Tweedy, Browne's 1st Quarter Investment Adviser Letter to Shareholders

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Jun 04, 2019
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Investment Adviser’s Letter to Shareholders

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply, and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

– Benjamin Graham,

The Intelligent Investor – Revised Third Edition (1965)

To Our Shareholders:

It was quite a roller coaster ride for global equity markets in 2018. After gaining increasing momentum during the early weeks of the year, global equity markets hit major turbulence in late January and early February 2018, tumbling as much as 8%-10%. They recovered somewhat later in February, only to hit another patch of choppy air in mid- to late March. The turbulence was thought to have been brought on by the first signs of wage pressure, an associated and unexpected rise in interest rates and inflationary expectations, a host of macroeconomic worries including the prospects for continued monetary tightening in the U.S. and Europe, and mounting trade tension between the U.S. and many of its major trading partners. However, beginning in early April 2018, markets rebounded. The S&P 500 Index climbed to all-time highs by mid-September, and most international indexes were up significantly as well. The exuberance was short-lived, however, as markets faced a major come-uppance (demonstrated by double digit declines) in the fourth quarter of 2018, and even broached bear market territory just before Christmas – only to recover somewhat during the last week of the year. It was an unsettling ride for investors to say the least. The tumult at year-end erased much, if not all, of the financial progress made by most investors during the year, and drove investment results for most international and global equity managers deep into negative territory.

In early January 2019, the U.S. Federal Reserve’s pivot to a more dovish approach to near-term monetary policy, coupled with indications of some progress in ongoing trade negotiations between the U.S. and China, helped to kick-start a significant rebound in global equities, propelling the S&P 500 Index during the first quarter of 2019 back toward its previous record high. U.S., global, and international developed market indexes finished a remarkable quarter, up between 10% and nearly 14%, despite evidence of slowing economic and corporate profitability growth in the U.S. and abroad.

Time and time again, when “Mr. Market” becomes agitated, he can become a good friend to the dispassionate value investor. In our view, the unsettling market turbulence at year-end, although short-lived, spawned a significantly improved opportunity set for price-driven investors such as ourselves. As we mentioned in our last letter to shareholders, idea flow has perked up considerably of late, and we have been busy planting seeds for potential future returns. However, as we write, valuations are once again on the rise, and there is evidence of an escalation in risk taking on the part of investors. With growth prospects in question in many, if not most, parts of the world, accommodations by central bankers may or may not be enough to support higher valuations. We believe our Fund portfolios are not only well positioned to benefit on an absolute basis should the market continue its seemingly inexorable advance, but should also hold up well on a relative basis if we have a return to the volatility experienced in the fourth quarter of 2018.

The Death of Value, Not So Fast!

Everything should be made as simple as possible, but not simpler.

– Albert Einstein

The value investing community is once again being taken to the woodshed in the financial press, as formerly reliable value metrics such as low price-to-book (P/B) and low price-earnings (P/E) ratios have proven of late not to be as profitable as simply paying up for disruptive technology stocks.

As we have mentioned in recent letters, this is the third time in the last 18 years that the value style of investing has been declared compromised at best, and dead or dying, at worst. We have now entered the 10th year of a highly resilient and seemingly never-ending economic expansion. One only has to think back to the tech bubble in 2000 and the peak of the credit and real estate cycle in 2008. We all know what followed these prior euphoric periods, but memories remain short, particularly when the valuations of risk assets are gaining momentum.

Embedded in this denigration of value is, in our view, a misunderstanding of what constitutes true value investing. For example, we believe the common practice of characterizing investment managers and their investment styles as either “growth” or “value,” based solely on a few valuation metrics such as P/B value and/or P/E is inherently flawed. These valuation metrics, by themselves, fail to take into consideration important company attributes that are critical to a rational and comprehensive assessment of a company’s intrinsic value – attributes such as a company’s industry dynamics, prospects for growth, balance sheet strength, culture, management quality, capital allocation record, customer relationships, brand power and patents and risks, among a host of others. These more qualitative characteristics are extraordinarily difficult to measure, but are often determinative in our assessment of a company’s intrinsic value.

Furthermore, the proliferation of “asset-light” and service-based companies over decades has decreased the usefulness to us of a metric such as book value as a primary anchor in assessing undervaluation, as it has led to fewer companies trading at or below book value. Moreover, book value per share can become untethered from intrinsic value when companies buy back their stock at prices above stated book value. Warren Buffett (Trades, Portfolio) addressed this in his latest annual letter to shareholders of Berkshire Hathaway, when he announced that Berkshire would no longer report its annual change in book value in referencing the company’s performance. He noted that:

  • accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years … it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality.

While we often use valuation metrics such as low P/B value as screening tools to uncover stocks for further study, low P/B is never the sole reason we purchase a stock. In certain types of businesses, such as banks, insurance companies, and other deeply cyclical businesses, low P/B value can be a relevant, useful and reliable indicator of undervaluation. However, even in the context of net-asset-based valuations, rigorous security analysis, in our view, calls for an examination of a myriad of other factors, not the least of which is a company’s growth prospects.

An exception to this statement is a category of bargain opportunities familiar to any reader of Benjamin Graham’s books: stocks priced at two-thirds or less of net current asset value (i.e., the total value of cash and cash equivalents, accounts receivable and inventory remaining after the subtraction of all liabilities senior to the common stock, including all current liabilities, long-term liabilities, lease liabilities and preferred stock), and sometimes referred to (especially by seasoned value investors) as “net-nets.” “Net current asset value” is a rough approximation of the liquidation value of a company’s assets, with no value ascribed to the company’s sales base, its earnings power, or the value of its property, plant and equipment. If you paid a price for the stock equal to two-thirds or less of net current asset value, you got all of these other values “for free.” Decades ago, Tweedy, Browne portfolios contained many net-nets. We bought them on a highly diversified statistical basis – and with very little review and analysis of qualitative aspects of the underlying businesses. On a group basis, the investment results of net-nets were quite good. However, with increases in the overall stock market over the last several decades, net-net bargain opportunities essentially became extinct (in Japan, Hong Kong and South Korea, net-nets have occasionally been sighted in recent years).

In our investment process, earnings-based appraisals have become much more relevant than asset-based appraisals. While we screen for cheap securities using a variety of quantitative methods, the most common include searching for stocks trading at low multiples of enterprise value to earnings before interest and taxes (EV to EBIT); enterprise value to earnings before interest, taxes and amortization (EV to EBITA); enterprise value to earnings before interest, taxes, depreciation and amortization (EV to EBITDA); and/or low multiples of enterprise value to net operating profit after tax (EV to NOPAT), the reciprocal of which we refer to as “owner earnings yield.” Tobias Carlisle and Wesley Gray, in their book Quantitative Value (2013), referred to these types of multiples as the “acquirer’s multiple” (enterprise value/ operating earnings). The numerator of these multiples (enterprise value) includes not only the market capitalization of the target company, but also the value of all of the company’s interest bearing liabilities minus any cash and cash equivalents carried on the company’s balance sheet. To use a metaphor, these multiples are quite comparable to the total price paid to acquire a house, which is comprised of the sum of two parts: the owner’s equity in the house, which is analogous to the market capitalization of a publicly-traded company’s shares, and the mortgage, which is analogous to the interest bearing debt, net of cash, of a publicly-traded company.

After we identify candidates selling in the stock market at low absolute multiples of EV to EBIT, EBITA, and/or EBITDA, or selling in the market at a price that provides a high owner earnings yield, we then study 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 real world acquisition multiples inform the multiples we use to value comparable businesses we are studying in the stock market.

Value-oriented enterprise multiples such as low EV to EBIT and low EV to EBITDA were found in a March 2019 research piece by the Leuthold Group entitled “Price To Book: The King Is Dead” to be quite robust as predictors of superior rates of return over the last 33 years (1986-2018). According to that study, this also held true over most of the last decade for a group of value metrics (in combination), including EBIT/EV, Free Cash Flow Yield, Earnings Yield and Shareholder Yield. In contrast, they found that the cheapest P/B value quintile in their study reached a peak in cumulative relative return in 2006, and has since produced trailing 12-month returns that were below zero for most of the period, rebounding only briefly following market declines in 2008 and 2016. While low P/B and P/E ratios are metrics that are considered in our research process, the enterprise multiples paid by knowledgeable acquirers in real world transactions more often than not drive our estimations of intrinsic value. In addition, these multiples offer the added dimension of incorporating the acquirers’ assessment of a comparable company’s future prospects.

In evaluating the intrinsic value of a company, we believe it is essential to estimate its normalized earnings power, i.e., an average of its earnings power over time. Normalized earnings power is highly subjective, and may materially deviate from current reported earnings. We normalize earnings in an effort to avoid overvaluing or undervaluing a business based on current reported earnings, which may be at peak or trough levels. This requires making judgments regarding current earnings in the context of each company’s idiosyncratic business cycle. Adjustments are often made to approximate normalized measures of EBIT, EBITA, and/or EBITDA, which may include an examination of multi-year averages of revenue and margins to arrive at a rational estimate of normalized earnings power.

As mentioned previously herein, we also generally look at what we refer to as the “owner earnings yield” or NOPAT to EV of a potential investment. A metric such as EV to EBIT is designed to adjust for different capital structures among corporations, but it falls short in capturing the impact of different corporate tax rates on business valuation. Owner earnings yield allows us to go further and incorporate disparities in corporate tax rates around the world into our valuations.

As noted above, on top of all of this quantitative analysis, in assessing valuation we also examine a plethora of qualitative characteristics, and also examine what company insiders are doing with their own capital when it comes to purchasing (or selling) shares in their companies. In our opinion, determining whether a potential investment is a “value” or not is more than simply a function of its price in relation to book value or its price in relation to earnings. We still strongly believe that price-sensitive security selection, combined with qualitative judgment, continues to offer investors the best path to long-term outperformance.

The compulsion to pigeonhole investment advisers as “value” or “growth” managers based on a few simple value metrics is not new. Warren Buffett (Trades, Portfolio) addressed the issue 25 years ago in Berkshire Hathaway’s 1992 annual report. We believe his view is as relevant today as it was back then:

But how, you will ask, does one decide what’s attractive? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as a positive.

In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor in our view financially fattening).

Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

We would caution investors to be leery of the tendency by some in the financial press to use simple “value” heuristics to characterize investment advisers and their investment portfolios, and to keep Warren’s words in mind before sounding the death knell for a form of investment that has proven to be reliable and profitable over decades.

Investment Performance

In last year’s challenging investment environment, the Tweedy, Browne Funds fared relatively well, and lived up to their defensive billing. All four Funds bested their respective benchmarks for the calendar year, and our flagship Fund, the Global Value Fund, finished in the top 2% of its foreign large value peer group as measured by Morningstar.

However, in the more “risk on” environment for equities that characterized the first quarter of 2019, the Funds made significant financial progress on an absolute basis (returns between 7.09% and 9.49%), but trailed their respective benchmark indexes. That said, all four Funds produced attractive absolute returns in the first quarter, and recouped all of their losses – and then some – suffered in the December decline. The Global Value Fund, Value Fund and Worldwide High Dividend Yield Value Fund each finished up for the fiscal year with positive but index-trailing returns; while the Global Value Fund II generated negative returns for the fiscal year, but outperformed its benchmark by 180 basis points.

Presented below is Morningstar peer group ranking information for the Global Value Fund, followed by 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) for the Global Value Fund.

Morningstar category percentile rankings for the Global Value Fund compared to other Funds in its category, “Foreign Large Value Funds”

The above chart illustrates the five-year average annual rolling returns (calculated monthly) for the Tweedy, Browne Global Value Fund, net of fees, since June 30, 1993 (Fund inception: June 15, 1993), compared to the five-year average annual rolling returns for its benchmark, the MSCI EAFE Index (Hedged to U.S.$) (the “Index”). The horizontal axis represents the returns for the Index, while the vertical axis represents the returns for the Fund. The diagonal axis is a line of demarcation separating periods of outperformance from periods of underperformance. Plot points above the diagonal axis are indicative of the Fund’s relative outperformance, while points below the diagonal axis are indicative of the Fund’s relative underperformance. Returns were plotted for three distinct equity market environments: a “down market” (benchmark return was less than 0%); a “normal market” (benchmark return was between 0% and 10%); and a “robust market” (benchmark return was greater than 10%). There were 250 average annual rolling return periods between June 30, 1993 and March 31, 2019. Past performance is no guarantee of future returns.

Our Fund Portfolios

Please note that the individual companies discussed herein were held in one or more of the Funds during the year ended March 31, 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 March 31, 2019.

As noted above, the Funds held up relatively well during the downturn in December, and have produced strong absolute results year-to-date in 2019. The Funds also produced positive (albeit index-trailing) returns for the fiscal year, except in the case of the Global Value Fund II, which outperformed its benchmark by 180 basis points, despite producing a negative return.

When investing, sometimes your success is defined as much by what you did not own as by what you did own. The Funds’ last fiscal year was one of those years. Our Funds benefitted from the fact that they had no exposure to Eurozone banks, which continued to underperform in a negative interest rate environment; no exposure to European car companies, which are facing a slowing car market and the prospect for disruptive change in the form of electrification, ride sharing and autonomous cars; and little to no exposure to Japan, which closed the year ended March 31, 2019 down 4.1% in local currency. Our currency hedged funds, Global Value Fund and Value Fund, continued to benefit from their use of currency hedging techniques, as the U.S. dollar remained strong relative to most major foreign currencies.

In terms of contributions from stocks the Funds did own, it was the more defensive, higher quality components of the Fund portfolios that stood out. The Funds benefitted from strong relative results from a number of branded consumer products companies, pharma holdings, an aerospace holding and a technology holding. This included companies such as Diageo, Nestlé, Heineken, Unilever, Roche, Novartis, Safran and Cisco. In addition, relative to their benchmarks, the Funds benefited from their allocations to financial holdings, particularly bank stocks and insurance holdings. The Fund’s bank holdings are largely Asian-related banks such as Bangkok Bank, DBS Group, United Overseas Bank, HSBC, and Standard Chartered (these banks were also down over the period, but not nearly as much as the Eurozone banks, which make up a larger portion of the Fund’s respective indices). Over time, we believe these banks should benefit from their entrenched positions in a faster growing part of the world. The Funds also had strong relative results from insurance holdings such as Munich Re, SCOR and Zurich Insurance Group, which continued to have solid underwriting records and good investment returns. SCOR, the French reinsurer, was the subject of a takeover bid last fall by the French mutual insurer, Covea; however, SCOR’s management concluded that the price was insufficient, and the stock has settled back somewhat from its previous highs.

In contrast, a number of more cyclical businesses, i.e., media, industrial and automobile-related holdings, disappointed in terms of their stock price performance. This included media companies such as Axel Springer, Mediaset and WPP, among others; industrials such as G4S, Ebara, and Krones; and auto-related holdings such as Hyundai Mobis, Hyundai Motor and Michelin. These more cyclically related holdings have rebounded nicely in the first quarter of 2019, but suffered through a tough stretch of performance in 2018. Sina and Baidu, two rather recent Chinese internet business purchases, also have had a rough go over the last year.

While idea flow has slowed a bit with the uptick in valuations this year, we continue to be encouraged by an improved opportunity set, largely produced by the decline in equity markets in the fourth quarter of last year. Since our last report in September of 2018, we established new positions in the UK-based defense manufacturer, Babcock International; Zeon Corporation, a Japanese manufacturer of synthetic rubbers, latex, and resins; Wuliangye Yibin, a Chinese consumer products company that produces baijiu liquors; Goldman Sachs; BASF, the German chemical company; and Carnival Cruise Lines. We also took advantage of pricing opportunities to add to a number of pre-existing positions across the Funds, including in companies such as BAE Systems, CNH Industrial, Michelin, Sina, Baidu, Axel Springer, Tarkett and Hang Lung.

Since we last reported to you, sales have generally out-paced purchases in the Funds, with the exception of the unhedged Global Value Fund II, which has experienced strong positive cash flows. Sales during the period included Honda, which had largely been a disappointment in terms of returns; and Schibsted, the Norwegian media company which had been a significant contributor to returns over the years, but had reached and exceeded our estimates of intrinsic value. We also sold G4S and ConocoPhillips, which were held by the Worldwide High Dividend Yield Value Fund.

In terms of portfolio positioning, our Funds today are invested across 30 to 90 different issues, 9 to 21 countries, 16 to 24 different industry groups, and consist of small, medium, and large capitalization companies which are domiciled in primarily developed markets, although as much as 11.2% of our international Funds (Global Value Fund and Global Value Fund II) is invested in emerging markets including China, Thailand, Mexico, Chile, South Korea, Czech Republic, Croatia, and Taiwan. The top 25 holdings in our Fund portfolios as of March 31, 2019 traded at weighted average price-to-earnings ratios of between 13 and 16 times 2020 estimated earnings, and paid dividend yields of between 2.3% and 3.8%. (Please note that this range of weighted average dividend yields is not representative of a Fund’s yield, nor does it represent a Fund’s performance. The figures solely represent the range of the average weighted dividend yields of the top twenty-five common stocks held in the Funds’ portfolios. Please refer to the 30-day standardized yields in the performance chart on page I-5 for each of the Fund’s yields.) With the increase in volatility in equity markets, cash reserves in the Funds have come down and average approximately 7.1% to 13.5% as of March 31, 2019. Finally, for those concerned with slowing growth in Europe, we would remind our shareholders that the bulk of our exposure in Europe consists of large, global enterprises whose future success, in our view, is more correlated with global GDP growth than with GDP growth on the continent.

While we have no clue how the markets will perform in the weeks and months ahead, if we do revisit the turbulence of December of last year, we believe we have built Fund portfolios that have the potential to hold up on a relative basis through whatever tumult the markets present.

Our confidence is bolstered by the following pillars of our investment approach:

  • As value investors, we take a conservative approach to business appraisal. We do not get carried away with respect to the multiples we use to value companies. In euphoric times, professional and individual investors often pay exorbitant prices for entire companies and/or equities. This is particularly true during periods of low interest rates, when borrowing costs are low. The companies that we invest in, on the other hand, have to be cheap (in our view) in comparison to observable merger and acquisition comps and on an absolute basis. The Funds’ portfolios are diversified by issue, country and industry, but this of course does not mean that their portfolios look like indexes. In fact, the Funds’ portfolios are very different from their benchmark indexes, with vastly different holdings, position sizes, country, and

    index weightings. For example, as of March 31, 2019, the Global Value Fund had only approximately a 1% weighting in Japanese equities and a 16% weighting in Swiss equities, compared to respective weightings in the EAFE Index of approximately 24% and 9%. In addition, each Fund’s “active share,” which measures how different a Fund’s portfolio is from its benchmark, remains high (indicating that the Funds’ portfolios look very different from those of their benchmark indexes).

  • The businesses that populate the Funds’ portfolios are typically underleveraged, which means they require modest to low levels of debt to finance their operations. High levels of debt can be a business killer in a challenging market and/or economic environment. Many of the Funds’ holdings are in a net cash position, which means they have enough cash on their balance sheets to pay off all their debt and have funds left over. The bulk of the holdings in the Funds’ portfolios have net debt-to-EBITDA ratios of less than two times, which means that, absent other changes, the entire debt load of the business could be paid off with two years of EBITDA.
  • As Chris Browne used to say, when it comes to choosing countries in which to invest, we only want to commit capital to countries we would not be afraid to visit with our families. Most of the companies in which we invest are domiciled in developed markets and the more developed of the emerging markets. When it comes to the emerging markets, we generally seek a reasonably stable political environment, established contract law and access to courts, the availability of cheap stocks, regulatory oversight, and the availability of a foreign exchange market that allows us to hedge foreign currency exposure at a reasonable cost should a Fund choose to do so.
  • Another source of risk reduction for the Global Value Fund and Value Fund comes from their practice of hedging their perceived foreign currency exposure back into the U.S. dollar. In our view, this practice allows the Funds to reduce volatility with modest and at times no cost in terms of foregone return over long measurement periods. We believe that foreign currencies can be extraordinarily volatile in the short run, which can cause hedged and unhedged results to vary markedly.
  • Finally, our team-oriented decision-making process offers checks and balances against extremes in decision-making, and benefits from diverse perspectives within a disciplined value framework.
  • New Additions to Our Fund Portfolios

    To provide some additional color with respect to the improved opportunity set which we spoke of earlier in this letter, we thought we would highlight just a few of the new names that have made their way into our Fund portfolios over the last fiscal year. In some instances, we were not able to build as large a position as we would have liked in certain securities as they moved away from our pricing parameters rather quickly.

Goldman Sachs (GS, Financial) (Value Fund). Founded in 1869, Goldman Sachs is one of the world’s premier investment banks. It has a diversified revenue mix, with businesses in investment banking, institutional client services, investment management, and investing and lending. The firm is also diversified by geography, with nearly 40% of revenue generated outside of the Americas. In the years since the financial crisis, the firm has strengthened its balance sheet, and today has quite robust capital levels. That said, this kind of stock is what we often refer to as a Ben Graham “bobber,” as it is an inherently leveraged, cyclical company that is statistically cheap. Goldman has an excellent long-term business track record, and its stock became, in our view, quite cheap in December, due to a combination of factors, including the general market selloff and a potential liability from its involvement in the Malaysian sovereign fund scandal (“1MDB”). While there are a wide range of potential outcomes from the 1MDB litigation, we believe that the firm could weather even a highly punitive outcome. At purchase, Goldman was trading at approximately 80% of its tangible book value and approximately two-thirds of our estimate of its underlying intrinsic value. The firm also continues to buy back significant amounts of stock, repurchasing nearly $3.3 billion of stock in 2018. Moreover, the new CEO, David Solomon, is currently reviewing Goldman’s various businesses with an eye to improving performance and return on equity.

CNH (Global Value Fund, Global Value Fund II, and Value Fund). CNH Industrial (CNHI, Financial) consists of Fiat’s former industrial assets: Case New Holland (global agricultural and construction equipment), Iveco (European commercial trucking) and Fiat Powertrain (industrial engines). The business has a captive finance company as well. CNH was created in 2013 when Fiat’s controlling shareholder, the Agnelli family, separated Fiat’s auto and industrial assets in order to better enable a broader restructuring of the various businesses. The industrial assets were combined into a single entity because they could leverage a common engine platform (the powertrain business). Following the separation, the agricultural cycle deteriorated dramatically, and as a result CNH’s financial track record has not been good. However, management has been restructuring the businesses and repaying debt. The company’s debt is now “investment grade,” and CNH has recently begun repurchasing its shares.

CNH’s largest and most valuable business and the reason for our interest in the stock is the Case New Holland agricultural equipment segment (currently 44% of operating profit). It competes with Deere and AGCO in a rational oligopoly that benefits from strong barriers to entry (e.g., dealer network) and positive long-term demand trends (an increasing global population requires higher agricultural output). The construction equipment and trucking businesses are subscale players competing against much larger competitors in industries where scale matters. As such, despite management’s efforts, both businesses are structurally somewhat challenged. The powertrain business supplies the various CNH entities with engines, but also makes over 50% of its sales to third parties, which somewhat validates it as a decent overall business. At purchase, CNH was trading at approximately 7.7X normalized mid-cycle EBITA, and the agricultural business is close to trough levels, but we believe it should be a beneficiary of strong long-term demand trends.

CNH is an example of a business with a well above average sub-segment (agriculture equipment) whose earnings power is being masked somewhat by the more average to below average construction and trucking segments. If management is skillful, and we have reason to believe they are, over time, the business should be able to be restructured in a way that more fully reveals the strength of its agricultural segment. If that happens, we believe the Funds will own an interest in a much more valuable enterprise. We also believe the company has the opportunity to benefit from an improvement in the agricultural equipment business, which is at cyclically depressed lows and is being negatively impacted by the global trade conflict.

Wuliangye (SZSE:000858, Financial) (Global Value Fund II). Wuliangye is recognized as one of China’s premium baijiu (spirit) brands. Wuliangye literally translated means “five grains liquid,” as it is brewed by a unique formula that combines the flavor of five different grains. Wuliangye has a very strong brand within China due to its premium quality and 600+ years of history, enabling the company to have strong pricing power (70%+ gross margin, approximately 40% EBIT margin). Wuliangye’s strong brand is supported by its aged cellar and unique brewing techniques. In the baijiu industry, cellars with a longer history typically produce higher-quality liquor (more microbes for fermentation). Wuliangye has tens of thousands of cavern fermentation pits, dating back from the Ming Dynasty (650 years ago) to several decades ago, and it has the largest single brewing workshop in China.

According to Wall Street research, the significant growth in China’s premium consuming class population should drive a mid-teens CAGR (compound average growth rate) in the consumption of ultra-premium baijiu over the next five years, as more consumers are able to afford the product and the consumption frequency of premium baijiu increases with income. Wuliangye is well placed to grow in the ultra-premium baijiu segment, as its flagship product is more affordable than Moutai, its chief competitor. Wuliangye also plans to launch a new generation of its flagship product (PuWu) this year, with new packaging and a higher price point. The company has also been making significant efforts to improve its marketing and distribution, which would be of incremental benefit if executed successfully.

Wuliangye has compounded intrinsic value per share over the last decade at approximately 20% annually. While the compound will likely be lower going forward, we believe the company should still be able to grow operating income at least in the low teens annually. The company has also been increasing its dividend payout ratio (currently 52%), and the dividend yield at the time of purchase was approximately 2.6%, with room for growth. Given the company’s wide moat around its premium-end brands and attractive margins, the company has also generated strong returns on equity, return on assets, and return on invested capital. At purchase, we paid roughly 9X 2019 estimated EV to adjusted EBIT, and approximately 13X 2019 estimated earnings.

Wuliangye is an example of a terrific business – a branded consumer products company with strong competitive advantages that have allowed it to have pricing power and to compound its intrinsic value at a well above average rate over time. It is rare to get pricing opportunities in businesses such as this. However, with the dramatic sell off in the Chinese stock market, we had an opportunity to purchase shares for Global Value Fund II in one of China’s premier businesses when it was trading at significant discounts, in our view, to what comparable beverage businesses were trading for in other parts of the world. The one caveat is that Wuliangye is a Chinese state-owned enterprise, and, as such, it is subject to potential corporate governance and other risks that are typically less of an issue in the developed world. That said, we feel that the Fund’s purchase price more than compensates it for these heightened risks.

BASF (MIL:BASF, Financial) (Worldwide High Dividend Yield Value). Founded in 1865, BASF is a global chemicals company with 122,404 employees operating in over 80 countries around the world. It is perhaps best known for its Verbund business model, which combines much of the chemical value chain into a single large facility. This allows for easy transportation of feedstocks and intermediate chemicals, as well as efficient power generation – all of which saves the company money. The company operates six Verbund sites with a seventh (a second site in China) on the way. BASF was traditionally a very complicated company to analyze, with 13 operating divisions reported in five segments. However, the business has changed and the new CEO, Dr. Martin Brudermüller, announced a new reporting structure that has simplified company reporting and also increased accountability at each of the new segments. In addition, BASF plans to dispose of its oil & gas business, which also will make the business easier to understand and perhaps more attractive to investors.

BASF produces chemicals and fertilizers, which are the building blocks for many products that are indispensable in our everyday lives. The company has stated that in roughly 75% of its businesses, it is in the first, second or third position in terms of market share. BASF is constantly shifting its portfolio of businesses, exiting low value-add or commodity businesses and focusing on attractive growing businesses or businesses where it has a cost advantage from its Verbund production sites. The company’s announced disposal of its oil & gas business and the recent acquisition of the agricultural chemicals business from Bayer are both examples of the company’s portfolio management in action.

While chemicals can be a cyclical business, BASF appears to be somewhat less cyclical than its peers. The company traditionally operates with a very conservative balance sheet, and although BASF did add some leverage with the acquisition of assets from Bayer, we expect the firm to return to its historically low level of leverage within the next two years.

At purchase, BASF was trading at approximately 70% of our estimate of its intrinsic value, at roughly 9.2X trailing twelve month earnings, and 1.5X book value (a historic low); had an owner earnings yield of approximately 8.8%, and paid an above-average dividend yield of around 5.4%, making it appropriate for the Worldwide High Dividend Yield Value Fund. The company expects to grow EBITDA 3%-5% per year for the next several years, and we expect the company to grow its intrinsic value at a similar rate. In addition, there was a significant amount of insider buying in late 2018. The CEO, the CFO, the Chairman of the Supervisory Board, and the former CEO all purchased shares at prices higher than we paid for our shares.

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As Tweedy, Browne’s 100th birthday approaches, we thought we would take the opportunity to re-visit the firm’s history and the impact it has had on the investment approach we practice today. Our intention is to include these installments in the next few letters. We hope you enjoy this walk down memory lane.

Tweedy, Browne, the Pawnbrokers of Wall Street

[The year was 1920.] The Great War had been over for more than a year [and the] Dow [Jones Industrial Average] opened the year around 100, then drifted downwards. ...

[In the early fall of that year] a horse drawn van blew up in front of 23 Wall Street, killing forty and injuring scores. Iron slugs whizzed by the head of Seward Prosser, [then] President of Bankers Trust Company, which was cater-cornered across the street, and he cut his lip when he ducked under his desk. “Bolsheviks” were promptly blamed.

It was into this atmosphere that [Forest Birchard “Bill”] Tweedy opened his business around the corner and two blocks away. He was twenty-eight.

– Raymond D. Smith, Jr.,

Tweedy, Browne Company – Recollections from the First Seventy-Five Years (1997)

Forest Birchard “Bill” Tweedy has been described as somewhat of a Dickensian character who wore suspenders, had a bushy mustache and an ample pot belly. As told, not long after the end of World War I, Mr. Tweedy was looking for a niche in the securities business where he would have little competition. He fell upon the idea of making markets in closely-held, inactively traded securities, so-called “trade by appointment stocks.” In late 1920, he established this market making enterprise as Tweedy & Co., and took up office space at 15 William Street in downtown Manhattan. He focused his attention on small, nearly illiquid companies with 50 to 100 shareholders. Bill would attend the annual meetings of these companies and copy down the registry list of stockholders. He would then send postcards to each of the stockholders offering to act as their broker in the company’s shares.

Bill continued this business through the 1920s and into the 1930s when, as fate would have it, a new and fortuitous relationship began. After graduating Phi Beta Kappa from Columbia College and a short stint as a bond analyst, the soon-to-be legend, Benjamin Graham, teamed up with his good friend Jerome Newman to start the Graham-Newman Corporation. Graham brought his bond analytical skills to bear in the analysis of common stocks. In bond analysis, the financial safety of a bond as an investment – i.e., the likelihood that the bondholder will be repaid the principal amount of the bond upon its maturity, and the likelihood that the company will pay interest to the bondholder during the term of the bond – is assessed by examining: (a) the collateral value of a company’s assets or its business in relation to the bond principal amount that a company is obligated to repay; and (b) the ratio of a company’s cash flow to the annual interest paid to its bondholders. The greater the quantity of collateral in relation to the bond principal repayment amount, and the greater the quantity of cash flow available to pay interest, the greater the degree of “coverage,” or cushion, for unforeseen reductions in collateral value and/or cash flow, and the safer the bond is believed to be. In a similar vein, in analyzing common stocks, Graham conceptualized that the value of the company’s assets, the value of its business, served as a kind of “collateral” standing behind and backing up the market value of the company’s stock. The greater the quantity of asset value/business value and cash flows in relation to the market value of the company’s stock, the safer he believed the stock would be.

Ben believed that there were two prices for every share of stock; the price you see in the market on the exchange on any given trading day, and the price that would accrue to the investor if the entire company were sold in an arm’s-length negotiated transaction. He referred to this latter price as the company’s “intrinsic value.” To Graham, the essence of investment was to try to exploit large discrepancies between these two prices, a spread he referred to as the investor’s “margin of safety” – a cushion to protect against financial adversity. The discount from intrinsic value helped to protect against mistakes in research and valuation. In addition, the discount from intrinsic value served as a guide to possible future investment returns: the greater the discount from intrinsic value, the greater the margin of safety, and the greater the prospects for future investment returns. For example, a stock with an intrinsic value of $100 per share, trading in the stock market at a price of $50 per share, would provide the investor with a “margin of safety:” intrinsic value could decline by 50%, a decline of $50 per share, before the intrinsic value backing would be less than the stock price. In addition, with an intrinsic value equal to 2X the stock price, an investment in the stock at a price of $50 per share would provide the investor with the prospect of a 100% gain if the stock increased in the market to a price equal to its $100 per share intrinsic value, or if the company were to be acquired at a price equal to its intrinsic value of $100 per share. We’ve all heard the financial theory, “the greater the risk, the greater the return.” Graham’s concept of investment analysis and valuation of common stocks turned this on its head: in his view, the lower the risk, the greater the future potential returns!

Ben had a prodigious intellect. His magnum opus, Security Analysis, which he co-authored in 1934, is considered by many to be the best book on investing ever written. He followed that book up with more of a layman’s version in 1949 called The Intelligent Investor. Both of these books are still in print and sell hundreds if not thousands of copies every year. He also taught a course in securities analysis at Columbia Business School for over 35 years. Ben was smart enough to realize early on that he could make more money practicing his investment principles than writing about them, and he pursued his investment interests at Graham-Newman Corporation.

The inactive securities in which Bill Tweedy made markets, more often than not, had the common characteristic that they traded at significant discounts to intrinsic value. When Ben Graham would go looking for bargains in the stock market, he increasingly came across the name Tweedy & Co., which often made markets in the shares in which he was interested, and a brokerage relationship ensued. This relationship continued through the 1930s and into the 1940s. In 1945, Bill Tweedy was joined by Howard Browne and Joe Reilly, and his firm became known as Tweedy, Browne and Reilly. Howard joined the firm from Bristol and Willet, where he had been in charge of bond trading. A man of few words, he was fond of saying “no one ever learned anything by talking.” Joe was a charming and gracious man who was something of a walking legend. On weekends, he would walk from his house in Flushing, Queens to his sister’s home in Port Washington, Long Island, and back, a total of 24 miles. The three partners took up office space in the same building and on the same floor as Graham-Newman’s offices at 52 Wall Street. In short order, Ben Graham became their largest customer. In those days, stock certificates were delivered by hand and checks were exchanged. The new location of the firm meant that its employees would not be exposed to the elements when settling trades with Ben.

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