Tweedy Browne Fund 2015 Annual Letter: "volatility begets more volatility"VW Staff
Tweedy Browne Fund’s investment adviser’s letter to shareholders for the year ended December 31, 2015.
“Interest rates are, of course, prices. They are the prices that set investment hurdle rates and that discount the present value of estimated future cash flows. They are the traffic signals of a market economy.”
“Far better that they be discovered in the marketplace than administered from on high.” – James Grant, editor of Grant’s Interest Rate Observer
Anyone tasked with having to explain the movement of equity markets around the world since our last letter six months ago has a job we certainly wouldn’t willingly volunteer for. To the extent equity markets are a proxy for the overall health of and outlook for the real world, in both an economic and political sense, the patient appears to swing between bouts of fever and complete remission. Volatility, which we believe benefits the few at the expense of the many, has been the defining characteristic of markets of late, and we believe volatility begets more volatility as “investors” try to capture returns from short-term price movements. We do wonder how many of those involved in this effort can be “winners” and how many of those “winners” consistently win. A strategy dependent upon outfoxing the next guy doesn’t strike us as a good formula for success over a longer time horizon.
The economic and political backdrop prevailing today surely accounts for a large part of the volatility in financial markets. The list of economic worries, however, does not seem to have lengthened appreciably over the past six months, with perhaps two exceptions: 1) the upcoming referendum in the U.K. on Great Britain leaving the European Union and the economic consequences of a “yes” vote; and 2) the immigration crisis in Europe, which is seen as a new test of Europe’s resolve to maintain a single political union. Continuing worries include turmoil in the Middle East, economic prospects in China, increasing doubts as to the success of Japanese policies to move Japan’s economy on to sustainable growth, disappointing economic growth in Europe, and inadequate growth in the U.S., depending on whether you are in the “glass half empty” or the “glass half full” camp. Again, these are not new, but they do seem to move on and off the front page periodically. A more astute observer could no doubt add to this list.
The other major element contributing to market volatility has been the continuing inability of governments and, more specifically, central banks to boost their economies by driving the cost of money (interest rates) to levels not seen in our fairly long lifetimes. A recent Bloomberg News article pointed out that yields on approximately $7.8 trillion of government debt around the world are currently negative.1 Ireland recently issued a 100-year bond with a yield of 2.35%. As of March 31, 2016, ten-year German government bonds yield .15%, while Japanese ten-year government bonds have a negative yield of .03%. Interestingly, corporate bond yields have dropped significantly, with the most glaring example being Unilever issuing bonds due in 2020 with a zero coupon and a yield of .08% (unlike governments, corporations can’t print money to refinance their debt). Whether there will be serious economic and political consequences in the future as a result of this experiment in global monetary largesse remains to be seen.
To us, it doesn’t seem surprising that, some six years into rising equity prices, negligible to no yield in fixed income markets, and an uncertain economic backdrop, there is an almost irrational search for returns. Obviously, there have not been many bargains to be had in this environment, and it has been in general a hard couple of years for investors such as us, who have been forced to step back from the “dance floor.” However, in a strange twist of fate, we believe the recent heightened level of volatility and uncertainty will, as it has in the past, produce opportunities for us to exchange more of our and your dollars for more promising investment opportunities. In this sense, we are optimistic that history will repeat itself.
Tweedy Browne Fund - Investment Performance
Over the last few calendar years, the Tweedy, Browne Funds have trailed their respective benchmark indexes as rapidly declining interest rates and massive flows into index funds fueled high and escalating equity valuations, resulting in a widening spread in favor of growth over value strategies. During this period, growth in equity prices far outstripped growth in underlying corporate profits (which have been anemic at best) with the bulk of returns taking the form of expanding price/earnings ratios. We have witnessed similar periods of irrational exuberance three different times in the last 18 years – in the run-up in valuations during the technology bubble between 1998 and 2000; the credit fueled expansion between 2005 and 2007; and today’s liquidity driven market. In each of these periods, value investors such as ourselves underperformed as valuations climbed to levels that were simply unsustainable. This too shall pass, and we believe the screw appears to be turning as we write. With the exception of the Worldwide High Dividend Yield Value Fund, which modestly underperformed its benchmark over the last three months, our remaining three Funds all outperformed their benchmarks in the first calendar quarter of this year, which led to an index-beating result, albeit negative, over the last fiscal year in our two global value funds.
Presented below are the results of the Tweedy Browne Funds for various periods through March 31, 2016, with comparisons to their respective benchmark indexes.
We have found over the years that a precondition to an excellent long-term investment record is an ability to withstand periods of relative underperformance. Sometimes these periods can last for stretches of time that are challenging, and almost invariably uncomfortable. We are hopeful that we are nearing the end of what has been a difficult, but quite normal one of those periods currently with respect to our value driven investment approach. Over the last two calendar years, the spread between the growth and value components of the MSCI World Index widened to levels last seen in 2007, immediately before the financial crisis, and before that, leading up to the bursting of the technology bubble in 2000. In fact, in 2015, four of these “growth” securities (the so-called FANG stocks: Facebook, Amazon, Netflix, and Google) accounted for 51% of what was a mediocre return for the index. As of calendar year-end, the trailing 12 month price/earnings multiples for these four companies were 82x, 544x, 402x, and 33x, respectively. While we purchased Google (now called “Alphabet”) for the Value Fund a few years ago when it was trading below our estimate of its intrinsic value, none of these securities qualifies for purchase in a value based portfolio today. In fact, if we had purchased them, you would no doubt be wondering if we had lost our way. We have been through periods like this before, and we will go through them again. It goes with the territory.
Our Funds hold different securities than benchmark indexes, so it goes without saying that the results will differ over time from the index, often markedly so in the short run. As Ben Graham postulated many years ago, “the market is a voting machine in the short run, but a weighing machine in the long run.” It is fair to say from an examination of what follows that our value based approach, up until more recently, has not been “receiving the votes” that the indexes have been receiving, particularly over the last two to three years. We are not alone, as some of the world’s most acclaimed value investors have shared our experience.
While the underlying growth of our estimates of intrinsic value for the bulk of the securities held in our Fund portfolios has progressed quite nicely over the last several years, the stock market’s pricing of that increase in intrinsic value has paled in comparison to its pricing of securities enjoying more near term price momentum. Nowhere has this been more apparent in our Fund group than in the Worldwide High Dividend Yield Value Fund, perhaps the most defensive of our four Funds. This Fund has delivered a satisfactory absolute return of 20.5%2 on a cumulative basis since 2011, a year when it bested its benchmark by a considerable margin and was our best performing Fund. However, it trailed its benchmark index during this period. The good news is that this phenomenon has been quite common along the course of long-term return streams, particularly in the later stages of a bull market, and empirically has not been predictive of poorer relative results over longer-term measurement periods for the fundamental, value driven investor. In fact, over the longer term, value investors such as ourselves have often delivered premium returns to the benchmark net of fees, generally at lower levels of volatility and underlying fundamental risk. Our long-term track records for each Fund (other than the Worldwide High Dividend Yield Value Fund) and independent empirical studies bear this out. In fact, an examination of the up and down periods that comprise our long-term investment results has indicated that the best time to have invested with Tweedy Browne in the past has often been after a period of underperformance such as we have experienced over the last several years. (Past performance is no indication of future results.) Unfortunately, to achieve the long-term benefits of a value driven strategy, clients must be willing to stay the course during periods of underperformance, which can challenge confidence. However, for those with patience and fortitude, better returns have often followed, for the markets are indeed “weighing machines” over the long term.
Here are some of the facts associated with our results to date as they compare to the MSCI World Index and the MSCI EAFE Index:https://valuewalkpremium.com/2016/05/death-zurich-insurance-ceo/
- The indexes do not include fees and expenses and are fully invested at all times, while our Fund results are net of fees and reflect average cash levels over the last several years of 10% to 20%.
- The fundamental risk, in our opinion, remains low in our Fund portfolios, which consist for the most part of larger capitalization, higher quality businesses with low leverage and, often, a history of consistent and growing dividends, priced at the time of purchase to afford what we believe to be significant collateral value protection.While we do not view volatility as risk, for those that do, the standard deviation3 of returns of our Fund portfolios has compared favorably to that of their respective benchmark indexes.
- On a market capitalization weighted basis, the MSCI World Index as of March 31, 2016 had 59% of its value in U.S. domiciled equities and 8% of its value in Japanese equities, versus 44% and 1%, respectively, for the Value Fund, and 22% and 0% for the Worldwide High Dividend Yield Value Fund. In addition, the MSCI EAFE Index had 22% of its assets in Japanese equities versus 1.4% and 2.2%, respectively, for the Global Value Fund and Global Value Fund II – Currency Unhedged.
- Together, the U.S. and Japan accounted for 86% of the return of the MSCI World Index over the last three calendar years; while Japan alone accounted for 38% of the performance of the MSCI EAFE Index. Price/earnings multiples in the U.S. and Japan have remained high, averaging approximately 17x and 18x, respectively, over the period October 2011-January 2016. Being underweighted in these two countries, where valuations have been high and (in the case of Japan) above-average dividends scarce has been a significant impediment to our ability to achieve indexbesting returns during this period.
- During 2014 and 2015, the performance spread between the value component of these benchmarks and the growth components (1,077 basis points for the MSCI World Index and 1162 basis points for the MSCI EAFE Index) widened to levels last seen in 2007, immediately before the financial crisis, and before that, leading up to the bursting of the technology bubble in 2000. The chart below illustrates this dichotomy for the last calendar year.
As we’ve discussed in recent letters, we believe that virtually all of the relative underperformance of our Funds versus their respective benchmarks in 2014 and 2015 is explained by our Funds’ cash positions, their underweightings in Japan and, with respect to the Value Fund and the Worldwide High Dividend Yield Value Fund, the U.S., poor relative currency translations in our unhedged Funds, and a few positions in oil & gas and Asian-related bank stocks. The cash reserves were, for the most part, residual and reflected our inability to find enough undervalued securities in this momentum driven market; the underweightings in Japan and the U.S. are understandable in light of valuations; currency translations are beyond our control and have been volatile to say the least; and our oil & gas and Asian related bank stocks to date simply haven’t met our expectations.
As we write, with the exception of the Worldwide High Dividend Yield Value Fund, year-to-date, our Funds are once again besting their benchmark indexes, which has allowed our two Global Value Funds to also move ahead of their benchmarks for the twelve months ending March 31, 2016. In the past, periods of underperformance have almost always been followed by periods of relative outperformance. While this pattern is not guaranteed, nothing has significantly changed at Tweedy Browne in terms of people, process, or approach, and we hope that Tweedy's successful past will be prologue for the future.
Tweedy Browne Fund - Impact of Volatile Currencies
Low to negative interest rate policies outside the U.S. have been in part responsible for increasing volatility in foreign currencies and the continued strength of the U.S. dollar. Commercial banks must now pay the European Central Bank, the Danish National Bank, the Swedish National Bank, the Swiss National Bank, and, more recently, the Bank of Japan to hold their reserves. The sovereign bonds (two-year maturities) of 12 European countries and Japan now carry negative interest rates. The increase in currency volatility that these low and negative interest rate policies have in part spawned has had significant impact on unhedged returns over the last several years. For example, shareholders in our unhedged Funds (Global Value II and Worldwide High Dividend Yield Value) were diluted during this period by the strong U.S. dollar, while shareholders in our currency hedged Funds (Global Value and Value) were largely protected from poor currency translations. However, with the U.S. dollar weakening in the first quarter, currency hedging over the last fiscal year had a negative impact on the returns of our two hedged Funds.
As a reminder, in our Global Value and Value Funds, our practice is to hedge what we believe to be our “perceived” foreign currency exposure, as opposed to fully hedging our “nominal” exposure. This means that many of our larger multi-national portfolio companies that have significant revenues and earnings in the U.S. dollar are not fully hedged, but rather are partially hedged to the extent of their approximate non-U.S. dollar revenues and earnings (as of March 31, 2016, 71% and 68% of the Global Value and Value Funds’ foreign currency exposure, respectively, was hedged back into the U.S. dollar). For example, a company such as Nestlé, which earns a substantial amount of its profits in U.S. dollars, is only partially hedged. We believe that its U.S. dollar revenues and earnings act as an implicit hedge. When the U.S. dollar strengthens versus the Swiss franc, Nestle’s U.S. dollar based earnings translate into more Swiss francs, thereby boosting Nestlé’s Swiss franc earnings and intrinsic value, which offsets to some extent the U.S. dollar based investor’s loss from the translation of a weak Swiss franc back into a strong U.S. dollar. To fully hedge the currencies of companies such as Nestlé would, in our opinion, be to overhedge those positions. The hedged MSCI World and EAFE Indexes, on the other hand, are fully hedged back into the U.S. dollar, which puts our currency hedged Funds at somewhat of a competitive performance disadvantage versus those indexes when the U.S. dollar is very strong, as it has been over the last several years.
Tweedy Browne Fund - Our Fund Portfolios
Please note that individual companies discussed herein were held in one or more of our Funds during the fiscal year, but were not necessarily held in all four of our Funds. Refer to footnote 6 at the end of the letter for the individual weightings of these companies in the respective Funds as of March 31, 2016.
Global equity markets over the last year are perhaps best characterized by a roller coaster ride, with the violent downtick of late last summer followed by a resurgence in equity prices in the late fall that led to another comeuppance as we headed into the new year, only to be followed again by a runup in equity valuations in late February and March.When the dust settled, there was very little change in U.S. equity valuations as measured by the S&P 500 year over year; however, non-U.S. equity valuations in developed markets, as measured by the MSCI EAFE Index, finished the twelve months ended March 31, 2016 down approximately 11% in local currency and 8% in U.S. dollars. While we welcomed this volatility for the opportunities it brought, our Funds did lose some ground on an absolute basis over the last fiscal year. Perhaps the greatest impact from the market’s turbulence in the Funds’ portfolios occurred in our oil & gas, bank, and pharmaceutical holdings. Oil prices became increasingly more volatile over the last year, negatively impacting our oil related stocks; difficulties in the oil patch, together with increasing uncertainty surrounding China’s economy, dragged down our Asian related bank holdings; and our pharmaceutical stocks in part faced political headwinds.
Energy related holdings such as Halliburton and oil & gas production companies such as Devon Energy, Cenovus, Total, and Royal Dutch were up and down over the last fiscal year (mostly down), as oil prices vascillated between $30 and $60 per barrel, even dipping down into the $20s briefly after calendar year-end. While your crystal ball is as good as ours, we continue to believe that, given industry demand and cost considerations, oil prices are likely to move higher over the longer term, and if that indeed bears out, we are well positioned in what we feel is a diversified and undervalued group of companies in the sector. We also have little doubt that the oil companies currently in our Fund portfolios have the financial resources to weather this period of lower energy prices.
While our bank stocks as a group were being buffeted by slowing global growth, increasing concern about the Chinese economy and collapsing oil prices, it is our position in Standard Chartered Bank that has to date proven to be the most disappointing. As you know from our prior letters, we first purchased shares in this emerging market dependent bank back in 2013, after it had declined from 18 pounds to approximately 13 pounds per share, a price we felt did not adequately account for its future prospects. As Will Browne has sometimes said, “there is a fine line between being early and being wrong.”
At the time of purchase, Standard Chartered, in our view, was conservatively financed, traded at a significant discount to our estimates of its intrinsic value, and paid an attractive dividend. That dividend was omitted last November due to mounting capital concerns, loan losses and uncertainty associated with the bank’s oil & gas loan book. As of fiscal year-end, Standard Chartered was priced at roughly 50% of its tangible per share net asset value (book value). If Standard Chartered’s earnings power were to recover to a 10% return on tangible equity (based on today’s book value), it would generate a 20% after-tax earnings yield on the current price. In other words, the current stock price would be 5 times aftertax earnings, if earnings recover to a 10% return on equity. In the past, banks in Asia have been acquired at significant premiums to tangible net asset value and at more than 10 times after-tax earnings. The bank is in the midst of a restructuring with new management, and appears to be taking all the right steps to put it back into a more competitive and more profitable position. That said, the near-term headwinds are significant. We continue to monitor the position carefully, and have eliminated it from our Worldwide High Dividend Yield Value Fund because it suspended its dividend.
As you also may know, we have investments in two Singapore banks, DBS Group and United Overseas Bank, both of which, in our view, are high quality, conservatively financed, and well-managed banking institutions that have significant growth prospects and currently pay us very attractive, 3% to 4% annual dividend yields. These bank investments have not been getting the votes from “Mr. Market” over the near term; however, over the longer term, China and other parts of Asia will, in our opinion, continue to grow at rates in excess of the growth rates found in most of the Western world, and we believe these banks should remain significant beneficiaries of that growth.
Despite near term challenges in our oil & gas, bank, and pharmaceutical stocks, the bulk of our Fund holdings made financial progress during the year. With markets in a state of flux, it is not surprising that it was some of the more defensive components of our Fund portfolios that performed the best over the last year. This included tobacco holdings such as Imperial Brands, Philip Morris and British American Tobacco; the Dutch and UK based food giant, Unilever; and beverage companies such as Diageo, Heineken and the Chilean Coca-Cola bottler, Embotelladora Andina. We also had strong results in our technology companies, Cisco and Google (now Alphabet), which, when we purchased them a few years ago, were simply too cheap to pass up, and had solid prospects for continued growth in intrinsic value. MasterCard and Verizon were also strong contributors to the year’s returns, as was TNT Express, as its deal with Federal Express was formally approved by European regulators.
The volatility of last summer and early this year allowed us to establish some new positions in our Funds and to make additions to a number of other pre-existing positions, working down the Funds’ cash reserves somewhat. Last summer, we began purchasing shares in two Korean automobile companies and their parts manufacturer. At purchase, Hyundai Motor, Kia, and Hyundai Mobis were all trading at discounts to book value and mid-single-digit price/earnings ratios. The reputations of these companies in terms of product quality and customer satisfaction have risen dramatically over the last decade, but a strong Korean won and concerns about Chinese demand in the near term gave us a pricing opportunity in the shares.
We also established positions in MRC Global, a U.S.- based but global distributor of pipes, valves, and fittings largely for the oil & gas industry; Ebara, a mediumcapitalization Japanese manufacturer of pumps, compressors, and incinerators; IBM, the information technology giant; Linde, the German industrial gas company that we had owned in the past; and, more recently, Avnet, a highly regarded global distributor of computer products and semiconductors. All five of these companies at purchase were trading at discounts from our conservative estimates of their respective intrinsic values. In addition, we believe they are financially strong and have attractive prospects for future growth in intrinsic value. Moreover, in the case of IBM, we currently receive an attractive dividend yield as we wait for value recognition in the market.
On the sell side of our Fund portfolios, we sold our remaining shares of BBA Aviation, Kuroda Electric, Samyang Holdings, Leucadia, and Imperial Brands, all of which had traded up to or near our estimates of their respective intrinsic values. As previously mentioned herein, we sold Standard Chartered in the Worldwide High Dividend Yield Value Fund. We also rationalized our oil & gas exposure somewhat by selling Cenovus, ENI, National Oilwell Varco and Vallourec, all four of which are facing more severe headwinds than most from low oil prices. We also took advantage of pricing opportunities to trim back a number of other holdings that were trading at, or marginally above, our estimates of intrinsic value, including Headlam Group, American National Insurance, Johnson & Johnson, Novartis, Roche, and Nippon Kanzai, among others.
As we write, our Fund portfolios remain, in our view, well positioned with a diversified mix of businesses that, in our estimation, are mostly reasonably valued and underleveraged and, as a group, appear to have strong future prospects, pay attractive dividends and have the financial strength to weather whatever storms may come their way. In addition, the Funds carry meaningful, but declining levels of cash reserves. Should global equity markets continue their advance despite recent volatility, our Funds should participate; however, should we revisit the instability of January and early September, we believe we are well positioned to take meaningful advantage.
Tweedy Browne Fund - Looking Forward
We have worked hard over the years to develop a “repeating golf swing” in the investment business – one that we hope will allow for some consistency of results over the longer term. While we believe our long-term records demonstrate some success in our service to shareholders, we remain humbled by the day-to-day vagaries of our capital markets, and how little control we ultimately have over our investment fortunes in the short run. The stocks we own don’t know that we own them, and therefore do not behave in ways that are always consistent with our near-term interests. We can ferret out pockets of what we believe to be undervaluation in our markets and individual securities that offer clues to future investment opportunity, but we have no assurance as to when, or if, that value will be recognized by other market participants, or by an acquirer.
In Plato’s Apology, considered by many to be one of his finest works, Plato offers his version of a speech given by Socrates over twenty-four hundred years ago where he postulated the following paradox in his lifelong quest for wisdom:
… it seems that neither of us knows anything great, but he thinks he knows something when he does not, whereas when I do not know, neither do I think I know. So it seems I am wiser than he in this one small thing, that I do not think I know what I do not know.
As with Socrates’ disdain for the arrogance of those who think they know, Benjamin Graham humbly fashioned an investment methodology focused on the knowable while protecting mightily against the unknowable. Distinguishing between investment and speculation, he required in his analysis for the former a “margin of safety,” “available for absorbing the effect of miscalculations or worse than average luck,” and placed “particular emphasis on the ability of the investment to withstand adverse developments.” In addition, Graham opined that:
Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings. Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy. But such claims are unconvincing. They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase… Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.
While there is much that remains unknowable in financial markets, what we do know is that Graham’s “big idea” – that a common stock represents a fractional ownership interest in a business and that the essence of investment is to attempt to exploit discrepancies between the intrinsic value of a business and its price in publicly traded markets – has empirically and practically worked over the long term. We have done our best at Tweedy Browne over these past 95 years to hone an investment organization that can execute on Graham’s promise. It is fair to say that our “road to Damascus” moment as an organization came when our forebears first met Ben Graham and adopted the tenets of his approach, and, to the extent we have achieved some success along the way, it can be largely explained by our steadfast commitment to that discipline. Today’s investment team remains unwaveringly dedicated to those principles, and we are confident that they will continue to serve us well over the long term.
Thank you for investing with us, and for your continued confidence. We work hard to earn and keep your trust, and we believe it is critical to our mutual success.
TWEEDY BROWNE COMPANY LLC
William H. Browne
Thomas H. Shrager
John D. Spears
Robert Q. Wyckoff, Jr.