Tweedy Browne Fund 2Q15 Letter: Value Investing & Market CyclesVW Staff
Tweedy Browne Fund commentary for the second quarter ended June 30, 2015.
Concerns about Greece’s possible exit from the eurozone and a sharply correcting Chinese equity market appeared to drive global equity indices lower around quarter-end, forcing benchmark indices (in local currency) and in turn, our Funds’ returns into flat to marginally negative territory for the quarter. All sectors and most industry groups finished the quarter in the red. This increase in equity market volatility, which occurred during the quarter, continues as we write this update, and we are hopeful this portends pricing opportunities for our Funds in the weeks and months ahead.
On a positive note, our portfolios’ tobacco holdings, Imperial Tobacco and Philip Morris, demonstrated their defensive character by producing solid returns during the quarter, as did several of our banks, Wells Fargo, DBS Group and UOB. We also had a very nice return in TNT Express in our two international Funds, Global Value and Global Value II, after Federal Express announced that it would be acquiring the company. Just after first quarter end, Federal Express announced that it would be acquiring TNT Express, the Dutch parcel company, in an all cash offer of eight euros/share, or a 37% and 39% premium over our cost in the shares. As you will recall, we purchased TNT a couple of years back, after its previously proposed merger with UPS fell apart when European regulators failed to approve the deal, feeling it would be anti-competitive. We believe there should be no competitive issues with Federal Express this time, as its footprint in Europe is much smaller than that of UPS. Federal Express was able to use a strong currency (the US dollar), and extremely low-cost debt to secure a deal that we believe is attractive for all parties to the transaction.
Leading the decliners in the Tweedy Browne Funds’ portfolios during the quarter were several of the portfolios’ oil & gas, insurance, and pharmaceutical holdings, which included companies such as Royal Dutch, Total, Munich Re, Zurich Insurance, GlaxoSmithKline, and Novartis. One of our media holdings, Axel Springer, also was down for the quarter as were Hyundai Motor and Kia, our two recent Korean auto purchases.
With the increase in volatility during the quarter, we had an opportunity to add a few new positions to our Fund portfolios including Hyundai Motor, Kia, and a couple of Hong Kong-based smaller capitalization companies. We also added to various positions including GlaxoSmithKline, HSBC, Verizon and Standard Chartered Bank. Aside from the sale of a couple of smaller Japanese and Korean holdings and one New Zealand holding, there were few outright sales in the portfolios; however, we did trim back a few positions including Imperial Tobacco and Emerson Electric. Two of our more recent purchases, Hyundai Motor and Kia, belong to the same “chaebol” in South Korea, and both have demonstrated an ability to grow their intrinsic values at attractive rates over the longer term. They have become significantly more competitive against their Japanese rivals in recent years as quality and customer satisfaction ratings have risen at both companies. At purchase, both companies were trading at discounts to book value, less than 10X earnings and at substantial discounts to our estimates of their intrinsic values.
Looking forward, valuations remain high despite the recent bumpiness in global equity markets. As of June 30, 2015, the weighted average price/earnings ratios on the top 25 holdings in our Tweedy Browne Funds ranged from 15.5X to 17.6X 2015 estimated earnings, and the weighted average dividend yield ranged from 2.97% to 3.94%. Cash reserves remain somewhat elevated, more so in our two international funds, and as of June 30, 2015, totaled between 8.8% and 25.6% across our Funds. (Please note that the weighted average dividend yields shown above are not representative of the Funds’ yields, nor do they represent the Funds’ performance. The figures solely represent the average weighted dividend yields of the common stocks held in each of the Funds’ portfolios. Please refer to the 30-day Standardized Yields in the performance chart on Page 1 for each of the Fund's yields.)
Tweedy Browne Fund - Thoughts about recent underperformance
As you know, equity return streams are lumpy by their nature. We can identify companies that we believe are undervalued at purchase, but have no control as to when (or if) that value gets recognized in public markets. That recognition often occurs with a great deal of randomness. Therefore, in all investment records, there is an element of both luck and skill. As we mentioned in our semi-annual report, since a multitude of variables move stock prices around, particularly in the short run, it is virtually impossible to divine skill from luck without a large sample size, i.e., a very long record. As Michael Mauboussin, the noted investment strategist and behavioralist, pointed out in his book entitled The Success Equation:
In a game of poker, a lucky amateur may beat a pro in a few hands but the pro’s edge would become clear as they played more hands… only a small percentage of investors possess enough skill to offset fees. As a result, investing, especially over relatively short periods of time, is more a matter of luck than of skill.
One thing we have in abundance at Tweedy Browne, given our long history and pedigree, are long investment records, and those records have for the most part bested benchmark indices since their respective inceptions. This also holds true for all four of Tweedy Browne Funds, however, those return streams have been lumpy with multiple interim periods of underperformance. And yet this periodic underperformance has been part and parcel in our case of long term successful index-besting records.
Our most recent period of underperformance, for example, in the Global Value Fund began in 2013 and extends through today. In 2013, we produced an absolute return in excess of 19%, while carrying cash reserves of approximately 16%. As we have suggested to many clients, if at the end of 2012 we had offered them a guarantee of a 19% plus return for the coming year, while carrying some dry powder to protect on the downside, and provide optionality for new purchases at attractive prices, would they have accepted that deal?
We think we all know the answer to that question. The real impact of underperformance in the Global Value Fund has taken hold over the last 18 months, and the reason for the underperformance is largely our cash reserve position, an underweighting in Japanese equities, a modestly overweighted position in oil & gas related businesses, and the fact that we hedge our perceived foreign currency exposure, which means we have not been 100% nominally hedged during a period of significant US dollar strength.
Invariably, in our Funds, periods of strong relative performance have been followed by periods of weak relative results, which have been followed by periods of good results, and so on, resulting in a very good long term absolute and relative return experience. As we have recently explained to clients, we have seen a version of this movie several times in our decades here at Tweedy Browne. We underperformed in 1998 and 1999, as cash built in our portfolios and technology took over the market capitalization of global indices.
We, of course, experienced redemptions when the tech bubble burst in March of 2000, whereupon our Funds significantly outperformed the index over the three years that followed. Global equity markets took off again in 2003, and in 2005 we closed our doors to new business across the board as cash began to build once again in our portfolios culminating in the credit crisis market implosion of 2008.
Our Fund portfolios underperformed their respective benchmarks for the 2005 through 2007 period, and once again, the Funds were redeemed somewhat in 2008. For example, coming out of the gate of the next bull market, the Global Value Fund subsequently and surprisingly in our opinion, outperformed in each of the years between 2008 and 2012.
This stretch of five straight years of outperformance was pretty long for us. Once again, we find ourselves in what appears to be a rapidly aging bull market (6.5 years with a hiccup in 2011), and, since 2012, cash reserves have grown considerably in the Global Value Fund, as undervalued stocks have become increasingly difficult to uncover. This ebb and flow of cash reserves, increasing during periods of buoyant valuations, and decreasing during periods of undervaluation, is a natural by-product of a serious and disciplined value-driven investment approach.
We might also add that the residual cash has dampened volatility, which generally makes the ride somewhat more tolerable for clients. While there are no guarantees, in our past experience we have generally underperformed in aggressively bullish environments and gained considerable ground against benchmark indices in difficult market environments, and this is consistent with what we believe most clients would expect from our investment approach. In fact, if we were winning big right now in this environment, it would certainly seem “out of step” with the pattern of our historical returns and no doubt prompt some questions.
On the pages following this narrative, we have included two charts that we believe provide additional perspective on the Global Value Fund’s 22-year investment record. The first chart shows the 3-, 5-, and 10-year rolling average returns for the Fund versus its benchmark, which clearly demonstrates that, the longer the measurement period, the greater the consistency in relative outperformance. The second is a scattergram that examines 3-year rolling returns for the Global Value Fund as compared to the MSCI EAFE Index (Hedged to USD) for different types of equity market environments. The chart illustrates that periods of relative outperformance for the Fund tend to occur in “bear” and more “normal” market environments, while periods of relative underperformance tend to cluster in very robust, more “speculative” market environments, like the one we have been in over the last three years.
Anecdotally, there are a number of factors that suggest valuations are stretched in today's markets. While these factors are primarily associated with US markets, we believe the direction holds true in developed markets abroad as well. The S&P 500, the DJIA and the MSCI World Indexes hit all time highs earlier this year. Simple P/E ratios are at 18 to 19 times trailing earnings. The Schiller Cyclically adjusted P/E ratio is at 26 as compared to its historical average of 16. The Buffet Valuation indicator (total market capitalization/GDP) is at approximately 132 or nearly twice its historical mean. 2014 marked the biggest year for US-listed IPOs, by both number and proceeds raised, since 2000. Private equity investors are routinely quoted in the press indicating what a wonderful time this is for selling businesses. Corporate lending standards are beginning to deteriorate as large LBOs are being screened in the context of 6X to 7X debt multiples (proforma debt to ebitda). CLO issuance reached $124 billion in 2014, higher than the previous peak of $97 billion in 2006. Covenant lite loans represent greater than 50% of new leveraged loan volume and PIK (payment in kind) toggle loans are back. Also, in our portfolios, many of the stocks we own today are at or near our estimates of fair value, and a few are above those estimates. The only place fear seems to reside in global equity markets today is in commodity related businesses, i.e. oil & gas, mining, metals, and some agriculture related businesses. Higher quality industrial companies, branded consumer products companies, pharmaceutical companies, and many financial related businesses we have analyzed trade near, at, or well above our estimates of fair value. As we think you know, we build our portfolios company by company based on our view that each company has a fundamentally attractive price to value relationship. Good entry point prices are important for long term success, and they are very difficult to uncover in this liquidity fueled environment which we have been in over the last several years.
Finally, if one measure of skill is, as we believe, whether an investment advisor delivered returns that were greater than the risks assumed to produce those returns, then it would be paramount to examine the risks of the advisor’s portfolio as compared to the risks inherent in the benchmark index. In this regard, we believe that when measured fundamentally, our Tweedy Browne Funds’ portfolios are hands down intrinsically less risky than the benchmark portfolios to which they are constantly being compared. Examined in that light, it would be possible for a good advisor to deliver returns that were less than those produced by the benchmark index but much better when evaluated against the risks assumed by the respective portfolios.
The underperformance of our value driven strategy over the last couple of years, we would contend, is quite normal and to be expected in the later stages of a bull market when equity valuations become untethered from underlying intrinsic values. While there are no guarantees, we believe that this too will eventually pass, and we will once again have new opportunities. We like what we currently own and are between 74% and 91% invested in equities across our Funds, which means we believe we will participate significantly if equity markets continue their advance, but will likely trail fully invested indices. If there is a correction or markets get choppy with increased volatility, we feel we are in a position to take meaningful advantage.
Thank you for investing with us and for your continued confidence.
Tweedy Browne Company LLC
William H. Browne
Thomas H. Shrager
John D. Spears
Robert Q. Wyckoff, Jr.
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