"We’ve gone from the low-return world of 2009-21 to a full return world, and it may become more so in the near term. Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets. Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21. And importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years — and most of the last 40 years — it should follow that investment strategies that worked over those periods may not be the ones that outperform in the years ahead.
That’s the sea change I’m talking about." -Howard Marks (Trades, Portfolio), Oaktree Capital Management, Dec. 2022
TO OUR SHAREHOLDERS:
It probably comes as no surprise to you that given the tenor of our previous letters, we share legendary investor Howard Marks (Trades, Portfolio)’ view that a “sea change” is likely afoot in our global economy and capital markets. While we are certainly not econo-mists, or market soothsayers for that matter, we do believe that the Rubicon has finally been crossed with respect to the “zero-bound” economy of the last decade, and that we are not likely going back to zero/negative interest rates anytime soon.
The COVID-induced closing and re-opening of the global economy, the unprecedented and globally seemingly coordinated monetary and fiscal largesse of the last decade plus, together with Russian aggression in Ukraine combined to create a macro shock that in our humble view has led to a “reset” in our capital markets, which is ongoing as we write. The bill for this period of extraordinary speculative excess has likely come due, and payment would appear to be unfortunately taking the form of stubbornly persistent inflation and interest rates, which have spiked, and are likely to normalize higher for longer.
As we have mentioned in past letters, the “risk on” environment of the last decade, turbo charged by zero-to-negative interest rates around the globe, catered to passive investment strategies over active strategies; longer duration growth and technology stocks over value stocks; and US-based “big tech” equities over their foreign counterparts. If we are indeed right about the reset mentioned above (and God knows we could be wrong), an environment where interest rates normalize higher for longer is likely to favor active investment strategies over passive strategies, value stocks over their growth counterparts, and non-US-based equities over “big tech” US-based equities. Evidence of the reset abounds in increasing market volatility, the pullback of large cap indices over the last year, the collapse of the FAANGs, the rather severe correction in the performance of other more speculative technology stocks, the relative resurgence of more price driven investment strategies, and more recently, the outperformance of non-US equities. We believe it is also reflected in the performance of the Tweedy, Browne Funds over the last year, and for that matter since we began to see a rotation from growth to value stocks back in the fourth quarter of 2020. We suspect, but of course cannot know for sure, that if the past is indeed prologue, the knock-on performance impact of this reset is likely to persist for many years to come. After all, it took over 15 years for the NASDAQ Index to fully recover after the last tech bubble burst in 2000.
That said, the near-term investment environment remains fraught with uncertainty, and will likely continue to be challenging as market prices adjust to reflect the new economic realities. Nevertheless, we remain optimistic about our future, and for equity returns moving forward. While we are not unmindful of the current turmoil afflicting our economy and capital markets, we are intensely focused on taking full advantage of the fallout from this volatile environment. We believe it is an extraordinarily good time to be “mining” for value. As Warren Buffett (Trades, Portfolio) has said on numerous occasions, a long-term consumer of equity securities should welcome pullbacks in equity markets, which may afford them the opportunity to buy interests in businesses at attractive prices. We absolutely concur. We would encourage our shareholders to buckle up for what could be a bumpy, but hopefully profitable time ahead for our style of investing. It would indeed appear that price matters again.
Before we address the performance of our Funds over the last year, we thought it would be instructive to describe in some detail one of the recent purchases made by three of our Funds — a case study if you will in value investing at Tweedy, Browne. We hope this provides you with some additional insight with respect to our investment approach and process. As Ben Graham advised in The Intelligent Investor, “Know what you are doing — know your business.” We hope the following example helps to reassure you that we have Ben covered in this regard.
Winpak-An Apparently Favorable Fact Pattern
We believe Winpak (TSX:WPK, Financial), a producer of plastic packaging materials, based in Winnipeg, Canada, represented a compelling investment opportunity at time of purchase. The investment case had many positive attributes including: stable end market demand, above-average organic growth, high margins and high returns on invested capital, an attractive balance sheet and material insider buying. Moreover, we believe the stock was cheap relative to industry precedent M&A transactions, and on a stand-alone absolute basis.Thus, in Tweedy parlance, Winpak, in our view, had a very favorable fact pattern.
The following data points for both qualitative and quantitative attributes are as of December 31, 2022 unless specified otherwise. Also, please bear in mind that Winpak trades in Canadian dollars but financially reports in US dollars.
Key attractive qualitative attributes included the following:
- Revenue Stability: >90% of Winpak’s sales are derivedfrom the packaging of perishable food & beverages, a relatively defensive end market. The vast majority of Winpak’s products end up being purchased in a grocery store. In the past two recessions (2009 and 2020), Winpak experienced at worst only modest low single digit organic volume declines.
- Switching Costs: Winpak is a specialist in extrusion technology that transforms pellets of resin into customized films with very specific product attributes. For example, Winpak produces the packaging for 100% of the bacon in Canada and ~60% of the bacon in the US. Key product attributes of a package of bacon include: extending shelf life, removing odors and providing puncture resistance to eliminate leaks. A package of bacon includes 13 custom layers of film. The use of proprietary films with custom resin blends increases customer switching costs.
- Pricing Power: The cost of raw materials, the three mostimportant being polyethylene, polypropylene and nylon, account for almost 50% of revenue. Thus, the ability to pass through changes in raw material input prices to customers is essential to profitability. Approximately 70% of Winpak’s revenue is under contract (2 to 5 years) where product prices are indexed to raw material input prices, albeit with a 4 to 6 month lag. During 2022, unique among most consumer products companies, Winpak delivered positive organic volume growth despite increasing price by +18%.
- Material Insider Buying: Since November 2020, ninecorporate insiders have purchased over CDN $6 million worth of Winpak stock at an average purchase price of CDN $39.21 per share.
- Nascent Growth Opportunity in Medical Packaging: In 2021,Winpak generated $40 million (~5% of total revenue) from medical packaging. Medical packaging is an attractive end market with high margins and high barriers to entry. It is highly regulated and requires FDA approval. Product safety testing alone normally exceeds one year. Switching costs are often material. Thus, medical packaging contracts take time to negotiate but often result in a stickier customer relationship. Winpak’s goal is to double the size of medical packaging revenue by 2025.
Key attractive quantitative attributes included the following:
- Above Average Organic Growth: Over the last 10-yearsaverage annual organic revenue growth was +6%, of which +4% was achieved from volume and +2% from price. Winpak believes it can grow volumes in the mid-single digits over the next several years.
- High Margins: In the last 10-years, Winpak averaged21% EBITDA margins. Winpak’s margins are among the highest in the packaging industry relative to publicly traded peers. Moreover, current EBITDA margins of ~19% are ~200 basis points below the 10-year average. While not key to our investment thesis, mean reversion in margins could lead to incremental upside in EBITDA.
- High Returns on Invested Capital: Over the last 10-years,after-tax return on invested capital (ROIC) has averaged 19%. After-tax ROIC is defined as after-tax EBITA / (Net Debt + Equity).
- Net Cash Balance Sheet: As of December 31, 2022,Winpak had $399 MM in cash and zero debt. At March 20, 2023, Winpak had 21% of its market capitalization in net cash.
- No One-Time Expenses: The vast majority of publiclytraded companies regularly report “one-time” expenses that analysts are trained to ignore in order to gauge “underlying” profitability. In an era when “one-time” expenses are the rule rather than exception, Winpak stands out as a business that has never disclosed a one-time expense in at least the last 13 years. The reported numbers are the numbers. We believe this is rare and admirable.
While Winpak has many favorable attributes, we believe there is a difference between a good business and a good investment. Price relative to value matters to us. One key way we appraise what a business is worth is by estimating private market value. In other words, what price would accrue to shareholders if 100% of the business were sold to a knowledgeable independent buyer? In estimating private market value, we study real world M&A transactions of similar businesses. After consulting with industry experts, we believe the following five recent food packaging M&A targets are most comparable to Winpak’s business.
As can be seen above, companies similar to Winpak have been acquired at an EV to EBITDA range of 10.3x to 14.5x. The average EV to EBITDA in the above transactions is 12.1x. Moreover, industry experts we contacted were unanimous in identifying Bemis as the closest publicly traded competitor to Winpak. Bemis was acquired by Amcor in a deal announced in 2018 for 11.7x Enterprise Value to EBITDA.
As of March 20, 2023 Winpak traded in the stock market for CDN $40.69 per share. Based on the year ending December 2022, Winpak trades for 7.0x EV to EBITDA and 8.8x EV to EBITA. If Winpak was valued using valuation multiples at the low end of the observed food packaging M&A range, or 10x to 11x EBITDA, its estimated intrinsic value would be approximately CDN $55 to $59 per share.
Moreover, the current Owner Earnings Yield (After-tax EBITA / Enterprise Value) of Winpak exceeds 8%. To us, this represents statistical cheapness on a stand-alone basis.
Of course, as with any investment, Winpak also has some less attractive attributes; but, in our view, those are outweighed by the positive factors described above.
Of course, a favorable fact pattern does not guarantee a successful investment outcome. Winpak is just one of many stocks that we hold in our Funds. It may or may not turn out to be a successful investment. However, we have observed that owning a large group of stocks with what we view as favorable fact patterns purchased at significant discounts to our best guess of private market value has produced favorable absolute, and at times index besting long-term returns.
Diversification does not guarantee a profit and does not protect against a loss in a declining market.
PERFORMANCE
With the onset of the Ukrainian conflict late last February, capital markets faced a downturn, which carried on through much of the second quarter. This volatility was particularly felt in the more speculative parts of the market, and on a relative basis, more price sensitive equities gained significant ground against their more growth-oriented counterparts. Despite a rather impressive summer rally that saw US and international equity indices recover much of their declines, markets became turbulent once again in the late summer and early fall, as August inflation data offered little prospect of a long hoped for “Fed pivot.” By September quarter end, the S&P 500, the Dow Jones Industrial Average, the NASDAQ, and the MSCI EAFE Index had all broken through their prior market lows and were trading well into bear market territory. In October, global equities began a rebound that lasted for much of the 4th quarter and has continued on into 2023 as the news about inflation improved, renewing hopes for a Fed pivot and the possibility of a soft landing for the global economy. This more recent rally has favored technology stocks and non-US-based equities. As we write, the market continues to shrug off the recent failure of three banks and tremors related thereto as regulatory authorities once again have ridden to the rescue guaranteeing deposits and providing lending facilities to the banking industry at large. Needless to say, the last twelve months in our capital markets have been incredibly challenging as a host of macroeconomic concerns continue to threaten investor confidence.
During this apparent reset in our capital markets, the Tweedy, Browne Funds gained significant ground on more broadly based unhedged market indices as well as the MSCI World Index (Hedged to USD), and that is precisely what one would expect from more price sensitive investment vehicles in a volatile, risk-challenged investment environment. On an absolute basis, all four funds finished the fiscal year either modestly in the black, or modestly in the red in the case of the Worldwide High Dividend Yield Value Fund. Three out of our four funds bested their respective benchmarks during the period. While our flagship International Value Fund underperformed its hedged benchmark during the period by 516 basis points, it outperformed the more broadly recognized unhedged MSCI EAFE Index by 332 basis points net of fees and expenses. The Fund’s underperformance relative to the hedged benchmark was largely related to the Fund’s policy of hedging only perceived foreign currency exposure (whereas the benchmark is 100% nominally hedged on a monthly basis). That said, hedging perceived foreign currency exposure continued to provide significant protection for our hedged funds against return dilution from declining foreign currencies, and that was critically important given that the pound, the yen, and the euro consistently declined relative to the US dollar for much of the period. While these currencies have since recovered somewhat, in the fall of 2022, all three of these major currencies were trading at multi-decade lows against the US dollar.
We are hopeful that the ongoing volatility associated with the apparent reset from the last ten-plus years of market excess will continue to favor more price sensitive investment strategies such as those practiced by our Funds, and that, over time, the Funds’ three, five, and ten year annualized performance figures will recover from the challenges posed by the excesses of the zero-bound speculative era.
PORTFOLIO ATTRIBUTION & POSITIONING
Please note that the individual companies discussed herein were held in one or more of the Funds during the fiscal year ending March 31, 2023, 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, 2023.
It was quite a roller coaster ride for global equities over the last fiscal year. Markets ratcheted down in the first half of the year largely as a result of supply chain constraints coupled with rapidly rising inflation and interest rates, and fears that tightening financial conditions could possibly result in a severe recession. Declines were led largely by the “big tech” technology companies and more speculative issues while gains occurred in more traditional value sectors including industrials, energy, financials, and consumer staples. However, as the news about inflation improved somewhat in the second half followed by declines, albeit modest, in the level of interest rates, global equity markets began to perk up, buoyed at least in part by renewed confidence in the tech sector, and less concern about a possible severe recession. In fact, over the last month, the markets demonstrated a great deal of resilience, shrugging off a number of bank failures in the US and abroad. It remains to be seen if such confidence is warranted in light of rather full equity valuations, particularly in the tech sector, and inflation that is proving to be quite stubborn.
The performance of the Tweedy Funds over the last year, while generally better than their unhedged market indices, was not immune from the markets’ ups and downs. Despite the uptick in markets of late, the volatility of the last year proved to be challenging for most sectors, industry groups, countries and individual securities.
In our view, the majority of companies in the Funds’ portfolios continued to make underlying financial progress independent of their stock prices, with underlying corporate earnings holding up fairly well; however, profit margins at many of them began to come under some pressure due to rising inflationary and supply-induced input costs. Some of the decline incurred by certain Fund holdings was no doubt also tied to a contraction in valuation multiples in the face of rising interest/discount rates as opposed to just deteriorating fundamentals.
The Funds generally remain diversified by issue, country, industry group and by market capitalization. On the whole, it was the Funds’ aerospace & defense, machinery, oil & gas, beverage, and chemical holdings that were some of the more significant positive contributors to the Funds’ results during the period. This included strong returns from companies such as Safran (XPAR:SAF, Financial), BAE Systems (LSE:BA., Financial), TotalEnergies (TTE, Financial), Krones (XTER:KRN, Financial), Coca-Cola FEMSA (KOF, Financial), and Kemira (OHEL:KEMIRA, Financial), among a host of other industrial companies. In contrast, a number of the Funds’ pharmaceutical, interactive media, food, and diversified financial services holdings took it on the chin, with the hardest hit taken by companies such as Roche (XSWX:ROG, Financial), GSK (GSK, Financial) (GlaxoSmithKline), Alphabet (GOOG, Financial) (Google), Alibaba (BABA, Financial), Nestlé (XSWX:NESN, Financial) and Berkshire Hathaway (BRK.B, Financial), among a host of others. From a geographic perspective, the Funds’ best returns came from their European holdings (France, Sweden, Germany, the UK, Italy, and the Netherlands) where a mild winter relieved some of the pressure on energy prices. In contrast, many of the Funds’ US-based holdings, and a number of their Asian holdings proved to be a disappointment. In addition to Berkshire and Alphabet mentioned above, other poorly performing US securities included Cisco Systems (CSCO), FMC (FMC), and Johnson & Johnson (JNJ). A number of Hong Kong, Chinese, and Korean companies also produced disappointing results including CK Hutchison (HKSE:00001), Alibaba and Samsung Electronics (XKRX:005930).
With market volatility persisting for most of the last year, we continued to remain active, establishing a significant number of new positions in our Funds. We also added to a number of positions during the period. As you can see in the chart on the following page, which outlines purchase and sale activity in our flagship Fund over the last year, these new positions, which consisted primarily of smaller-and medium-sized companies, were, for the most part also significant positive contributors to the Fund’s performance.
On the sell side, we sold the bulk of our Funds’ remaining shares of BASF (XTER:BAS), the German-based chemical company; 3M (MMM), the US-based manufacturer of consumer brands; Astellas Pharma (TSE:4503), the Japanese pharmaceutical company, GSK (GlaxoSmithKline), the UK-based pharmaceutical company; and Bollore (XPAR:BOL), the French-based holding company with interests in transportation, logistics, and media. The stock prices of these businesses had either reached our estimates of underlying intrinsic values, or had been compromised in some way by virtue of declines in our estimates of their underlying intrinsic values and future growth prospects. In other instances, we trimmed back positions to make room for new additions or to generate losses, which could be used to offset realized gains.
Last fall, in our semi-annual letter to shareholders, we discussed becoming active in one of our Funds’ holdings, Bachoco (IBA), a Mexican poultry company. We had argued aggressively against a proposed voluntary tender offer by the Robinson Bours family, which we viewed as well below intrinsic value, unfairly benefitting the family at the expense of minority shareholders. We made numerous efforts to put pressure on the controlling family through the press and combined efforts with other shareholders in hopes of achieving a better outcome. However, we unfortunately must report that our efforts were to no avail. The family moved forward with their voluntary tender offer, and we were left with two bad options: be forced to embrace, in our view, a low-ball offer and tender our shares well below our estimates of their fair value; or not tender, and face even less liquidity in an already thinly traded stock. We reluctantly decided to take option one and tendered our shares at the last minute. While the returns we earned in Bachoco were positive, we felt we were forced to leave a lot of money on the table in terms of potential foregone value. Other than the Bachoco outcome, there was little else to report in terms of material risk or opportunity on the environmental, social and/or governance (ESG) front. Rest assured we remain committed to carefully evaluating any material risks or opportunities that ESG issues we identify may pose to our estimates of the future compound of the underlying intrinsic values of our Funds’ portfolio holdings. Our approach to ESG has always been, and will continue to be, aligned with our fiduciary obligations and our goal to seek to provide the best risk-adjusted returns to our shareholders, consistent with the Funds’ investment objectives and strategies.
We believe the Tweedy, Browne Funds remain well positioned to take advantage of the opportunities presented by the apparent ongoing “reset” in our capital markets. First and foremost, the Funds’ portfolios bear little resemblance to large cap indexes. You can see in the following chart the multi-cap character of our International Value Fund’s portfolio, which has a significant percentage of micro, smaller and medium capitalization companies. As of March 31, 2023, roughly 28% of the Fund’s equity market capitalization was invested in companies with market capitalizations below $10 billion. This compares to only 10% of the MSCI EAFE Index being invested in companies with market caps below $10 billion.
The Funds’ country weightings are also substantially different from those of the MSCI EAFE or World Indices. For example, the Worldwide High Dividend Yield Value Fund has approximately 15% of its equity capital invested in US companies compared to the MSCI World’s US weighting of 68%. The International Value Fund II-Currency Unhedged has roughly 6% of its equity capital invested in Japanese companies compared to the MSCI EAFE Index weighting of 22% in Japan. In addition, according to Bloomberg, as of March 31, 2023, all four Funds have “active share” calculations respectively, of 89.8% (International Value), 90.0% (International Value II), 94.2% (Value), and 95.5% (Worldwide High Dividend Yield Value). Active share calculates the percentage of stock holdings in a fund portfolio that differs from the fund portfolio’s benchmark index.
Secondly, all four of our Funds have been non-US-centric in terms of their portfolio allocations for years, and remain so today. As we mentioned earlier, the valuation differential between US and non-US equities has grown quite significantly over the last many years and, in our view, remains largely in favor of non-US equities.
And thirdly, we believe it would be hard to dispute that our Fund portfolios are attractive, on the whole, from a valuation perspective. Each of our four Funds’ portfolio holdings, when considered in aggregate, generally trade at what we consider to be reasonably attractive weighted average valuation multiples such as price in relation to forward earnings, price in relation to book value, and price in relation to measures of pre-tax operating income. The owner earnings yield, defined as net after tax profit divided by enterprise value, for many, if not most of the new buys for our Funds over the last couple of years, has typically been right around 7-8% or higher, which compares quite favorably to most corporate after tax earnings yields.
In our view, the Funds’ diversification by issue, country, industry group and market cap, not only helps to reduce volatility, but more importantly it helps to lessen fundamental risk. (As noted above, diversification does not guarantee a profit and does not protect against a loss in a declining market.)
In addition, the vast majority of the companies in which the Funds are invested carry, in our view, very modest levels of debt leverage. New purchases for our Funds are generally made at prices in the stock market that represent significant discounts from our conservative estimates of underlying intrinsic value. For our flagship International Value Fund and our globally invested Value Fund, we hedge perceived foreign currency exposure back into the US dollar where practicable. Studies have shown that this reduces volatility in international equity portfolios. While we personally put very little stock in statistical measures of risk that focus on volatility of returns such as standard deviation, beta, and/ or Sharpe ratios, all four of our Funds generally compare favorably to benchmark indices on those measures over the long term. On an overall basis for the period ending March 31, 2023, Morningstar rated the International Value and Value Funds with their lowest risk rating, “Low;” and the International Value – II and Worldwide High Dividend Yield Value Fund with their next lowest rating, “Below Average.” As Warren Buffett (Trades, Portfolio) has frequently said, “to finish first, you must first finish.” We never lose sight of that admonition.
As we have mentioned in past reports, our Tweedy Fund portfolios contain a diversified mix of what we believe to be high quality companies that we often refer to as better businesses; more cyclical, asset-rich enterprises whose fortunes ebb and flow to a certain extent with the economy; and smaller positions in a number of companies with compelling statistical profiles that we classify as statistical bets. Insider buying is often a factor in this segment of the portfolio, which we have often referred to as the underwriting component, since it is metaphorically akin to the way an insurance company uses statistics and diversification to “underwrite” risk. When we are asked by prospective clients what makes us different, it is this mosaic of value that, in our view, distinguishes our approach from most of our competitors.
FINANCIAL SUBURBANS
The better business component of the portfolio often includes companies that we believe have demonstrable and durable competitive advantages that should allow those companies to earn above-average returns on their invested capital. At times, we have referred to these types of companies as “financial Suburbans,” i.e., businesses that we believe can withstand virtually any economic headwinds or accidents that come their way. They are ideal candidates for purchase but, unfortunately, they rarely trade at compelling discounts from conservative estimates of underlying intrinsic value. Pricing opportunities in these companies often occur only in severe market downturns when investor fear is rampant. But when they do appear, we pounce. Higher confidence levels in these businesses often allow us to take larger position sizes at purchase. And once purchased, we can often own them for very long holding periods, sometimes for decades, as they have had an uncanny ability to steadily compound their intrinsic value over long measurement periods at levels that allow for continued collateralization of their stock prices.
Nevertheless, clients and consultants often ask why our portfolios continue to hold meaningful positions in companies such as Nestlé, Heineken, and Diageo, among others, which we have owned for multiple decades. After all, these “better business compounders” are not always cheap and are not typical “value stocks” for much of the time. So why do we own them, and why are they an important part of what we do?
In our opinion, all three of these companies have solid business models that are propelled by a global presence and brand positions that competitors find difficult to fight with. They tend to sell many low-priced items rather than a few big-ticket items, and we think there is safety in that. It’s generally easier to splurge on a bottle of Heineken or a Nestlé Nespresso pod than on a new BMW. Consumer identification with their brands is strong, and they have scale in production and advertising, as well as distribution power. Another important element is that they appear to have been able to absorb input price inflation much more comfortably than competitors with weaker or no brands, and lower margins. Typically, raw materials are a much larger part of total costs for their weaker and non-branded competitors. People appear to be willing to pay up for these brands. In addition, in our experience, as a consumer’s income goes up, there is a tendency to upgrade to “better” brands. Premiumization is a big long-term trend in all three of these businesses. The reasons why people pay up for brands are many — perceptions of better quality, aspiration, status and social signaling, among others. These companies have been hawks when it comes to keeping their brands connected with the consumer, and assuring that they remain relevant and interesting. For example, Nestlé continues to “reinvent” coffee. They have turned Nespresso into a luxury product, and are working hard to keep their coffee products connected to a younger audience. Diageo, similarly, has focused its attention on younger consumers, in an effort to increase their knowledge and appreciation of cocktails, mixers, and premium spirits. If you want to impress guests and/or feel good about yourself, as aspiring, rising income consumers are often want to do, purchasing a premium bottle of tequila or whiskey may be a small price to pay to “keep up with the Joneses.” The additional outlay may appear even smaller when the premium spirit is being consumed on a per drink basis.
We have also found, through experience, that there is often economic protection in brands. These kinds of companies generally charge more for branded products and, in turn, produce higher gross margins that afford them room to maneuver through difficult economic times. Branded consumer products companies often produce high returns on their invested capital (the money they invest into their businesses). In our view, they have been unusually focused on doing their best to drive the value of company shares over the long term. For example, when it comes to Nestlé, Diageo, and Heineken, in our estimation, they have been able to grow their per-share intrinsic value annually in the roughly 6-8% range over decades. These attractive, and relatively stable, levels of growth have been driven in large part by: 1) high returns on capital, 2) relatively stable top line (revenue) growth, 3) increase in EBIT margin from both premiumization (trading up) and efficiency gains, and 4) cash generation. In some cases, this value growth has been enhanced further by intelligent share buybacks. Finally, the less knowable factor that can further drive (but also detract from) value growth is acquisitions. We follow merger and acquisition (M&A) activity closely as bad and/or expensive acquisitions can sometimes destroy value. We take some comfort in the notion that these types of companies are typically very large, and that when they do on occasion become acquisitive, the transactions are generally smaller in scope, and therefore mathematically less likely to impair or materially affect value and value creation. The risk of overpayment for an ill-advised acquisition is, in our opinion, not likely to cause the ship to go radically off course.
While overall, we believe companies like Nestlé, Diageo, and Heineken are very attractive assets, it doesn’t necessarily mean they are cheap stocks offering above-average odds of making good returns by buying them blindly at any point in time. And so we reiterate, like broken records: it is all about price. We try to buy stocks like these when their valuations in the market reflect significant discounts from M&A deals for similar companies. As previously mentioned, entry point pricing opportunities in companies like these are extremely rare. We would analogize it to the chance of stumbling on a family of snow leopards in the wild. On those few and far between occasions when we believe they are trading cheap, lower stock prices are often the result of bad news, a major breakdown in the stock market, or some other Black Swan event. In those circumstances, we remain laser-focused in our analysis of valuation and the risk of franchise impairment. We ponder if what we are seeing is just the fashion or delusion of the day or a more secular structural change. If we think only short term, non-structural considerations are driving a share price down, we may buy or add. Then we sit and wait and, hopefully, our Fund shareholders will enjoy the fruits of the investment. We believe these types of investments have at least two engines — one being growth in the intrinsic value of the shares our Funds own and the other one being the closing of the valuation gap that we identified at purchase (from cheap to what-you-would-expect-for-a-business-of-that-caliber). A share buyback executed at low prices can often be the third engine that helps to drive value and the share price over the longer term.
All of the above factors, together with the relative stability of the value compound over time, often leads to long holding periods in these stocks. When, in our view, the valuation gap closes (or is more than closed), as market conditions warrant, we may reduce the position in the stock, incrementally taking money off the table, hoping that one day we’ll be able to add to the position cheaply again. Our work in the meantime is to monitor company developments, industry trends, and M&A deals and continue paying close attention to price versus fundamental value.
As is apparent, these stocks continue to play an important role in our Fund portfolios. If this were a discussion about electricity generation, we’d call these stocks “base-loaders” because they tend to be, in our view, large, reliable, and weather-proof. Although they may not offer the very best prospect of outsized returns at given points in time, in our experience they generally tend to come into their own over time. And, when the chips are down, both in the stock market and in the economy, they often provide meaningful ballast. This quality matters to us in trying to protect your capital in weaker markets and grow your capital over the longer term.
FINAL THOUGHTS
"Capitalism without failure is like religion without sin. It doesn’t work." -Allan Meltzer, former Federal Reserve historian and acting member of the Council of Economic Advisors
As we write, we find ourselves once again in a period of great economic uncertainty and periodic financial instability. The performance of our capital markets over the last year, plagued by stubborn and pernicious inflation and spiking interest rates, at times, resembled the proverbial “slow train wreck.” While the COVID-induced opening and closing of the world economy, and the Ukraine War have played no small role in this calamity, identifying the ultimate culprit for the turmoil we find ourselves in today requires a somewhat more nuanced analysis. Borrowing from Shakespeare, “the fault dear Brutus” would appear to lie with the well-intended, but ill-advised, zero-bound monetary policies put in place by policy makers to spur economic growth and to help support our financial markets post the 2008 financial crisis. The past decade-plus of easy — let us rephrase that — almost free money, has spawned a whole host of unintended consequences, not the least of which, are fragility in our capital markets, precious little organic growth, low levels of productivity in our workforce, and disparities of wealth and income, which in turn have ignited a dangerous populism threatening democratic institutions at home and abroad. We realize this is quite a mouthful, but low interest rates are a powerful elixir. Negative interest rates, in our view, create moral hazard on steroids.
While we are certainly not economists at Tweedy, Browne, Allan Meltzer’s observation in the quote above, at least to us, has a ring of truth to it. An appropriate colloquial corollary thereto might be “no pain, no gain.” If the economy and financial markets are not allowed to face painful fallout from competitive market discipline from time to time, they can become weak and vulnerable to Black Swan events such as pandemics and foreign wars. One of our worthy competitors, Tom Russo (Trades, Portfolio), has often remarked that the measure of a great company is its “capacity to suffer.” We believe fervently that having to face the discipline of the market is good for business and the economy. In our view, investors develop a better understanding between risk and return when they have to confront periodic hardship. The seemingly endless interventions of central bankers around the world over the last decade to keep rates at the zero bound essentially freed investors from the requirement to pay much, if any, attention to the value they received versus the price they paid for risk assets. Zombie companies, meme stocks, crypto currencies, special purpose acquisition companies (SPACs), technology unicorns, boom and bust cycles, and the buildup of massive leverage in our financial markets are just a few of the side effects associated with the periodic palliative care offered up by our well-intentioned regulators. We at Tweedy often long for the return of market discipline and the periodic financial cleansing afforded by the rolling recessions that in the past were a natural part of the good old business cycle. Attempts by policy makers to sort through endless amounts of data and engage in financial engineering in an effort to try to eradicate it, are, in our view, often counterproductive and, at times, fraught with peril. With the Fed at a crossroads of late, having to periodically face Hobbesian choices between supporting market stability (bank failures) and battling persistent inflation, the need to address the folly of past policy may finally be upon us. In this respect, we remain hopeful that a “sea change” is indeed likely afoot in our economy and in our capital markets.
So where does that leave us? We do not want to appear giddy or unduly optimistic, but these are the moments in markets that get value investors “chomping at the proverbial bit.” While it remains unclear whether markets, as of yet, have adequately adjusted to reflect the new economic realities, we do not see the world in some state of terminal economic decline. As Bruce Greenwald, the former long-time director of the Heilbrunn Center for Graham & Dodd Investing at Columbia Business School, and a shrewd investor in his own right, pointed out at a Columbia Business School value conference almost a decade ago, “the apocalyptic view is almost never justified.” Our perspective is to continually ask ourselves where we are likely to be over the next three to five years. Viewed through that lens, we are very excited about what the Funds own and the new investment opportunities that have become available to them in this turbulent period. Moreover, we are reassured by our belief that many of the businesses the Funds own are adaptive, competitive organizations with financial and human resources that should allow them to adjust to changing circumstances and markets. If we are right about the apparent reset in our capital markets, the days ahead may very well continue to favor our style of investing.
Thank you for your continued confidence and trust.
Sincerely,
Roger R. de Bree, Andrew Ewert, Frank H. Hawrylak, Jay Hill, Thomas H. Shrager, John D. Spears, Robert Q. Wyckoff, Jr.
INVESTMENT COMMITTEE
May 2023
Mention of a specific security should not be considered a recommendation to buy or a solicitation to sell that security. Portfolio holdings are subject to change at any time without notice and may not be representative of a Fund’s current or future investments.
The views expressed represent the opinions of Tweedy, Browne Company LLC as of the date of this letter, are not intended as a forecast or a guarantee of future results, or investment advice and are subject to change without notice.
