It is during our darkest moments that we must focus to see the light.
– Aristotle
To Our Shareholders:
We hope you and your loved ones remain safe and well, and are coping as best you can in this challenging environment. At Tweedy, Browne, we feel we are truly blessed to be able to continue to work and serve our clients during this crisis. While we are acutely aware and sensitive to the fact that the lives of so many have been turned upside down by this pernicious virus, we are encouraged of late by the slow, but steadily improving economy, and the prospects for medical treatments and/or vaccines.
Seldom have we seen the rise of a phoenix the likes of which we witnessed over the last six months in global equity markets, particularly in capitalization-weighted indexes. For the average stock, it has been somewhat of a different story. While many, if not most, sectors, industry groups, and stocks participated in the recovery in stock prices, the strongest returns, overwhelmingly, were concentrated in technology stocks, particularly those dominant U.S. companies we have grown to know so well. These enterprises actually benefitted from the pandemic-driven economic lockdowns that were occurring all over the world. Value stocks, particularly those that are more economically sensitive, took a backseat to their higher-growth brethren, despite a significant pick-up in economic activity off of a bottom that some would argue at least temporarily rivaled the initial declines of the Great Depression. This has led to a bifurcated market where the spread between growth and value indexes has rarely if ever been wider. For example, the MSCI World Value Index in local currency trailed its growth counterpart over the last six months ending September 30, 2020 by over 2,297 basis points; and, year-to-date as of September 30, 2020, the Value Index remains behind the MSCI World Growth Index by over 3,324 basis points. If the past is indeed prologue, the factors which have weighed value down relative to growth will eventually recede, allowing this investment teeter-totter to shift back in favor of the more value-oriented components of the market. We just don't know when.
In this robust but bifurcated environment for stocks, all four of the Tweedy, Browne Funds made considerable financial progress. However, for the six-month reporting period ending September 30, they trailed their respective benchmark indexes, which were propelled by the narrow group of aforementioned technology companies.
The impact of a rather narrow group of technology stocks on performance over the last six months cannot be overstated, and this has been a global phenomenon. One of our Managing Directors recently tracked the performance of the largest companies in terms of market capitalization in the United States, Europe, and Japan as of September 30, 2020. He found the following:
- There are 114 companies in the world with a market capitalization above $100 billion. Of these, 92 are based in the markets studied: 70 are U.S.-based, 5 are in Japan, and 17 are in Europe.
- Applying the "Buffett indicator" (i.e., a comparison of the total market capitalization of a country or region's equity market compared to the GDP produced by that country or region) to these markets, he found that the U.S. equity market traded at a valuation in relation to GDP that far exceeded Europe's and Japan's equity markets. The total market capitalization of the U.S. equity market was 1.7 times U.S. GDP; in contrast, the total market capitalization of the Japanese equity market was 1.2 times Japan's GDP; and the European equity market had a total equity market capitalization that was only 0.4 times total GDP of Europe.
- The 25 biggest companies in each of the regions (U.S., Japan, and Europe) make up roughly 40% of the overall market capitalization of their respective regions.
- A review of enterprise value ("EV") multiples and performance year to date for the top 25 companies in each region vs. the relevant benchmark indexes (MSCI USA Index, MSCI Europe Index, and MSCI Japan Index) reveals that the top 25 U.S. stocks were nearly twice as expensive as their European counterparts, and roughly 1.3 times more expensive than the top 25 in Japan. Furthermore, while the returns of the U.S. top 25 dominated those of Europe and Japan, the year-to-date performance for the top 25 companies in each region crushed the performance of their respective benchmark indexes.
- Technology-related stocks make up 67% of the market capitalization of the top 25 companies in the U.S., and there are no oil, energy, mining, or chemical companies in the group. The automobile industry's sole representative is Tesla, whose market cap ranks it the eighth largest company amongst the 25.
- In Europe, there are only three technology companies in the top 25, consisting of 14% of the total market capitalization of the top 25, ranking this sector behind pharmaceuticals (29%), consumer durables (19%), and consumer staples (17%). There are no telecom, banking, or media companies in the top 25.
- Technology-related stocks in Japan make up 37% of the market capitalization of Japan's top 25 companies.
- In each region, the technology sector was the driving force in terms of performance for the top 25, accounting for 74% of the U.S. top 25 total return, 70% of the European top 25 total return, and 87% of the Japanese top 25 total return. The technology sector consisted of 12 stocks in the U.S. group, 3 stocks in Europe, and 9 stocks in Japan. In the U.S., virtually all of the remaining return of the top 25 companies was accounted for by Tesla, which was up over 400% year-to-date through September 30, 2020.
Nir Kaissar of Bloomberg, in an article entitled Money Managers Are Punished by a Runaway S&P 500 published on September 1st, confirms the conclusions of our own findings, but over a longer time horizon. To quote Kaissar:
….the more managers diversified their portfolios, the more they lagged the market………What happened? The fault is in the stocks. A handful of them have performed spectacularly in recent years while the rest have stalled or worse. There are roughly 9,000 companies in indexes that track the broad global stock market, but just 30 of them produced more than 70% of the total gain over the past five years, more than half of them U.S. companies. Ten stocks--Amazon.com Inc., Apple Inc., Microsoft Corp., NVIDIA Corp., and Advanced Micro Devices Inc., in the U.S.; Alibaba Group, Tencent Holdings Ltd., and Kweichow Moutai Co. in China; Shopify Inc. in Canada; and Magazine Luiza SA in Brazil – were responsible for more than 50% of the gain. And amazingly, just three – Amazon, Apple, and Microsoft – contributed 25% of the gain.
Investment managers and institutions who have prudently been diversified and selective in building their portfolios have been severely punished in terms of relative return. Kaissar, citing data from Morningstar, points out that of the roughly 10,000 equity and alternative U.S. mutual funds with a five-year record, only 17% were able to best the S&P 500. He further found that of the 38 university endowments tracked by Bloomberg that have reported performance through fiscal year 2019, all of which have assets greater than $1 billion, not one beat the S&P 500 over the previous five years, and that included even Harvard and Yale. The quandary of course, rightly pointed out by Kaissar, is where active investment managers go from here – chase the "puck," or stick to their respective disciplines patiently waiting for the equity market to correct?
The last time money managers had to face such an anxious choice was in 1999-2000, at the height of the tech bubble. The choice was particularly stark for professional value investors, many of whom were thought to be on their very last breaths, with clients abandoning them in droves. Many of you probably remember the aftermath of that period, which is often referred to as the "dot-com era." The technology bubble burst in March of 2000, sending technology stocks and indexes crashing down while value regained ascendency.
We decided to take a trip down memory lane to examine what happened to some of the most successful dot-com darlings of that era. Many of these stocks had appreciated by 400% to 500% during the late 1990s, greatly surpassing what was a strong period overall for stock market performance. In the chart below, we attempt to illustrate the before and after for a number of those companies. Bear in mind that these companies were not dot-com "airballs," but rather were rapidly growing and profitable companies much like the FAANGs today.
Quite unexpectedly, the stock prices of these great, seemingly indestructible franchises in late March of 2000 began to correct. By late 2001, companies such as Microsoft (MSFT, Financial), Cisco (CSCO, Financial), Oracle (ORCL, Financial), Intel (INTC, Financial), and Hewlett-Packard (HPE, Financial) had lost between 44% and as much as 80% of their value. Despite the collapse in their stock market valuations, these companies continued to grow their earnings. Only Microsoft, IBM (IBM, Financial) and Oracle were able to recoup and surpass their 1999-2000 peak stock market valuations, but it took them until October of 2016, October of 2010 and June of 2017, respectively, to do so. The rest never reclaimed their prior glory. Despite becoming the largest company in the world in terms of market capitalization in 2000, Cisco's growth slowed in the years following, and its stock price as of September 30 of this year remained just over 50% below its peak price achieved on March 27, 2000. IBM, of late, has languished, and is today trading below its 1999-2000 peak, as it has not been able to innovate fast enough to offset the declining value of their legacy businesses. Lucent fell on hard times and merged into Alcatel; Nortel went bankrupt; and Sun Microsystems was acquired by Oracle. Even though Intel has continued to maintain its dominance in the production of microprocessors, its stock price has never regained the levels it achieved during the dot-com bubble. And, Amazon – a smaller company at the time whose stock price had gone up by over 4,800% between June 1997 and late 1999 – lost 85% of that equity value by year-end 2000.
Between March 9, 2000 and October 9, 2002, the NASDAQ Index lost over 77% of its value, and it did not recoup its peak 2000 value until 15 years later, in April of 2015. In our humble view, the lesson to be gleaned from the dot-com bubble and what followed is that price matters, even when it comes to highly innovative and disruptive technology stocks.
As technology slowly regained its footing in 2003 and began its long march back, another group of innovative companies moved to the head of the class led by Google (GOOG, Financial)(GOOGL, Financial), Facebook (FB, Financial), Netflix (NFLX, Financial), and joined by re-energized stalwarts, Amazon (AMZN), Apple (AAPL) and Microsoft. As you can see from the chart below, all six of these companies enjoyed explosive growth after the financial crisis in 2008, and as a group today trade at valuations in some instances comparable to those of the dot-com darlings of 2000.
It's understandable that the tech companies have benefitted from the "stay-at-home" economy that has been imposed upon us by COVID-19. But what will happen to the market leadership going forward, especially looking further out over the longer term? Will the past be prologue? Will the proverbial tortoise catch and surpass the hare, as the fable portends? Or are we indeed in an unending "new era," dominated by a handful of companies that face little to no competition, and whose exuberant valuations are supported by a central bank that will do whatever it takes to keep the music playing? It is impossible to know of course, but as Lew Sanders of Sanford Bernstein once said, the money on the table is considerable, and the question deserves serious thought.
Signs of Speculative Excess in Equity Markets
Paraphrasing the lyrics of Diana Ross's (The Supremes) hit song from 1970, "Ain't no mountain high enough … to keep me from getting to you," there isn't a valuation high enough these days to keep investors away from high-flying technology stocks. According to Amrith Ramkumar of The Wall Street Journal, "companies that do everything from manufacturing phones to operating social-media platforms now account for nearly 40% of the S&P 500, on pace to eclipse a record of 37% from 1999, according to a Dow Jones Market Data analysis of annual market-value data going back 30 years." In another recent WSJ article, Gunjan Banerji and Peter Santilli point out that "more stocks skyrocketed at least 400% at some point in the first three quarters of the year than in any comparable period since 2000." This included companies such as Tesla (TSLA), Zoom (ZM), Moderna (MRNA), Nikola (NKLA), and Overstock.com (OSTK), among a host of others. According to Banerji and Santilli, at their various individual peaks during the first three quarters, over 60 NASDAQ stocks had risen more than 400%, and four of those companies exceeded 2,500%. This is in sharp contrast to 1,000 stocks in the index that suffered declines of 50% at their low points during the same period.
One of the poster children of this group that has developed almost a cult following, of course, is the electric automobile company, Tesla, which was up 413% year to date and 791% for the one-year period ending September 30, 2020. In comparison, older-economy auto companies such as BMW (XTER:BMW), Daimler (XTER:DAI), Porsche (XTER:PAH3), GM (GM), and Toyota (TM) produced returns of 1.1%, 3.4%, -14.7%, -19.2%, and -0.8%, respectively, for the one-year period ending September 30. Tesla is now the eighth largest company in the United States, and as of September 30, 2020, traded at a price earnings multiple according to Bloomberg of 680 times trailing and 137 times estimated 2021 earnings. For purposes of comparison, using the roughly $400 billion market cap that Tesla enjoys today (as of September 30, 2020), one could own all of BMW, Daimler, Toyota, GM, and Porsche, earn 25 times the 2020 estimated earnings of Tesla, and have $20 billion left over for walking around money. And up until the last five quarters, Tesla had not made a dime in reported earnings. Of the $8.8 billion in revenue Tesla generated in the 3rd quarter, about 4.5%, or $397 million, came from the sales of zero-emission vehicle (ZEV) regulatory credits, and not from car sales. These credits can be used by non-compliant auto companies to offset regulatorily imposed penalties for the failure to produce electric, hybrid and other zero-emission vehicles. Since Tesla only makes electric vehicles, they have no use for them other than to sell them to other car companies who are not yet in compliance with regulations. Without the regulatory credit revenue, Tesla would have remained unprofitable over the last five quarters. In fact, Tesla's revenue from regulatory credit sales during the quarter was greater than the company's free cash flow, and amounted to 132% of the company's 3rd quarter net income to common stockholders. As other car companies gradually come into compliance, the ability for Tesla to generate revenue from the sale of credits will likely decrease or go away.
Another sign of excess in equity markets centers around Wall Street's revival of the SPAC, or special purpose acquisition company, last popular during the height of the credit bubble in 2007. SPACs are essentially shell companies with no assets, products or earnings which are brought public via an Initial Public Offering (IPO) for the sole purpose of making acquisitions. These vehicles have been around for decades, and are often referred to as "blank check" companies.
While there are more protections for investors in today's SPACs, sponsoring promoters still have an unusual amount of discretion over how the money gets invested, and generally receive a "promote" consisting of nominally-priced founder's shares entitling them to as much as 20% of the total shares outstanding following the IPO. According to James Mackintosh of The Wall Street Journal, SPACs raised a record $53 billion in 2020; and if you add in 2019, more money has been raised by SPACs in 2019 and so far in 2020 alone than by all SPACs since the concept originated in 2003 (through the end of 2018). Such is the faith accorded by investors to savvy financial engineers in a momentum-driven equity market fueled by essentially free money.
Perhaps the most troubling sign of speculative excess in our equity markets today is the reappearance of the day trader. One cannot help but harken back to the late days of the 1999-2000 tech bubble when New York cab drivers were reportedly day trading equities on laptops in the front passenger seats of their cabs. Such was the confidence of investors in these new innovative companies that provided the spark for a new industrial revolution in which the normal rules of finance seemed to no longer apply.
Fast forwarding to this year, investors, bored out of their minds, stuck at home, unable to bet on sports in the early days of the pandemic, took to their computers and flocked to internet trading platforms such as E*trade (ETFC) and the more recent start-up, Robinhood. It has been reported that E*trade opened 260,500 new accounts in the month of March, which was more accounts than the company had ever opened in a single year since its inception. Robinhood, the popular new commission free trading app, reportedly logged three million new customers in the first quarter of this year, and now has over 13 million accounts directed by investors whose median age is 31. According to Bloomberg, the no-fee trading app logged daily average revenue trades (DARTs) of 4.3 million in June, higher than all of its publicly-traded rivals, including the likes of Charles Schwab (SCHW). Once you complete a trade, celebratory confetti flashes on the trader's computer screen, with effects similar to a videogame. This gets the endorphins flowing, and increasingly, day trading investors have even been utilizing options to effectively leverage their online bets on stocks. Sound familiar?
Are we in the midst of a tech bubble, and if so, for how long can all this frenetic enthusiasm around tech stocks continue? The difference this time around, as some would suggest and we find hard to take issue with, is the extraordinarily low level of interest rates, which many of our most well-respected professional peers would argue justifies high valuations. The question, of course, is how high.
And for how long can such an accommodative interest rate structure be successfully engineered? It is as if the Federal Reserve's endless interventions to keep rates low through the cutting of the discount rate and quantitative easing have freed investors from the requirement to pay much, if any, attention to the value they receive vs. the price they pay for risk assets. After all, an earnings yield of only 1%, which implies a valuation of 100 times earnings and a payback period of 100 years, is today about five times the three-year Treasury bond yield of 0.19%. While Ben Graham often found value in securities whose earnings yields exceeded those of risk-free instruments, we find it difficult to believe that the extraordinarily high equity valuations we are seeing today in technology stocks would have caused the likes of a skeptical but rational investor such as Benjamin Graham to "tremble with greed."
While intervention by the Federal Reserve was, of course, required during this pandemic, and is helping to bridge the economic gap until an eventual recovery, zero interest rate policies (ZIRP) put into effect on such an unprecedented scale as they have been over the last decade can produce unintended consequences, not the least of which, as we have observed, is the escalation of risk asset prices, inequalities of wealth and income, anemic economic growth, and incentives for moral hazard. In an article in the The Wall Street Journal in late July entitled The Rescues Ruining Capitalism, Ruchir Sharma went so far as to say that, "Our growing intolerance for economic risk and loss is undermining the natural resilience of capitalism and now threatens its very survival."
While we are not sure we would go so far as Mr. Sharma in suggesting the imminent demise of capitalism, zero interest rates have without doubt helped to fuel the animal spirits of investors over the last many years, and helped drive valuations in the tech sector to levels for many companies that we believe are unsustainable over the longer term. It has also helped fuel the poor relative returns of value investors.
Investment Performance
While the four Tweedy, Browne Funds were up between 23.8% and 29.5% since the March 23rd market lows through September 30, and have recouped much of the ground lost during the pandemic-driven sell-off, they remain in the red year-to-date, and have trailed their respective benchmark indexes. This is largely due to the Funds' value and international orientations. These areas of the global equity markets have lagged their growth and U.S. counterparts. Recent underperformance has compromised the Funds' annualized comparisons over one-, five-, and ten-year periods. Prior to 2013, all four Funds outpaced their benchmarks in most standardized annualized reporting periods. As a result, longer-term comparisons remain quite favorable, particularly for our flagship fund, the Tweedy, Browne Global Value Fund, which over time has ranked near the top of its peer group universe at Morningstar. Following are the Morningstar peer group comparisons for the Global Value Fund and the performance history for all four Funds, including comparisons with relevant benchmark indexes.
