Many individual investors embody value investing—Benjamin Graham and Warren Buffett immediately come to mind. Among investment management firms, perhaps none is as devoted a follower of the principles of value investing as Tweedy, Browne Company.
In his book “Smarter Stock Picking” (FT Press, 2010), David Stevenson wrote: “Graham may be the patron saint of most value-based investors, but it’s Tweedy, Browne who are the Jesuits—the brains behind the scene who bother to work it all out and put it into practice.”
In 1992, Tweedy, Browne published “What Has Worked in Investing: Studies of Investment Approaches and Characteristics Associated With Exceptional Returns,” a paper outlining many of the key characteristics of their own long-term investment portfolios. They issued a revised edition in 2009.
In this article we discuss the characteristics Tweedy, Browne looks for in its investments.
The “What Has Worked” Criteria
Tweedy, Browne has incorporated the following basic selection criteria since at least 1955:
- Low price in relation to asset value;
- Low price in relation to earnings;
- A significant pattern of purchases by one or more insiders;
- A significant decline in a stock’s price; and
- Small market capitalization.
Assets Bought Cheap
Numerous studies have shown that, over the long term, stocks with low price-to-book-value ratios outperform stocks with high price-to-book-value ratios. The studies point to price-to-book ratio values in the bottom 20% to 30% as an attractive investment universe (This is one of the cornerstones of AAII’s Model Shadow Stock Portfolio). Tweedy, Browne’s experience indicates that stocks selling at low prices in relation to book value are often priced at significant discounts to real-world estimates of company value.
Tweedy, Browne also has studied the impact of leverage on the performance of stocks that are priced at 66% or less of net current asset value and across the range of price-to-book-value ratios. Their findings show that unleveraged firms (those with a debt-to-equity ratio of 20% or less) were somewhat better than those companies with debt-to-equity ratios greater than 20%.
Stocks that are even more attractive to Tweedy, Browne are those trading at a discount to net current assets (current assets less all liabilities, including preferred stock and unfunded pension liabilities). The approach was popularized by Benjamin Graham, who called for the purchase of stocks that are priced at 66% or less of a company’s net current assets. Graham viewed net current asset value as the estimated liquidation value of the business and used the net current asset investment selection strategy extensively to power his Graham-Newman Corp. portfolio to an average annual return of roughly 20% over a 30-year period. However, it is rare to find companies trading at a discount to net current asset value.
Earnings Bought Cheap
Tweedy, Browne’s “What Has Worked” booklet also cites research showing that stocks purchased at low price-earnings ratios offer better long-term performance than those with higher price-earnings ratios.
Tweedy, Browne illustrates how investing in low price-earnings ratio stocks can also be a profitable methodology. (Several other studies, including those conducted by Ibbotson Associates, confirm the firm’s assertion.) Investing in stocks with a price-earnings ratio ranking in the lowest 20% to 30% of the stock universe seems to be the most profitable approach.
When investing in low price-earnings stocks, Tweedy, Browne points out that it is preferable to choose those companies with good prospects for earnings growth. All else being equal, low price-earnings ratio stocks with good earnings growth prospects outperform low price-earnings ratio stocks lacking earnings growth potential.
Included in this discussion are techniques that look for stocks with high dividend yields and low prices relative to cash flow. Dividend yield (dividends per share over the next 12 months divided by current share price) is another popular measure used by value investors, especially those interested in dividend income. Historically, stocks with higher dividend yields outperform those with lower yields. However, Tweedy, Browne cites a 2006 Credit Suisse Quantitative Equity Research study showing that there is a direct correlation between low payout ratios (dividends per share over the trailing 12 months divided by earnings per share for the same period) and higher returns within the higher dividend yield universe.
Another study they cite by David Dreman also showed that between 1970 and 1996 high dividend yield stocks outperformed stocks with low price-earnings ratios, low price-to-book-value ratios, and low price-to-cash flow ratios during down quarters (although all of these strategies outperformed the overall market).
Investing With the Inner Circle
Tweedy, Browne feels that company insiders—officers and directors—tend to buy their company’s stock when they perceive it to be undervalued relative to the value of the company’s assets or relative to the value of the business as a whole in an acquisition. The firm also argues that companies will repurchase their own shares when management believes the shares are worth significantly more than their current price. Furthermore, insiders have “insight information,” which they believe will increase the value of the firm.
Several studies cited by Tweedy, Browne have shown that buying company stock following public disclosure of insider purchases would have generated returns greater than the market index. Furthermore, companies that repurchase their shares tend to outperform the overall market. When officers and directors are significant shareholders in the company, such stock repurchases are similar to insider purchases. Tweedy, Browne quotes a Fortune Magazine study from 1974 to 1983 showing that companies purchasing large amounts of their own stock outperformed the S&P 500 on an annual basis; 22.6% to 14.1%, respectively.
Stocks Price Declines
Often, a decline in stock price is accompanied by a decline in earnings or an earnings disappointment. While such events can have a negative impact on share performance for many months after they occur, Tweedy, Browne believes there is a natural tendency for company performance to “revert to the mean.” As a result, they have found that companies with poor recent performance tend to improve over time.
The “What Has Worked” booklet cites several studies that show that selecting the worst-performing stocks generates excess positive returns going forward relative to selecting the best-performing stocks. This outperformance, however, can take years to play out.
Followers of AAII’s Model Shadow Stock Portfolio know the benefits of investing in small-cap stocks. The Tweedy, Browne booklet highlights several studies that show that, over the long-term, investing in smaller companies (as measured by market capitalization) yields better results than investing in large(r)-cap companies.
Beyond the U.S. equity markets, they cite studies showing excess returns from investing in small-cap stocks in the U.K., France, Germany, Australia, Canada and Japan, too.
Tweedy, Browne’s “What Has Worked in Investing” is a thoughtful analysis of investment characteristics that tend to generate excess returns. The authors admit that these factors do not guarantee outperformance all of the time. However, by building a screen to capture stocks that, historically, have generated excess returns, you improve your chances of long-term investing success.
This article is adapted from an article I wrote for the AAII Journal. For an unabridged version of the article, as well as tips on how to create a screen following the “What Has Worked” criteria, click here.