"You can’talways get what you want. But if you try sometimes, you just might find, you get what you need." - The Rolling Stones
TO OUR SHAREHOLDERS:
It was with an overwhelming sense of relief and exhilaration that we welcomed the majority of our employees back to the office on a regular basis beginning October 4th. We welcome and encourage you to visit us when you are in the area. Back in mid-October, we had our first in-person meeting at our offices with an investment consultant, the first such meeting in a year and a half. It’s hard to express how good it felt to sit across the table from living and breathing human beings in a three dimensional setting instead of in a Zoom meeting. While the pandemic has been horrific and a tragedy for so many, with more people getting vaccinated and new therapeutics on the way, there are glimmers of light appearing at the end of this long dark tunnel.
Since the vaccine announcements last November, investors have been engaged in nothing short of an ongoing tug-of-war between the so-called “reopening trade,” which favors more economically-sensitive (often value) stocks, and the “stay at home” trade, which favors large technology stocks. Since mid-May, concerns about the Delta variant’s impact on the continued strength of the recovery has allowed the growth component of the MSCI World Index to claw back a good deal of the ground it lost to the value component, when the rotation back into value stocks began in earnest during the last few months of 2020. However, as market volatility picked up around the end of the third quarter, in part due to inflation concerns and continued worries about the Delta variant, we were encouraged to see the value component rebound, if ever so slightly. Amidst this back and forth, rising vaccination rates around the world, coupled with the prospects for an eventual retreat of COVID-19, continued to fuel economic reopenings, the recovery and growth in corporate earnings, and, in turn, what has been a historic advance in global equities and other risk assets. As we write, many equity market indices have hit all-time highs, particularly US-based indices.
Global equity valuations remain elevated, as overworked acronyms such as FOMO (fear of missing out) and TINA (there is no alternative) continue to influence investor behavior. However, economic storm clouds appear to be gathering on the horizon in the form of supply chain disruptions and recent increases in prices, inflationary expectations, and interest rates. The question of whether this inflationary threat proves to be temporary or more permanent will likely continue to drive investor sentiment and stock prices in the near term.
We continue to believe that a strong fundamental economic recovery, fueled by accelerated reopenings across the developed and developing world, significant valuation disparities between value and growth stocks, and the prospects for increasing rates of inflation, inflationary expectations, and interest rates will, over time, favor value stocks. We are hopeful that the “great rotation into value,” which began roughly a year ago, is still ongoing and sustainable.
“Have the Chickens Finally Come Home to Roost?”
CAVEAT EMPTOR, we are not economists. That said, we have always been amused by the Federal Reserve’s seeming concern that we have too little inflation. For many years now, the Fed has pursued a policy that has targeted 2% inflation to support full employment and to protect against deflation. The Fed recently amended its policy to allow for inflation to temporarily exceed 2% in order to make up for past low inflation. The key aim of this policy shift was, apparently, to try to anchor inflationary expectations around 2% as inflation temporarily drifted higher. After well over a decade of well-intentioned monetary largesse that lowered interest rates to near zero and flooded our economy with liquidity, along with a more recent assist from supply chain disruptions and soaring vaccine-induced aggregate demand, Jay Powell and his predecessors have finally gotten their long awaited inflation wish. The Wall Street Journal pointed out in an editorial many years ago, “Central bankers who wish for more inflation usually get their wish, and the result is rarely benign.”
The Wall Street Journal reported in late October that the Federal Reserve’s preferred measure of inflation, the personal-consumption-expenditures price index (PCEPI)1, rose 4.4% for the twelve months ending September 30, which according to the Commerce Department was the fastest pace in thirty years (since 1991). In addition, through October, year over year, the Consumer Price Index (CPI)2 was up 6.2%, the highest year over year increase since 1990. Even the core CPI, which excludes more volatile food and energy prices, was up 4.6%. Prices are rising everywhere you look — in housing, autos, groceries, producer prices, shipping, furniture, and rent, among a host of other products and services. For example, new vehicle prices are up 9.8% for the year; producer prices are up 8.6%; oil prices are up over 125%; car and truck rentals up 39.1%; beef prices up 20.1%; fish and seafood up 7.5%; major appliances up 6.0%; furniture and bedding up 12.0%; and the Case-Shiller Home Price Indexes3 through August are up 20%. And this list could go on and on. Significant increases in key input costs such as wages, transportation (trucking and shipping rates), producer and commodity prices (oil & gas, metals) are also putting considerable upward pressure on consumer prices.
Inflation is not just a US phenomenon. Inflation rates are climbing in many parts of the world, particularly in the emerging markets, fueled in large part by surging commodity and food prices. The November 6th edition of the Economist reported that among the 38 countries that make up the Organization for Economic Cooperation and Development (OECD), “inflation rose to an uncomfortable 4.6% year on year in September 2021.” After all, this should not be unexpected, as the expansive monetary and fiscal policies of the last decade were a somewhat coordinated and global phenomenon. Eurozone annual inflation surged to 4.1% in October, according to Eurostat, the EU statistics agency, significantly exceeding market expectations and adding to concerns that the European Central Bank may be underestimating inflationary trends. Consumer prices in the UK increased 4.2% in October, the fastest rate of inflation since December 2011. According to Destatis, the German statistical agency, the German CPI grew at a year over year rate of 4.1% through September. The CPI through September was up year over year 4.1% in Canada, 3% in Australia, 5.8% in Mexico, 4.6% in the Philippines and 2.6% in South Korea. While consumer price inflation was up only marginally year over year in China, 1.5%, Chinese producer prices climbed 13.5% from a year earlier, which according to Bloomberg was the fastest pace in 26 years.
Of even greater concern is what would appear to be rising inflationary expectations despite Federal Reserve Chair Powell’s reassurance that such expectations remain “well anchored.” While we are well aware that inflation has been rather low for a long period of time, if consumers and workers begin to believe that there has been a shift and that higher prices are inevitable, and these feelings become embedded in their psyche, it can lead to increasing demands for higher wages and a willingness to accept higher prices, which could result in a seemingly never ending cycle of wage and price increases that can be very hard to break. According to the New York Fed’s October survey, consumers expect inflation to run at 5.7% in the coming year and at an average annual rate of 4.2% for the next three years.
The bond market has also taken notice of these increases in inflation and inflationary expectations. As reported in the same previously mentioned November 6th edition of the Economist, five-year bond yields across a group of 35 economies have risen by an average of 65 basis points in just the past three months.This has yet to be felt in equity markets which continue to rally to record highs as investors continue to believe that central bankers will respond rationally and sensibly to make sure inflation does not get out of hand.
To that end, central bankers all over the world have been quick to reassure us that these near-term inflationary fires are temporary and will abate once supply chain disruptions subside and economic activity begins to normalize. However, one cannot help but flash back to the 1960s and the fiscal and monetary stimulus needed to finance the Vietnam War and support Lyndon Johnson’s “Great Society,” and, ultimately, the role that an oil embargo, and in turn, a spike in oil prices (1973 to 1974), had in helping to fuel pernicious inflation, and the near-decade-long stagflation4. This time around, the stimulus, both fiscal and monetary, employed over the last ten plus years to aid recovery from the financial crisis and the COVID pandemic reportedly dwarfs that of the 1970s.
While we want to emphasize again that we are not economists, there are a number of factors that suggest to us that the inflation we are experiencing may not be temporary, but in fact could persist:
- Wages are under increasing pressure ~ Wages are up fairlysignificantly over the last year due in part to worker shortages. Past experience would suggest that wage increases tend to be sticky. It’s hard to take money away from workers once you have given them a raise. Labor is also gaining leverage in compensation negotiations, as evidenced by increases in collective bargaining and the number of current and potential strikes on the horizon. A recent survey of small businesses indicated that 46% of small businesses plan to raise prices due to higher labor costs.
- Fiscal and monetary stimulus remains unprecedented ~As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.” Unprecedented monetary and fiscal stimulus since the financial crisis of 2008, which has, admittedly, had little or no impact on price levels up until very recently, has, in our view, allowed a borrow and spend mentality to become embedded in the psyche of policy makers. One can only wonder what impact the recent passage of the Biden administration’s $1 trillion infrastructure bill and its proposed $1.75 trillion social spending and climate bill will have on an accelerating economic recovery, and in turn, price levels. According to John Greenwood and Steve Hanke (Too Much Money Portends High Inflation, The Wall Street Journal, July 20, 2021), since March of 2020, the money supply in the US has grown at an annualized rate of 23.9%, the fastest since World War II.
- Inflationary expectations are rising ~ Numerous recentsurveys suggest an increase in inflationary expectations. If they become embedded in the minds of consumers, it could lead to a vicious wage-price spiral that is difficult to unwind.
- Globalization appears to be in retreat ~ This political shiftback to more nationalist and populist policies many years has spawned trade disputes, tariffs, and supply disruptions that continue to put upward pressure on prices.
- The global population is aging ~ According to data fromthe World Bank, populations around the world are aging and retirements are on the rise, especially in high income countries, cutting into the size of the workforce and impeding productivity. Recent research suggests that as workers retire, they are likely to keep spending while their contribution to production declines creating a supply demand imbalance that could add to inflationary pressures.
- Climate change is helping to inflate energy prices ~ “Greenpremiums” associated with more climate friendly alternative energy sources are driving up energy costs, which are a critical input cost in so many products. Oil and gas prices are also hitting near term highs and, with concerns about the impact of climate change on the rise, significant increases in hydrocarbon production may not be likely
It would be cavalier and somewhat irresponsible for us to suggest that we are not worried. As Paul Ryan, the former Speaker of the House and Ranking Member of the House Budget Committee, said many years ago, “The inflation dynamic can be quick to materialize and painful to eradicate once it takes hold. It’s hard to overstate the consequences of getting this wrong.”
We thought it might be worthwhile to take a moment to revisit the impact that inflation can have on purchasing power. For instance, if you had $1,000 today and simply put it under the mattress, it would not earn a return other than the “psychic income” associated with knowing it’s there. Assuming an inflation rate of 2% per year, and a ten year time horizon, the $1,000 today would have purchasing power of just $817.07 in ten years, representing a cumulative decline in purchasing power of 18.3%. At an inflation rate of 4% per year, the $1,000 today in ten years would have purchasing power of $664.83, representing a decline of purchasing power of 33.5%. At an inflation rate of 6% per year, $1,000 today would in ten years have purchasing power of $538.62, representing a decline of purchasing power of 46.1%.
Of course, while we don’t have to keep our money under the mattress, finding investments that can help us maintain and grow purchasing power in the face of inflation presents a difficult proposition for investors, particularly on an after-tax basis. And taxes are likely headed up as well. Nevertheless, we have always believed that well selected value-oriented equities, rather than bonds or expensive growth stocks, give investors who have the luxury of a longer-term perspective the best chance of keeping the inflation wolf from their door. Zero interest rate policies (ZIRP) have driven high quality government and corporate bonds and most risk assets dramatically up in price over the last decade. This is true for global equity securities, particularly high quality growth stocks and the familiar big cap technology companies in the US that we have all grown to know so well. Value-oriented equities, on the other hand, have not benefitted nearly as much as their more growth-oriented brethren, and as a group today, trade at significantly lower relative valuations. As a result, we have been very active over the last year and a half since the pandemic set in, and have continued to uncover attractively priced value-oriented global equities. That will become abundantly clear later in this report.
We have spoken at length in past reports about the deleterious effects that inflation and higher interest rates have on the wealth of all investors, but particularly so in the case of lenders, i.e., bond holders. The bond investor’s coupon is fixed, and the investor’s income cannot grow to keep up with rising price levels. Higher interest rates can also severely impair the principal value of long duration fixed income instruments. Moreover, the lower the coupon, the larger the swing in prices for a given change in interest rates. In a rising inflation and interest rate environment, holders of these instruments not only lose current purchasing power, but face substantial capital impairment if the bonds are not held to maturity. For example, an investor who today purchases a 30-year government bond at par with a 2% current yield would effectively earn over the life of his or her investment an annual after-tax yield of 1.3% (assuming today’s marginal federal tax rate of 37%), and would receive the return of his or her principal 30 years from now if the bond is held to maturity. Meanwhile, as we write, the consumer price index remains north of 5%, and for as long as it remains elevated, it will significantly impair the purchasing power of the bondholder’s current after-tax yield. At some point, inflation at anywhere near these levels will likely cause a corresponding rise in interest rates, particularly if rising inflationary expectations take hold. A rise in interest rates (from 2% to 5%) on the 30-year bond would lead to a decline in principal value of 45%. This decline in principal value would not be as great for a shorter duration bond. Of course, government bondholders are contractually guaranteed the return of their capital if they hold their bonds to maturity, albeit at a potentially inflationary-reduced dollar value. Equity investors have no such guarantee. In contrast to an investment in bonds, an equity investment in a company that has the ability to increase the price of its products to offset rising costs and to grow over time as the underlying business compounds its intrinsic value could provide the equity investor some opportunity to keep up with rising price levels, even net of taxes.
Stocks and bonds are subject to different risks. In general, stocks are subject to greater price fluctuations and volatility than bonds and can decline significantly in value in response to adverse issuer, political, regulatory, market or economic developments. Unlike stocks, if held to maturity, bonds generally offer to pay both a fixed rate of return and a fixed principal value. Bonds are subject to interest rate risk (as interest rates rise bond prices generally fall), the risk of issuer default, issuer credit risk, and inflation risk, although US Treasuries are backed by the full faith and credit of the US Government.
We believe a similar dynamic to that of longer maturity bonds is also likely to hold in a rising inflation and interest rate environment for longer duration risk assets such as growth and technology stocks, particularly when their valuations are precariously high, as we believe they are today. Growth stock valuation multiples, almost by definition, depend on increasing (and perhaps less certain) cash flows that extend far into the distant future. By contrast, value stock valuation multiples are much more influenced by current earnings power and near term cash flows. In an inflation-induced, rising interest rate environment, the longer duration cash flows of growth stocks are typically worth less than the nearer-term cash flows of shorter duration value stocks. Other things being equal, the longer the duration of the risk asset, the greater sensitivity the value of the asset has to even modest changes in interest/discount rates. (The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis.) To be clear, rising discount rates should have a disproportionately more negative impact on the longer duration cash flows of growth stocks versus their shorter duration value brethren. This, of course, does not mean that growth stocks are unlikely to continue to grow their earnings over time at an attractive rate, but it does mean that the underlying fundamental business valuations derived from those streams of earnings could decline more than the fundamental business valuations attributable to the earnings streams of value stocks. And, at least in theory, the stock prices of growth stocks and value stocks over time should behave accordingly.
Over the last year we have been able to uncover what we believe are undervalued equities that we think represent compelling opportunities, especially when compared to fixed income alternatives or other longer duration assets such as high priced growth stocks. When we make an investment in an equity security, we are essentially buying into the company at a discount to what we believe a rational buyer would pay on a per share basis if he acquired the entire business in an arms-length negotiated transaction. For example, over the last year, we invested in Megacable, the second largest cable company in Mexico. It has a dominant market share in its markets and a mid-teens figure nationally. It sells cable services and internet connectivity (broadband) to an underpenetrated subscriber base. Megacable has been quite profitable (~49% EBITDA margin in 2020), has consistently earned high returns on tangible capital (an average ~20% ROE excluding goodwill from 2011 to 2020), and has a very conservative balance sheet (0.34x net debt-to-EBITDA as of Q3 2021). Its stock price is trading at 8.4x EV/2021 estimated EBIT (enterprise value/earnings before interest and taxes) and 5.1x its EV/last twelve months EBITDA (enterprise value/last twelve months earnings before interest, taxes, depreciation and amortization as of September 30, 2021), and merger & acquisition deals of comparable cable businesses have occurred at high single-digit EBITDA multiples. It also has a current dividend yield of over 4%. A stock purchased at 8.4x EV to EBIT has an effective pre-tax earnings yield of approximately 12%. Applying a 37% tax rate to this pre-tax yield gives the equity investor an implied after-tax yield of roughly 7.6%, which is nearly six times more than the 1.3% after-tax yield on a 30-year US long-term government bond. This results in a price-to-value advantage for this security over the long-term government bond that Ben Graham would almost certainly have found compelling. Some of the drawbacks are that the investor cannot put this equity yield in his or her pocket year in and year out. The coupon (profits) can and will vary over time and is not guaranteed, and the return of the initial investment is not contractually guaranteed as it is with bonds.
If our estimate of the intrinsic value of Megacable is correct, and if the company is able to grow its operating income over time as we expect it will, the effective yield on this investment should grow. If at some point in the not-too-distant future, the Funds sell their shares of the company in the stock market at the estimated intrinsic value, we believe they could make a very nice return that should exceed all but the most severe rates of inflation.
In contrast, a fast-growing and popular technology company such as NVIDIA, a designer, developer, and marketer of 3D graphics processors and related software, trades at roughly 99 times enterprise value to estimated 2021 EBIT, which implies an after-tax earnings yield of approximately 0.63%. This after-tax yield is roughly half the 1.3% after-tax yield of the 30-year US government bond referenced above, and approximately a tenth of the current inflation rate (as measured by the CPI in October 2021) of 6.2%. On top of this, in a rising inflation induced interest rate environment, the higher discount rate applied to the longer duration cash flows of NVIDIA could produce significant downward pressure on its fundamental valuation. While the intrinsic value of value-oriented stocks such as Megacable will also likely face downward pressure in a rising interest rate environment, in our view, it should not be as dramatic as that experienced by a highly valued stock like NVIDIA, where so much of the value is dependent on the cash flows received in the distant future.
In the tug of war between value and growth, which is ongoing as we write, inflation and higher interest rates favor the value investor. While higher inflation and interest rates are certainly not a pre-condition for value’s outperformance, they do provide a favorable backdrop. If the current rise in inflation, inflationary expectations and interest rates proves not to be temporary, but instead persists, value could outperform growth for a considerable period of time. We believe strongly that well-selected value-oriented equities offer investors a better chance of preserving their purchasing power, just as they did in the late 1970s.
INTEGRATING ENVIRONMENTAL, SOCIAL, AND GOVERNANCE FACTORS INTO OUR INVESTMENT PROCESS
As we have mentioned in previous reports, environmental, social and governance factors (ESG), which can present both risks and opportunities when investing, are becoming increasingly important to many of our shareholders and prospective shareholders. With increased focus on responsible investment,Tweedy, Browne established a formal policy some time ago that defines how we incorporate these factors into our investment process. We thought we would take this opportunity to briefly share with you our thinking in this area.
Our policy is grounded in the belief that good corporate citizenship and the compound of the intrinsic value of our investments, more often than not, go hand in hand with one another. In fact, it has become abundantly clear to us that a company’s intrinsic value can be significantly impacted by the way it addresses environmental, social and governance issues. Companies that are mindful of the future, protect the environment, treat their employees fairly, have a positive impact on their communities, and allocate capital in a rational and responsible manner often have more sustainable, resilient, and value enhancing business models. Thus, we believe incorporating ESG factors into our investment analysis can potentially reduce risk and enhance returns, and is therefore completely consistent with our fiduciary obligation and the Funds’ objectives of seeking long-term capital growth. Accordingly, ESG considerations play an increasingly important role in our research and decision-making processes.
If a material ESG risk or opportunity is identified during our research process, it is formally evaluated, included in the analyst’s research materials, and brought to the attention of our Investment Committee. In this regard, a “material” ESG risk or opportunity is one that, in our assessment, could materially impact our estimate of the long-term value of the company under consideration. Such a material issue could result in the company being eliminated from investment consideration, or cause us to adjust the multiples we use in our calculations of its intrinsic value. For example, when valuing Chinese companies, we will often use lower multiples than those used in calculating intrinsic value for similar developed market companies, largely due to the increased governance risk. In contrast, companies that are able to capitalize on an ESG opportunity, such as the production of a product that helps solve an environmental or social issue, and/or have strong records of good corporate governance, could command higher multiples in our valuation process. However, it is also not always clear how to trace sustainability issues and their impact on valuation.
The identification of a material ESG risk will not necessarily be determinative in our decision to buy, sell, or hold a company, particularly if the company is taking meaningful action to mitigate our concerns, or is trading at a valuation that, in our view, more than appropriately reflects those concerns. In those circumstances, we may choose to engage with the company in an effort to encourage remedial behavior. We neither use ESG factors in our initial value screens when we are looking for new undervalued opportunities, nor maintain a list of companies that are automatically excluded from consideration due to ESG concerns. Rather, ESG issues are considered and addressed as they are identified on a stock-by-stock basis, as part of our rigorous research process. ESG issues are a formal agenda topic at each Investment Committee meeting.
Nowhere has the incorporation of ESG concerns played a more important or long-term role in our investment process than in the area of corporate governance (the “G” of ESG). Irresponsible corporate governance can often present a material risk for future value sustainability and growth. We have never had a desire to become a so-called “activist manager,” waging expensive proxy battles and the like. However, we have not hesitated to defend our clients’ interests, when necessary, through engagement with the companies whose shares are held in our clients’ portfolios. This has involved direct communication with senior management and/or directors on issues such as responsible and intelligent capital allocation, management compensation, board composition, merger and acquisition activity and voting restrictions, among others. Moreover, in certain warranted circumstances, we have engaged collectively with other shareholders in order to advance client interests.
Past engagements, which have not always been successful, include but are not limited to: Hollinger International, where we played a critical role in catalyzing an investigation into corporate malfeasance that resulted in the dismissal and eventual jailing of members of senior management; Volkswagen, where we campaigned at the company level and through appeals to shareholders to prevent a conflicted corporate board member from becoming Chairman of the Supervisory Committee; SK Telecom, where we appealed directly to senior management to reconsider what we felt was an inadvisable and expensive acquisition; and AKZO, where we actively encouraged the company to engage in merger and acquisition discussions with a potential suitor, and supported a resolution to remove the company’s chairman. More recently, we engaged with the management and Board of Directors of Bachoco, a Mexican poultry company, requesting that they consider repurchasing their company’s shares in light of their significant undervaluation and the company’s cash-rich balance sheet. This request was based on our belief that “intelligent” share repurchases in this specific instance would increase the value per share for the remaining shareholders in a low risk way. This form of capital allocation is much like mini-merger & acquisition activity, in that every share bought back is like a small take-over of the business the management knows best, their own company.
In summary, we have been taking an increasingly active approach to incorporating ESG analysis into our security research and valuation process, and believe this is important in fulfilling our fiduciary obligation to our shareholders. Jay Hill, a Managing Director who serves on both our Investment and Management Committees, and Ben Whitney, one of our client services professionals, recently became holders of the CFA Institute’s Certificate in ESG Investing.
How one goes about incorporating ESG considerations into one’s investment process remains a complex and evolving topic in the investment management industry that has yet to produce any clear and consistent standards. It is not always easy to confidently assign a value to potential long-term risks and opportunities that could play out in a multitude of ways and are often dependent on several other confounding variables. We have tried to take a thoughtful and nuanced approach to ESG, rather than react in a knee-jerk, commercial manner. We further believe that active engagement on ESG issues should also serve in some small way to help incentivize the companies our Funds invest in to behave in a way that will not only enrich their shareholders, but also other stakeholders such as their employees and their communities. To paraphrase Ben Graham, perhaps “investment is most intelligent when it is most ‘responsibly’ business-like.”
As we mentioned earlier in this report, market conditions over the six months ending September 30 favored the “stay at home trade.” In this more growth-oriented and US-centric environment, the Tweedy, Browne Funds produced modestly positive returns with the exception of the Worldwide High Dividend Yield Value Fund, which produced a marginally negative return for the six-month period ended September 30, 2021. That said, year-to-date through October 31st, the Funds have produced good absolute returns of between 9.92% and 15.12%, net of fees. On an even more encouraging note, over the last 12 months through October 31st, the Funds are up between 30.99% and 36.42%. During this period, value stocks remained ahead of growth stocks, as evidenced by the performance of the value and growth components of the MSCI World Index.
In early summer, Andrew Daniels of the mutual fund research department at Morningstar did a comprehensive review of our flagship fund, the Tweedy, Browne International Value Fund. We thought his findings with respect to the performance pillar of Morningstar’s analysis might be of interest.
During the trailing 10 years through June 2021, the Fund’s 6.6% annualized gain beat the MSCI ACWI ex USA Value Index’s 3.5% as well as 93% of its foreign large-value Morningstar Category peers. The fund was among the category’s least volatile during the period (as measured by standard deviation of returns), so risk-adjusted returns were even better. The fund’s 0.57 Sharpe ratio not only beat the index’s 0.25 but also beat 99% of its value-oriented peers. The fund tends to generate its best relative returns when markets falter: Indeed, its downside capture ratio of 52% relative to the index in the trailing decade was better than all its peers. But investors should expect this fund to lag in rising markets, considering its upside capture ratio of 72% ranked near the bottom of the category ... This historical performance profile helps explain the fund’s relatively poor showing in the year ended June 2021, when its 29.1% gain underperformed the value index’s 37.6% gain as well as 79% of its value-oriented peers.
Tweedy, Browne Global Value, A good non-US equity option for conservative investors,Morningstar, July 2021
Morningstar has ranked the International Value Fund among its peers in the Foreign Large Value Category. For the 1-, 5- and 10- year periods ending September 30, 2021, Morningstar has ranked the International Value Fund in the top 64% out of 347 funds for the 1-year period, top 51% out of 269 funds for the 5-year period, and top 17% out of 180 funds for the 10-year period. Percentile rank in a category is the Fund’s total-return percentile rank relative to all funds that have the same Morningstar Category. The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100. The top-performing fund in a category will always receive a rank of 1. The “out of” number represents the total number of funds in the category for the listed time period. Percentile rank in a category is based on total returns, which include reinvested dividends and capital gains, if any, and exclude sales charges. The preceding performance data represents past performance and is not a guarantee of future results.
While pleased, we are also not surprised by Morningstar’s findings. In our view, the results of the Fund are largely what our shareholders have come to expect … strong relative results when markets are challenging, and good absolute performance during more buoyant environments, while besting the Fund’s benchmarks and the bulk of its peers over the longer term.
Please note that the individual companies discussed herein were held in one or more of the Funds during the year ended September 30, 2021, 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 September 30, 2021.
The strongest overall contributions to our Funds’ performance over the last half year came from a variety of sources, including strong returns across most of our Funds in their US and European holdings, particularly companies in the UK, Switzerland and France. A number of holdings in certain industry groups including food and beverages, energy, financials, health care, and communication services also delivered strong returns for the period. This included strong performances from food and beverage companies such as Nestlé, the Swiss food giant, Coca-Cola FEMSA, the Mexican Coca-Cola bottler, and Diageo, the UK-based global spirits business, all of which benefitted from the reopening of economies around the world. TotalEnergies, the French oil & gas company, has benefitted from the recent spike in oil prices, as have the stock prices of machinery and beverage equipment companies such as CNH and Krones, which have been driven by the strong cyclical recovery. It has been a particularly beneficial environment for bank holdings such as Wells Fargo, DBS Group, United Overseas Bank, and Bank of New York Mellon, which have been clear beneficiaries of the increase in financial activity, advisory fees and net interest margins. Pharma companies such as GlaxoSmithKline, AbbVie and Roche continued to benefit from strong drug pipelines. Interactive media holding, Alphabet (Google), whose growth trajectory in search and other online businesses has remained extraordinarily strong, and the Swiss media company, TX Group, which through a recent joint venture expanded its digital classified ad business, also produced strong returns for the period. The stock prices of British defense-related companies, BAE Systems and Babcock International, also responded well during the period. BAE recently de-risked its pension plan and in our view continues to have an attractive mix of defense businesses in demand by the UK military, while Babcock International is in the midst of a turnaround by new management, which is gaining credibility amongst investors. The share price of Bollore, the French logistics and media company, strongly benefitted from the recent spinoff of Universal Music by Vivendi (Bollore has ~30% ownership of Vivendi and therefore indirectly owned ~18% of Universal Music).
A number of other holdings saw their stock prices advance during the period including AutoZone, the US-based aftermarket auto parts retailer, which has benefitted from disruptions in the automotive supply chain, and Tarkett, the French commercial flooring business, which was the subject of a family and private equity led buyout. Carlisle, the US-based commercial roofing company, also performed well in the period as it continues to benefit from a strong re-roofing backlog due to deferred jobs from COVID, and the increasing age of the commercial building stock in the US. The Italian industrial gas company, SOL SpA, whose medical gases business has been a beneficiary of the pandemic and the more recent variant surge, also had a strong six-month return.
In contrast, returns from emerging market holdings, insurance holdings, a number of auto-related, chemical, and industrial conglomerate holdings, and a gas distribution holding proved to be somewhat of a disappointment. This included poor returns from a number of our Chinese- and South Korean-based companies. In China/Hong Kong, holdings such as Alibaba, Baidu, and A-Living were negatively impacted by recent interventions in various industry groups by the Chinese government. One of the Funds’ South Korean holdings, LG Corp, was held back because of battery recalls at its affiliate, LG Chem. The stock prices of insurance companies such as French-based CNP Assurances, US-based National Western Life, and the Swiss-based reinsurer SCOR were all negatively impacted in the near term by mortality concerns associated with the surging Delta variant. The results of automotive component companies such as Autoliv, Hyundai Mobis, and NGK Spark Plug, and chemical companies such as BASF and Kuraray, continue to be plagued by supply disruptions. Industrials such as 3M, Safran, and Trelleborg have faced near term headwinds from the surge in the Delta variant and its impact on global economic growth. Rubis, the French gas distribution company, faced modest weakness in its Caribbean gas distribution business, in part due to COVID measures and a slowdown in tourism. In addition, the Funds’ continued underweight in Japan played a role in the Funds’ relative underperformance, as Japanese equities in general performed well during the period.
As you are no doubt aware, recent and surprising interventions by the Chinese government have led to rising uncertainty and volatility in Chinese equities and have stoked real fear, particularly among Western investors. Some prominent market observers have even begun to question whether China is investable in light of these actions. We do not take these heavy-handed actions by the Chinese government lightly, nor are we so naïve as to think that investment in China is not accompanied by additional risks beyond those of a business or economic nature. However, for people like ourselves who scour the world looking for increasingly rare mis-pricings in equity markets, the near-term turbulence in China is presenting an opportunity to invest a limited portion of the Funds’ assets in what we feel are terrific businesses at prices we rarely see. You can be assured that we have exercised extreme price sensitivity when making purchases, demanded a more substantial discount from our estimates of intrinsic value, and have diversified the Funds exposure by issue. After thoughtful and careful examination and review, we believe that the prices the Funds have been afforded in the limited group of Chinese companies in which they are invested more than adequately compensates them for the risks assumed. As of September 30, the Funds had between 5.7% and 8.4% of total assets invested in Chinese and Hong Kong equities, and we are seeking to stay within the 5% to 10% range in these two countries (at cost) for the time being.5
We do not share the view that the Chinese government is out to destroy the economic miracle of the last quarter century, which has lifted over 800 million people out of abject poverty, and provided the political stability that likely remains foremost in the minds of China’s leaders. We believe this particularly holds for many of China’s most innovative and rapidly growing technology companies. We believe the cloud computing, fintech, and social media capabilities of Alibaba and Tencent, and the artificial intelligence and autonomous driving innovations of Baidu, are strategically important to China’s future, and we remain optimistic that these companies and the government will be able to strike a balance between providing the necessary incentives for continued innovation, and the government’s goal of achieving sustainable and socially responsible growth. As an aside, we were also encouraged to see that the Daily Journal, a company whose Chairman is Charlie Munger (Trades, Portfolio), Warren Buffet’s partner at Berkshire Hathaway, earlier in the year established a meaningful position in Alibaba, and substantially added to that position in the third quarter.
Despite rising valuations, we continue to be very active in adding to and pruning our investment garden. Over the last six months we uncovered numerous equities that we believe to be undervalued, particularly in Europe and the emerging markets, but also in the US. We established a number of new positions during the period and added
to many others, including Industrias Bachoco, the Mexican poultry company; FMC, the US-based agricultural and chemicals company; Kemira Oyj, the Finnish global water chemistry company; Tencent, the dominant Chinese social media and gaming company; Uni-President, the China-based instant noodles and beverage company; Norma Group, the German manufacturer of industrial joining and fluid handling products; Taikisha LTD and Takasago Thermal Engineering, air-conditioning systems companies, and Transcosmos, the call center and data processing company, all based in Japan; Vivo Energy, the UK-based petroleum distributor with significant operations in Africa; Chow Sang Sang Holdings, the Hong Kong-based jewelry retailer; LG Corp, the Korean conglomerate; Okamoto Industries, the Japanese rubber products company; Rubis, the French based gas distributor; Dali Foods, the Chinese beverage and snack foods business; and, near period end, Rheinmetall, the German-based defense systems and automotive components company. All of these companies, at purchase, were trading at substantial discounts from our conservative estimates of intrinsic value, were financially strong, and in our view had good prospects for future growth. To make room for the new acquisitions and additions, we sold and trimmed a number of holdings including Bangkok Bank, Hankook, Coltene Holdings, Heineken Holding, Novartis, Roche, Alphabet, Johnson & Johnson, Standard Chartered, Trelleborg, AbbVie, and a host of others.
EXAMPLES OF NEWLY ESTABLISHED POSITIONS
Industrias Bachoco, the Mexican poultry company, founded in 1952, is a roughly $2B market cap company that operates poultry production and distribution facilities primarily throughout Mexico, where it breeds, processes, and markets chicken, which accounts for the overwhelming bulk of its sales. It is the number one chicken producer and the number two egg producer in Mexico, with 35% and 5% market shares, respectively. While the chicken business is notoriously cyclical, with profitability varying significantly year-to-year based on the volatility of chicken prices, the company’s volumes steadily grow, and even in the company’s worst years, it has not lost money.
Over the last decade, the company has been able to compound its tangible book value per share, including dividends, by 11.5% per year. At purchase, Bachoco had net cash constituting over 40% of its market cap and was trading at 8 times current P/E, 6 times normalized EBIT, around tangible book value, with a dividend yield of a little under 2%. It also had a normalized owner earnings yield above 12%. In August, a US-based poultry company, Sanderson Farms, was acquired by a joint venture company owned by Cargill/Continental Grain in a 100% cash transaction. Other than having different geographic locations, Sanderson and Bachoco are directly comparable poultry businesses with similar long term records. In thinking about the value of Bachoco, if one were to ascribe the same multiples paid for Sanderson to Bachoco, it would imply an estimated intrinsic value for Bachoco that is more than double the average price the Funds paid for their shares.
(International Value, International Value II, and Value Funds)
FMC Corp. provides crop chemicals for the agriculture industry. Crop chemicals protect farmers’ fields from insects, fungus, and weeds, which allows them to increase their crop yields. As a result, farmers are more than willing to pay a price premium for effective products. Similar to pharmaceutical companies, crop protection products also are often “patented,” which gives them pricing power. In addition, the development time and investment, combined with navigating the regulatory process in a variety of jurisdictions, and then achieving distribution at scale, provides immense barriers to entry in the industry. Small companies may be able to conduct research on active ingredients, but it will be difficult for them to “commercialize” them. Given all of this, FMC has enjoyed a high return on capital and has been a very profitable business, earning a 27% EBITDA margin and a 25% ROE for the year 2020.
FMC is diversified geographically and by crop, which should serve to make it a less cyclical business. It also has, in our view, a very good new product pipeline, and aims to grow its revenues at 5% to 7% annually through 2023, and its EBITDA at 7% to 9% annually through 2023. The company also has had some insider purchases recently from both its CEO and CFO.
While FMC could face some ESG risk associated with increasing regulations that ban certain crop chemical products due to their environmental impact, we do not think it is likely that this risk will be material. To date, FMC has actually benefited from this dynamic. Many older crop chemicals, particularly certain insecticides, are “broad-spectrum,” and can be quite toxic to the environment because they impact everything that they come into contact with. As a result, regulators are increasingly prohibiting the use of the older, more harmful chemistries. In contrast, FMC produces a lot of “targeted” crop chemicals, which affect only the “targeted” pests, and therefore have a lower environmental impact. This has allowed new products to take market share from the older, more toxic ones that are being banned, allowing FMC to grow at nearly twice the industry growth rate. In this respect, rather than negatively influence our valuation, environmental impact concerns actually caused us to increase the multiples we used to estimate the company’s intrinsic value. We valued FMC between 13 times and 14 times EV to EBITDA, although there have been a number of recent comparable industry acquisitions at multiples in the mid-to-high teens. At purchase, it was trading at roughly 10.5 times its 2022 estimated EBITDA, and at a relatively low price earnings multiple (12.2x 2022 estimated EPS) in part due to its low tax rate. It also had an “owner earnings” yield (net operating profit after tax/enterprise value) of approximately 7.6%.
(Worldwide High Dividend Yield Value Fund)
Founded in 1920 and based in Helsinki, Finland, Kemira is a global leader in chemicals for water intensive industries. Kemira’s products enable customers to improve product quality while simultaneously delivering environmental benefits such as: reduced water consumption, cleaner drinking water, treating wastewater for safe reuse or release into nature, reducing CO2 emissions and improved recyclability (replacing plastics with paper). Kemira’s customers typically come from industries that use large amounts of water, including pulp mills, paper mills, municipal water systems, breweries, wineries, industrial manufacturers, mine operators, and upstream and downstream oil & gas companies.
Kemira derives 80% of its revenue from 4 key product categories: bleaching & pulping (25% of revenue), sizing & strength (15%), coagulants (20%) and polymers (20%). These products are manufactured in 69 manufacturing sites globally. A key and valuable attribute of the business is customer proximity to the manufacturing site. Because these chemicals include a high water content, they are heavy and thus expensive to transport over long distances. Thus, a regional cost competitive advantage exists when a manufacturing plant is physically closer to the end customer.
Other attractive attributes at purchase included a strong balance sheet (~1.5x net debt to EBITDA), an above average dividend yield (~4.3%) and material insider buying by knowledgeable insiders, including the CEO and Chairman of the Board (€52 million at an average price of €13.89 Euros per share). At an average purchase price of ~€13.50 per share, we paid 7x EBITDA and 14x P/E. A careful review of 8 precedent M&A transactions reveals that strategic and financial buyers have paid an average of 10x EBITDA in acquiring businesses similar to Kemira. At 9x to 10x EBITDA, Kemira would be worth €17 to €20 Euros per share.
The rebound in technology stocks over the last six months could cause one to question whether the market’s pivot towards more value-oriented securities, which began last Fall with the vaccine announcements, will in fact be durable. The resurgence of value is, in our view, long overdue.
Our former partner, Chris Browne, used to say that inflection points in equity markets often arrive when high equity valuations are confronted by a serious macroeconomic shock. We believe we could be in the midst of just such a scenario today, as high liquidity-induced equity valuations of the last many years collide with a global health pandemic. The sudden shutdown and restart of the global economy is a macroeconomic shock, the likes of which we have never seen before.
Will the near-term global economic environment rhyme with the 1970s stagflation that gripped our economy, sparked by an oil embargo that nearly quadrupled oil prices overnight?
It is, of course, hard to know, but for the reasons outlined earlier in this letter, it is no time for investors to be complacent.
Perhaps the specter of accelerating inflation, and the resulting havoc that it could wreak upon our economy, will be the catalyst for a repudiation of zero interest rate policies, returning much needed price discipline to our capital markets. The challenge that this might present to risk asset valuations may not be what investors want in the short run, but it just might be what value investors need in the long run.
Thank you for investing with us. Stay well.
Roger R. de Bree, Frank H. Hawrylak,Jay Hill, Sean McDonald, Thomas H. Shrager, John D. Spears, Robert Q. Wyckoff, Jr.
1 The personal consumption expenditure price index (PCEPI) is one measure of US inflation, tracking the change in prices of goods and services purchased by consumers throughout the economy. Of all the measures of consumer price inflation, the PCEPI includes the broadest set of goods and services.
2 The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
3 The S&P CoreLogic Case-Shiller Home Price Indexes, also known as simply the Case-Shiller Home Price Indexes, are a group of indexes that track changes in home prices throughout the United States.
4 Stagflation is defined as persistent high inflation combined with high unemployment and stagnant demand.
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.
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