Tweedy, Browne Fund letter to investors for the half year ended September 30, 2017.
Investment Adviser’s Letter to Shareholders (Unaudited)
These are the times that try men’s [value investors’] souls.– T homas Paine
Neither the vengeance of Mother Nature, North Korea’s threats of nuclear retaliation, an increasingly fractious political environment both at home and abroad, a rising terrorism threat, nor the prospects for coordinated monetary tightening by central banks in the US, the UK, and Europe were enough to shake investor conviction over the last several quarters. Global equity markets continued their advance unabated. Such has been the enduring strength of what is now the second-longest bull market in modern financial history. Why then do we suggest these are “trying” times? Are they not to be celebrated? This, of course, requires a fuller explanation.
While our Funds have been significant beneficiaries of this extended bull market, as reflected by our results over the last year, the relentless press of “animal spirits” in our capital markets has elevated equity market valuations to levels that will be hard to sustain without increasing underlying fundamental support.
You have heard us remark in the past that Wall Street often takes a good thing to a bad place. In this instance, central bankers around the world have been complicit. Unfortunately, their experiment with extreme, and what some consider to be radical, monetary policy over the last many years (however well-intentioned) has been accompanied by some unintended consequences that in our opinion may have led to some of the extremes that we have seen of late in our markets and in our politics – extremes which could threaten the sustainability of this long expansion.
Few would doubt that monetary stimulus was required to “get the patient off the ground” immediately following the financial crisis, and clearly central banks played the pivotal role in that successful resuscitation. However, their subsequent inability to pull the palliative needle from the arm of our recovering economy has led in part to extended asset valuations, rather tepid economic growth, the increasing absence of price discovery in our capital markets, and compromised capital allocation. In addition, excessive monetary stimulus has contributed indirectly to disparities in income and wealth that, together with increasing globalization and technological disruption, have led to a populist awakening manifested in the election of President Trump in the United States and nationalist movements across Europe, the most significant of which is the United Kingdom’s pending break with the European Union.
These unintended consequences have been masked, at least to date, by strong returns in virtually all asset categories, and a virtually unprecedented level of calm in our financial markets as measured by the VIX (the Chicago Board Options Exchange Volatility Index). It is no wonder that investors have begun to throw caution to the wind when it comes to risk taking.We would humbly advise against such behavior.
As Brett Ryder recently pointed out in an article in the Economist:
Yet rarely have so many asset classes – from stocks to bonds to property to bitcoins – exhibited such a sense of invulnerability … rarely have creditors demanded so little insurance against default, even on the riskiest “junk” bonds. And rarely have property prices around the world towered so high … add to this the craze for exotica, such as cryptocurrencies, and the world is in the throes of a bull market in everything.
With short-term interest rates still hovering near zero or even negative in many parts of the world, money has been very cheap, if not essentially free, and that can theoretically translate into nearly limitless valuations for financial assets. Given their extraordinarily low yields, ten-year government bonds as of September 30 in the US, the U.K, Germany, and Japan traded at implied P/E ratios of 43X, 73X, 216X, and 1,667X their respective annual rates of interest. For the twelve months ending September 30, 2017, the S&P 500, MSCI World and MSCI European indexes all traded north of 21X trailing earnings. These multiples imply an earnings yield of approximately 5%, and, if your view is that interest rates will remain at these extremely low levels for years to come, these valuations may not appear to be extreme. However, if you believe as we do that these low rates will not always be in vogue, then today’s valuations are stretched. In addition, the Shiller Cyclically Adjusted Price Earnings (CAPE) ratio today is approximately 31X, compared to its historical average of 17X, and according to industry sources, the “Buffett Indicator,” which measures the ratio of total US equity market capitalization to gross domestic product (GDP), is today at approximately 138%, or nearly double its long term average, and approaching its all-time high recorded during the tech bubble in early 2000. These high valuations have been accompanied by record high levels of margin debt – $560 billion as of September 30, 2017, according to NYSE data, which is over 46% higher than it was in July of 2007, its last peak before the financial crisis began. (Margin debt is money borrowed from brokers by investors to purchase securities.) According to The Washington Service, a leading provider of insider trading data, news, and analytics, the ratio of companies with insiders purchasing to companies with insiders selling in the month of October dipped to an all-time low since they began collecting data on insider trading in 1988.
It has been reported that Facebook, Amazon, Apple, Netflix and Google (the FAANGs), which are perhaps the poster children of this extended bull market, have added nearly $2.2 trillion to their combined market capitalizations since the financial crisis. (Note that our Global Value and Value Funds have long owned shares of Google, now known as Alphabet.) As of the end of October, these companies traded, respectively, at 35X, 280X, 19X, 198X and 31X their trailing twelve month earnings. With respect to Amazon and Netflix, it would take nearly two centuries’ worth or more of current earnings to recoup one’s investment in these companies. When contemplating the sustainability of valuation multiples such as these, we are reminded of Cisco, the darling of the tech, media and telecommunications bubble of the late 1990s. In early 2000, Cisco became the most valuable company in the world, trading at over 230X earnings at its peak. We should not forget that in the succeeding 10 years Cisco’s multiple fell to approximately 10X earnings, which allowed even value investors such as ourselves the chance to establish a position. We continue to hold Cisco and its P/E today stands at approximately 16X. These companies may very well grow into their lofty valuations, but their technological future, while bright, is fraught with uncertainty and assured change. When valuations become untethered in the near term from underlying fundamentals, as we believe they have for FAANGs such as Amazon and Netflix, the risk of potential permanent capital loss increases significantly. When such untethering occurs across virtually all asset categories, our capital markets become more fragile. More about Amazon later in this report.
While the so-called FAANG stocks have been growing at a rapid rate, the same cannot be said about the global economy as a whole. The economic recovery since the financial crisis has been rather anemic up until only very recently. According to information from The World Bank and the World Economic Forum, GDP in the United States has grown ever so modestly over the last eight to nine years, on average between 1% and 2% per year. Europe’s overall growth has been only marginally positive during this period, and growth in China has slowed dramatically from the high growth rates it enjoyed prior to the financial crisis. Returns in equity markets since the financial crisis have largely been due to significant increases in the prices investors have been willing to pay for a dollar of earnings, and not so much due to growth in those earnings. In fact, organic growth has been tough to come by for most companies. Much of the growth in corporate earnings has instead come about due to restructurings, stock buybacks and accretive merger and acquisition activity. While most market observers today feel that economic growth is on an uptick and near-term chances for a global recession are remote, we would caution against such complacency, particularly in light of the prospect of coordinated tightening by central banks around the world.
A worrisome by-product of central bankers’ monetary largesse over the last few years has been the increasing absence of price discovery in our bond and equity markets. What exactly do we mean by that? As we mentioned in our last report, interest rates are essentially prices to which the value of financial assets are directly or indirectly tied. A decline in interest rates lowers the discount rate applied to the future earnings streams of a bond or an equity security, and correlates to higher valuations for each. A rise in rates has the opposite effect. What valuation should one apply to a security whose future earnings are being discounted by near zero to negative interest rates? Discovering a fair value for such an asset can be a daunting proposition. And yet investment capital continues to flow aggressively into higher risk and increasingly lower yielding assets. In equity markets, this has translated into massive flows of new capital into low cost, passively managed index funds and ETFs, which have received over a trillion dollars worth of new investment over the last five years.
This torrent of money into passively managed products has for the most part been indiscriminately invested in index constituents based on their proportional market capitalization, without regard to fundamental financial analysis. Other things being equal, as more and more money proportionally and mindlessly flows into many of the larger, better performing index constituents, their valuations often continue to climb resulting in many of the most highly valued companies in the index being priced ever higher. This goes on and on until it doesn’t.
According to the May 5, 2017 Grant’s Interest Rate Observer, “$21 trillion or so of today’s invested capital belongs to value-indifferent stewards.” Think central bank bond purchases, index funds and ETFs. As Jim Grant has repeatedly warned, “Prices convey information. Distorted prices convey misinformation.” Without rational price discovery, asset bubbles can percolate, and scarce financial resources are likely to be allocated irrationally. If the proverbial black swan appears at some point, price agnostic investors in index funds and ETFs will be without a fundamental anchor in the ensuing storm, and the money could leave these assets faster than it came to them.
So what implications does all of this have for you, an investor in our Funds? In summary, as the noted high yield master investor, Howard Marks, recently commented, “We are living in a low return, high risk world.” We agree. While we, as shareholders, have been significant beneficiaries of our strong equity markets over the last many years, the inexorable rise in valuations has created “trying times” for disciplined, price-conscious value investors. Our available opportunity set has shrunk dramatically. New bargains, which plant the seeds for future returns, have been increasingly hard to uncover, and residual cash reserves in each Fund at quarter end accounted for between approximately 11% and 17% of total Fund assets. While we have pruned our investment garden carefully and are comfortable with the current structure of our Fund portfolios, the price to value ratio for many, if not most, of our portfolio holdings today is nearly full. Should the bull market continue in the weeks and months ahead, we will certainly participate although we will likely fall short of our fully invested benchmarks. If, on the other hand, our markets face a comeuppance, which in our view is increasingly likely, we have dry powder in the form of our cash reserves that we hope will allow us to take meaningful advantage of pricing opportunities. In the interim, we would encourage our shareholders to “Be careful out there.”
All four of the Tweedy, Browne Funds made significant financial progress over the last six months, and all but the Worldwide High Dividend Yield Value Fund trailed their respective benchmarks, which, as we write, continue to hit all time highs nearly every day. Over the last twelve months, all four Funds produced double digit returns that ranged from 14.28% net of fees for the Global Value Fund to 17.85% for the Worldwide High Dividend Yield Value Fund. These strong absolute returns were achieved in spite of the Funds carrying residual cash reserves that averaged between 11% and 15% over the last twelve months.
Absent yield producing alternatives, enthusiasm for equities remains extraordinarily high, valuations are elevated, and bargains around the world are very hard to come by. We hate to have to throw a cold shower on what has been a very robust period for equities, but at a minimum, equity investors at current price levels will have to temper their expectations regarding future returns.
Presented below are the results of the Tweedy, Browne Funds for various periods through September 30, 2017, with comparisons to their respective benchmark indexes.
Our Fund Portfolios
Please note that the individual companies discussed herein were held in one or more of our Funds during the six-month period ended September 30, 2017, but were not necessarily held in all four of our 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, 2017.
As you would gather from the introductory commentary in this report, most countries, sectors, industry groups and their constituents performed on the whole very well over the last six to twelve months in our Fund portfolios. Our European and emerging market holdings were significant contributors to returns due in large part to a much improved outlook for near-term economic growth abroad and favorable currency translations. Most major foreign currencies appreciated against the US dollar, providing a currency boost to the returns of our two unhedged Funds, Global Value II and Worldwide High Dividend Yield Value. Our two funds that hedge foreign currency, of course, do not generally benefit from rising foreign currencies.
With the exception of negative results in several of our auto-related, media, and tobacco holdings and a few of our oil & gas holdings, nearly all other sectors and industry groups within our Fund portfolios finished nicely in the black over the last six months and year to date. Our best performers included a number of our food and beverage, financial, industrial and internet technology holdings, including strong results in branded consumer products companies such as Diageo, Heineken, Nestlé and Unilever; Asian-centric banks such as DBS Group and HSBC; industrial companies such as Safran and Teleperformance; and our two search engine businesses, Alphabet (Google) and its Chinese counterpart, Baidu. Our timing on our investment in Baidu was particularly fortuitous in that, shortly after purchase, the company had a favorable earnings report which validated improving prospects for their search business and affirmed the establishment of cost controls over new business initiatives. This boosted investor confidence and, in turn, its stock price. Safran, the jet engine manufacturer, parts and maintenance company that we have owned for the last several years, continues to flourish as the steady and growing stream of shop visits required for engine maintenance we forecasted years ago continues to materialize, increasing its earnings power. We also had strong returns in our Chilean copper mining company, Antofagasta; in MasterCard, our US-based transaction processing company; in our long-time pharmaceutical holding, Novartis; in our Hong Kong based hotel investments, which we sold in part, and in AGCO, the US-based farm equipment manufacturer, among others.
In terms of near-term price disappointments, we faced continued weakness in our two Korean-based auto companies, Hyundai Motor and Kia, as worries regarding their current model lineup (fewer SUVs), industry overcapacity and longer term concerns about competition from electric cars continue to weigh on their stock prices. Both companies, in our view, are bound to benefit in the long run from their high quality ratings, innovative new offerings including new SUVs and crossovers and their strength in emerging markets, and thus offer significant upside potential from today’s valuations. The stock prices of several of our media and tobacco holdings were also under pressure, including Mediaset España, the Spanish television broadcaster; UK-based publisher, the Daily Mail; British American Tobacco; and Imperial Brands. In addition, Provident Financial faced a substantial decline, in part due to its ill advised attempts to bring technological efficiencies to what was a proven business model. Concerns about possible shortfalls in future funding led us to sell our remaining shares.
The Worldwide High Dividend Yield Value Fund has been our best performing fund of late, relative to benchmarks, attributable in part, to its significant weight in European equities and strong currency translations back into the US dollar. Its returns were led in part by strong results in companies such as Michelin, Diageo, Royal Dutch, Novartis, Cisco and Verizon, while Nestlé, GlaxoSmithKline, and G4S were under price pressure. By far and away, its best performing portfolio holding was Berendsen, the UK-based uniform and logistics company, which was the subject of a buyout at roughly a 47% premium over our cost by French-based Elis that closed right around the end of the reporting period.
The Funds’ oil & gas related holdings were mixed over the last six months as news of increasing inventory stockpiles pushed oil prices down, negatively impacting the stock prices of several holdings such as Devon Energy, Halliburton and MRC, among others. Conoco Phillips, Royal Dutch and Phillips 66 finished the period with nicely positive returns, while Total had only a very modest decline. As we have mentioned in previous letters, while there will likely be ongoing near-term price volatility in our oil & gas related holdings, as sentiment swings back and forth between concerns about high inventory levels and the prospects for increasing demand against a backdrop of relatively low excess capacity, we believe the future for our oil & gas holdings continues to be positive. We continue to believe that, in light of overall supply/demand considerations, the prospects for ongoing Saudi constraint, and continued rationalization of capital spending by the oil majors, oil prices should drift higher over the longer term. In the interim, companies such as Total and Royal Dutch, where the bulk of our exposure resides, continue to pay substantial dividends, which appear safe for the time being while we wait for value recognition in their stock prices. Furthermore, these two fully integrated oil companies are partially hedged by their downstream refining and chemicals businesses, which benefit from lower oil prices. In early November, oil prices drifted above $60 per barrel for Brent crude, reflecting in part increasing worldwide demand, relatively low excess capacity, numerous conflict related concerns, growing confidence that OPEC will agree to extend their production cuts beyond March of 2018, and increasing capital discipline by US exploration and production companies.
One final note with respect to attribution. We are asked frequently about our rather significant underweighting in Japanese equities. As you probably know, Japan has a considerable weighting in both the MSCI EAFE Index (23%) and the MSCI World Index (9%), so any significant movement up or down in Japan will have a material impact on our relative results. The Japanese stock market has been a strong performer in recent years and our low weighting has thus impacted our relative returns. This underweighting has simply been a consequence of our bottom-up stock selection approach rather than any active bet against the country. We had low representation in Japanese stocks going into the market rally several years back and have been net sellers in recent years, reflecting the closing of the valuation gap between Japan and the rest of the world. Today we have less than a 2% position in Japan in our Fund portfolios. Opportunities to increase our position have been examined on a stock by stock basis but have largely been limited of late to the addition of a few smaller capitalization, less liquid companies.
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