average dividend yield, a low price-to-sales ratio compared to other companies in the same industry, a significant pattern of purchases by insiders, a significant decline in share price. There’s a lot more to it of course, and individual analysts here put their own spin on it, but the basic selection criteria described in What Has Worked in Investing have been incorporated in Tweedy, Browne’s investment process for at least 60 years.
Jay Hill: We try to buy companies at two thirds or less of a conservative estimate of what Benjamin Graham called intrinsic value, with intrinsic value defined as what the business would be worth in an acquisition or by estimating the collateral value of its assets and/or cash flow. As Bob said, the first part of the process is to find stocks that meet a statistical fact pattern we find interesting. Often when that’s the case the companies have, shall we say, issues. Our job is to determine if those issues are secular and more permanent, or whether they’re cyclical and otherwise temporary.
Thomas Shrager: Value investing is like going duck hunting. You sit in a blind and wait for the ducks to come. If they come you shoot them down.
Can you generalize about what the “issues” tend to be that help create potential opportunity?
JH: Our investment in agricultural equipment manufacturer AGCO Corp. [AGCO] illustrates one common type of situation that attracts us. We started buying the stock in 2014 at a time when if you looked at long-term average revenues and profitability, you could make a very strong case that the company had normalized earnings power of at least $4 per share, at a time when the stock was in the low-to-mid-$40s. The earnings outlook then was much lower because the #1 determinant of agricultural-equipment demand is farm income and the #1 determinant of farm income is crop prices, and crop prices were – and still are – historically weak. So the near term was uncertain, earnings were declining and it was very difficult to know when that might turn.
But we were very comfortable that the big-picture trends around food consumption were a long-term tailwind that argued for even better than a reversion to the mean. The sell-side in these types of situations tends to value companies at peak multiples of trough earnings, and only shifts to the more mid-cycle earnings and valuation we use when there’s clear evidence the cycle has turned. Investing with a longer-term view when that’s too uncomfortable for others often provides us with an attractive entry point.
Where do your companies tend to fall on the quality spectrum?
JS: If you look at stocks we’ve owned the longest and where we have the largest gains versus our entry prices, they have been in high-quality companies that generate spendable cash profits that they can put to good use. Like a Nestle [NESN:VX], or a Philip Morris International [PM] or a Johnson & Johnson [JNJ]. If you buy a quality business at a big discount to intrinsic value, you get the potential of a double dip – the gap to intrinsic value hopefully closes and then you can also benefit from the company compounding per-share value over a number of years.
At the other end of the spectrum, though, we will also buy into highly cyclical, junkier and low-return-on-capital companies. The stocks of these types of businesses often bob up and down, so we’re just trying to buy them when they trade at a significant discount to what we think they’re worth – in many cases also relative to book value or to net current assets – and then be very sensitive to getting out if and when they reach intrinsic value.
At the end of the day the portfolio is a mix in terms of quality, but in every case we’re paying a price we believe is well below a conservative estimate of fair value.
We see Tweedy, Browne today more as a non-U.S. investor than a U.S. one. Why did that happen?
BW: We examine businesses all over the globe, focusing primarily on the developed world and the more developed of the emerging world. We’ve always liked the idea of having a bigger shopping aisle of opportunity, and the reality has just been that when it comes to entry-point pricing opportunities, we’ve simply found more value elsewhere. The equity culture outside the U.S. is still much less developed than it is in the U.S., which appears to us to result in a greater level of inefficiency.
TS: Remember what I said about ducks? We go where the ducks are. “Small market capitalization” is one of the stock characteristics highlighted in What Has Worked in Investing.
How would you characterize today’s opportunity set for the global investor?
BW: As a price-sensitive investor, it has been a tough environment. To give a sense of that, we recently did a global screen of nearly 5,800 non-financial companies with market values greater than $300 million, positive free cash flow over the past 12 months, at least an 8% return on equity over the past 12 months, net debt to EBITDA of no more than 2.5x and a trailing EV/EBIT multiple of no more than 8x.
Between 2010 and 2012, we would have had 650 to 800 companies meet that criteria. Today the number is 188, concentrated largely in retail, auto parts, homebuilding, airlines and precious metals. The odds are that we’re in for a bit more volatility going forward – which can help us find the entry points we need – but it’s not easy for us to put money to work right now.
One final question: Has the ongoing rise of passive investment strategies and algorithmic trading at all impacted how you do things?
BW: Breaking that down a bit, there’s no question that well-constructed quantitative models can be tough competitors, but it hasn’t impacted our process or strategy. Automated buying and selling can impact how securities trade, but behaviorally things haven’t fundamentally changed. Investors still overreact on the upside and the downside, and if anything, algorithmic trading often accentuates those moves and creates pricing opportunities for people like us to exploit.
We view rapid flows into passive strategies as a cyclical phenomenon which invariably distorts equity valuations in the later stages of a bull market. When we do have a difficult time in the equity market, as we invariably will, you’ll see a comeuppance for index funds and you’ll see active managers attract much more interest.
A great “unwind” typically inures to our benefit as value investors due to relative out-performance. Even John Bogle is lamenting the massive flows of funds from traditional index mutual funds into specialized ETFs that can be traded on a minute-by-minute basis. This may all seem a bit unsettling, but think back to 2009 when market commentators were hailing the “death of equities.” Stay tuned, things have a way of changing.
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