Tweedy Browne's 2018 Semi-Annual Letter to Shareholders

Investment Adviser’s Letter to Shareholders

For over a thousand years, Roman conquerors returning from the wars enjoyed the honor of triumph, a tumultuous parade. In the procession came trumpeters, musicians and strange animals from conquered territories, together with carts laden with treasure and captured armaments. The conqueror rode in a triumphal chariot, the dazed prisoners walking in chains before him. Sometimes his children robed in white stood with him in the chariot or rode the trace horses. A slave stood behind the conqueror holding a golden crown and whispering in his ear a warning: that all glory is fleeting.

George S. Patton, Jr.

“Patton” (1970)

To Our Shareholders:

The bull market in U.S. equities is now in its 10th consecutive year, making this the longest uninterrupted expansion in the post-war era. To a great degree, the heroes of this triumph have been a handful of highly innovative entrepreneurs who have created large dominant companies that today have almost monopoly power in their respective markets. This group includes Mark Zuckerberg of Facebook, Jeff Bezos of Amazon, Tim Cook and the late Steve Jobs of Apple, Reed Hastings of Netflix, and Sergey Brin and Larry Page of Google. Together they constitute the ubiquitous FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks. According to Scott Galloway, author of The Four: The Hidden DNA of Amazon, Apple, Facebook, and Google, these four companies have generated unprecedented wealth – by our calculation approximately $3 trillion through 9/30/18, for their shareholders. If you add in Netflix, the number approaches $3.5 trillion.

The great bulk of this wealth was produced over the last five years, as these companies helped to power the U.S. and global stock indexes forward. Amazon, for example, year to date through September 30, is up 71%, growing its market capitalization this year alone by over $413 billion. To put that growth in perspective, there are only five other companies in the world today that have a total market capitalization of $400 billion or more: Microsoft, Apple, Google, Berkshire Hathaway, and Facebook (FB, Financial). Amazon (AMZN, Financial) was able to essentially grow a company the size of Facebook ($407.10B as of 11/12/2018) in just nine months.

To quote Galloway:

Our governments grant them special treatment regarding antitrust regulation, taxes, even labor laws. And investors bid their stocks up, providing near-infinite capital and firepower to attract the most talented people on the planet or crush adversaries.

As of September 30, 2018, the FAANGs accounted for 13% of the valuation of the S&P 500, and over the last two years their stock prices are up cumulatively approximately 88%. With this meteoric rise, none of the FAANGs today trade, in our view, at a reasonable discount to a conservative estimate of intrinsic value. During 2012, we did have an unusual opportunity to purchase Google at a price which fit our value framework. While we believe the business is fully valued today, we still own Google because we believe the value will continue to compound at an above-average rate. From a quantitative standpoint, Apple certainly fit our framework for a better part of the last five years. Qualitative concerns regarding the history of technology hardware businesses led to our inaction. While Facebook’s valuation today is not terribly excessive, we do not believe that it is trading at a discount to underlying value. Conversely, Amazon and Netflix are both currently trading at price earnings ratios above 100 times earnings and have never remotely appeared cheap to us. In fact, Amazon and Netflix are emblematic of the venture capital mentality in public markets that we have observed more frequently in the last several years. This Silicon Valley inspired ethos seemingly prioritizes customer and revenue growth over all other goals, including profitability. To quote Elizabeth Winkler of The Wall Street Journal in a recent article (August 26, 2018) entitled Why No One Can Catch Netflix, “Netflix’s great advantage over its rivals is it doesn’t need to show profits, as long as the subscriber numbers keep climbing.” While this approach is common in the early years of a company’s life, it is increasingly being applied to many large, more mature public companies. We remember a time 18 years ago when numerous innovative technology companies achieved similar nosebleed valuations based on something other than underlying profitability. It did not end well for investors in those businesses.

Thanks in large part to the extraordinary performance of these technology companies, the S&P 500 Index in the month of September hit an all-time high valuation. Also, thanks to the FAANGs, the growth style of investing has far outstripped the results produced by value investors over the last many years, causing some market prognosticators to conclude that value investing is once again dead. Having been at this investment game for a long time here at Tweedy, Browne, we know that this goes on until it doesn’t. Eventually these disparities are almost invariably corrected by the sheer weight of the companies’ valuations.

Value investors should not despair. Numerous academic and empirical studies suggest that over the longer term, value investing has generally outperformed growth investing ... that the proverbial tortoise more often than not beats the hare1. There are many theories that seek to explain the reason for value investing’s empirical return advantage over time. In our view, one of the most notable reasons is behavioral. Growth investing feels better. It’s easier, more comfortable and often lulls the investor into a sense of complacency. Lakonishok, Shleifer and Vishny, in their classic study, “Contrarian Investment, Extrapolation, and Risk” (1993), found that investors appear to consistently overestimate the future growth rates of glamour stocks relative to value stocks, putting excessive weight on recent past history despite the fact that future growth rates are highly mean reverting. In addition, they found that investors often confuse well run companies with good investments. This often translates into buying glamour securities with widely recognized competitive advantages and lofty expectations for future growth, regardless of price. In addition, recent favorable stock price action often reinforces the growth investor’s conviction. As Warren Buffett (Trades, Portfolio) has observed, investors tend to gravitate toward a cheery consensus.

Conversely, value investing often feels uncomfortable and challenging. Buying out-of-favor stocks with low expectations and well publicized issues, however temporary, requires fortitude and a contradictory mix of conviction and humility that is often in short supply in the investor community. It almost always requires the ability to look wrong for a while, and a willingness to embrace uncertainty, price volatility, and the recognition that a fair number of individual ideas will lose money for one reason or another. Behaviorally, value investing is simply harder; however, the Lakonishok et al. study confirmed that this hardship has historically been rewarded with returns that over time exceeded those produced by growth (glamour) stocks.

With considerably less exposure to technology stocks, the returns of non-U.S. equity markets of late, while quite solid, have paled in comparison to the returns of the U.S. equity market. Non-U.S. equities in the near term have been weighed down in part by projections of slowing economic growth, political upheavals, trade war concerns, and highly volatile currencies, while U.S. stocks have had the benefit of increased fiscal stimulus in the form of corporate and personal tax cuts, increased defense spending, and capital investment, which gave a significant boost to economic growth, reported corporate earnings, and in turn U.S. stock prices. Beset by these headwinds, non-U.S. equities have emotionally been harder to own. Over the last ten years, the S&P 500 has compounded at over twice the rate of the MSCI EAFE Index. Year to date through September 30, 2018, that spread widened. The S&P 500 is up 10.56% year to date through September 30, versus 1.38% for the MSCI EAFE Index in local currency and -1.43% when translated back into U.S. dollars. These robust U.S. equity returns have, in our view, caused U.S. equity valuations to become stretched compared to their non-U.S. counterparts. According to Bloomberg, on a simple price-to-earnings ratio basis, the S&P 500, at the end of October, traded at approximately a 33% premium to the MSCI EAFE Index. Jason Zweig, the writer of The Intelligent Investor column in The Wall Street Journal, commented on this contrast in valuations between U.S. and non-U.S. equities in a recent article entitled “The ‘Dumb’ Money Is Bailing on U.S. Stocks. That’s Smart.” He cautioned:

If U.S. growth merely slows relative to other economies, stock markets elsewhere in the world are likely to catch up to or surpass the S&P 500.

Stocks in the U.S. may be more vulnerable than usual to such a reversal, given how expensive they are. Compared with the rest of the world, U.S. stocks are at their highest valuations on record, according to Bank of America Merrill Lynch – trading for twice as much, as measured by price to net worth, as international shares.

This dichotomy between U.S. and non-U.S. returns has not always been in favor of the United States. In fact, in his article, Jason Zweig pointed out that there have been numerous multi-year periods where non-U.S. returns have significantly outpaced those of their U.S. counterparts. Moreover, as you can see in the chart below, between 1974 and 2018, the S&P 500, on a rolling ten-year return basis, outperformed the MSCI EAFE Index only 52% of the time. The Zweig article also indicated that, for the ten years ending December 1986, non-U.S. equities on average surpassed the performance of stocks in the U.S. by over 6.2% per year. This also held true for the ten-year period ending December 2007, when non-U.S. equities outperformed U.S. equities by 3.1% per year. He also noted that retail investors had redeemed $34 billion out of U.S.-based funds while adding over $1 trillion to non-U.S. funds over the last 10 years, leading him to comment that, “sooner or later, that’s going to make the so-called dumb money look smart.” We would agree.

10-Year Rolling Returns | December 31, 1974 through September 30, 2018

U.S. equity markets (S&P 500 Index) outperformed international markets (MSCI EAFE Index (in U.S.$)) in just over half of the 10-year rolling periods (52% of observed periods).

The vertical axis represents the returns for the S&P 500 while the horizontal axis represents the returns for the MSCI EAFE Index (in U.S.$). The diagonal axis is a line of demarcation separating periods of outperformance from periods of underperformance. Plot points above the diagonal axis are indicative of the S&P’s relative outperformance, while points below the diagonal axis are indicative of its relative underperformance.

As with life, there is an ebb and a flow to investing. As value investors, we seek to take advantage of the fact that, empirically, “Mr. Market” has a proven behavioral tendency to overreact on the upside as well as the downside. And we can have faith that equity valuations should mean revert over time. But we can never know when the mean reversion will occur, and value investing can remain out of favor for periods of time that are disconcerting at best and sometimes downright uncomfortable. That said, redemption has generally come for patient, disciplined, price conscious value investors who stay the course. As we write, volatility has returned to public equity markets. Technology stocks have begun to falter; fears of a trade war and projections of slowing economic growth have driven the Chinese stock market (including dividends) down more than 26% through October 31, 2018, from its late January highs; Europe is bracing for the possibility of a hard Brexit; and numerous emerging markets are in turmoil due to high levels of U.S. and euro-denominated debt. On top of all this, inflation, interest rates and oil prices are on the rise. On an optimistic note, these concerns are also producing near term pricing opportunities in an increasing number of non-U.S. equities. Idea flow has picked up considerably for us of late and, as you will see later in this report, we have been busy planting the seeds for potential future returns.

Year to date, the Tweedy, Browne Funds continued to make financial progress in this dichotomous environment. However, on a relative basis, the Funds’ results were mixed. Our flagship Tweedy, Browne Global Value Fund marginally trailed its hedged benchmark year to date through September 30, but bested the unhedged benchmark by 378 basis points (3.78%). The Tweedy, Browne Global Value Fund II – Currency Unhedged, our unhedged international fund, bested its unhedged benchmark by 264 basis points. The Tweedy, Browne Value Fund, however, trailed its global benchmark by a considerable margin. The Tweedy, Browne Worldwide High Dividend Yield Value Fund outpaced the MSCI World High Dividend Yield Index by 187 basis points, but trailed its benchmark, the MSCI World Index. The Value Fund and the Worldwide High Dividend Yield Value Fund, our two global funds, have had relatively modest exposure to U.S. equities and, as a result, have not compared favorably in the short run to the MSCI World Index, where U.S. equities represent as much as 60% to 65% of assets.

Presented below are the performance results of the Tweedy, Browne Funds for various periods with comparisons to their respective benchmark indices. Following those comparisons are the Funds’ complete performance histories.

• The performance data shown represents past performance and is not a guarantee of future results. Total return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. The returns shown do not reflect the deduction of taxes that a shareholder would pay on Fund distributions or the redemption of Fund shares. Current performance may be lower or higher than the performance data shown. Please visit www.tweedy.com to obtain performance data that is current to the most recent month end, or to obtain after-tax performance information. Please refer to footnotes 1 through 5 at the end of this letter for descriptions of the Funds’ indexes. Results are annualized for all periods greater than one year.

• Investors cannot invest directly in an index. Index returns are not adjusted to reflect the deduction of taxes that an investor would pay on distributions or the sale of securities comprising the index.

• Each Fund’s expense ratio has been restated to reflect decreases in the Fund’s custody fees that became effective on August 1, 2017.

• Tweedy, Browne has voluntarily agreed, effective December 1, 2017 through at least July 31, 2019, to waive a portion of the Global Value Fund II’s, the Value Fund’s and the Worldwide High Dividend Yield Value Fund’s investment advisory fees and/ or reimburse a portion of each Fund’s expenses to the extent necessary to keep each Fund’s expense ratio in line with the expense ratio of the Global Value Fund. (For purposes of this calculation, each Fund’s acquired fund fees and expenses, brokerage costs, interest, taxes and extraordinary expenses are disregarded, and each Fund’s expense ratio is rounded to two decimal points.) The net expense ratios set forth above reflect this limitation, while the gross expense ratios do not. Please refer to the Funds’ prospectus for additional information on the Funds’ expenses. The Global Value Fund II’s, Value Fund’s and Worldwide High Dividend Yield Value Fund’s performance data shown above would have been lower had certain fees and expenses not been waived and/or reimbursed during certain periods.

1. See, for example: What Has Worked in Investing, Tweedy, Browne (Revised 2009); Value and Growth Investing: Review and Update by Louis K.C. Chan and Josef Lakonishok, Financial Analysts Journal (January/February 2004); What Works On Wall Street by James P. O’Shaughnessy, McGraw-Hill Education (Fourth Edition, November 2012).

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