Tweedy, Browne: “What Has Worked in Investing”
Wayne Thorp will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
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. This article, which was revised in 2009, is available for free from the Tweedy, Browne website: www.tweedy.com/resources/library_docs/papers/WhatHasWorkedInInvesting.pdf.
In this article we discuss the characteristics Tweedy, Browne looks for in its investments and build a stock screen based on these elements.
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. 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 20% over a 30-year period. However, it is rare to find companies trading at a discount to net current asset value. (For more information on Graham’s net current asset value approach, Computerized Investing subscribers should read the February 2010 CI Online Exclusive article available at www.computerizedinvesting.com.)
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. Currently, this translates into a price-earnings ratio of less than 12.
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.
Building a Stock Screen
Using AAII’s Stock Investor Pro fundamental stock screening and research database program, we developed our own Tweedy, Browne “What Has Worked” screen. Tweedy, Browne’s “What Has Worked in Investing” booklet cites over 40 different studies. Implementing all of the findings into a single stock screen would create an overly restrictive strategy, meaning too few stocks would pass on a regular basis to be useful to individual investors. The booklet, however, does provide several primary concepts that a screen can be based on. We have combined these concepts into our Tweedy, Browne “What Has Worked” screen:
- Price-to-book-value ratio ranks in the bottom quartile (25%) of the stock universe;
- Price-earnings ratio ranks in the bottom quartile (25%) of the stock universe;
- Long-term-debt-to-equity ratio is less than or equal to 50%;
- The number of insider sell transactions does not exceed the number of insider buy transactions; and
- Market capitalization is less than or equal to $1 billion.
We also excluded real estate investment trusts, closed-end funds, stocks trading over the counter , non-U.S. stocks, and American depositary receipts ( .
Profile of Passing Companies
Table 1 presents the characteristics of the stocks that passed our Tweedy, Browne “What Has Worked” screen as of March 4, 2011. (In all, 43 companies passed the screen.)
In order to pass this screen, a stock must rank in the bottom 25% of the entire stock universe in terms of its price-to-book-value ratio. For all passing companies, the price-to-book ratios range from 0.36 to 0.95 with a median or midpoint value of 0.69. By comparison, the typical exchange-listed stock has a price-to-book-value ratio of 1.73.
|Portfolio Characteristics (Median)||
|Price-to-book-value ratio (X)||0.7||1.7|
|Price-earnings ratio (X)||8.0||18.1|
|Dividend yield (%)||0.0||0.0|
|EPS 5-yr. historical growth rate (%)||4.4||3.2|
|EPS 3-5 yr. estimated growth rate (%)||10.0||12.6|
|Market cap. ($ million)||52.9||550.0|
|52-week relative strength vs. S&P* (%)||-9||0|
|*S&P 500 index = 0.|
|Data as of 3/4/2011.|
We also limit the passing companies to the bottom 25% of the stock universe for price-earnings ratio. For the 43 passing companies, price-earnings ratios range from 0.6 to 10.5, with a midpoint of 8.0. In contrast, the median value among all exchange-listed stocks is 18.1.
Although this is a value-oriented screen, we do not have any specific criteria when it comes to dividends. As a result, only 19 of the 43 passing companies currently pay a dividend. Therefore, the median dividend yield for the companies passing our Tweedy, Brown “What Has Worked” screen is 0.0%. The typical exchange-listed stock does not pay a dividend.
While not explicitly part of our Tweedy, Browne “What Has Worked” screen, expectations regarding a company’s prospects do impact share performance and, therefore, multiples such as price-to-book, price-to-sales and price-earnings. The median average five-year earnings growth rate for the companies passing this screen is 4.4%, while exchange-listed stocks have a median growth rate of 3.2%.
Looking forward, analysts have published three-to-five year earnings forecasts for only nine of the 43 passing companies. For these companies, the median projected growth rate is 10.0%, while the typical exchange-listed stock is expected to grow its earnings, on average, by 12.6% a year for the next three to five years.
The Tweedy, Browne “What Has Worked” screen focuses on companies with a market capitalization of $1 billion or lower. This threshold is commonly used among institutional investors to define small-cap stocks. However, the median market cap for the 43 passing companies is only $52.9 million, well within the micro-cap realm. This is not surprising, since stocks with very low price multiples—the focus of this screen—tend to be small- or micro-cap stocks. The typical exchange-listed stock has a market cap of $550.0 million.
Lastly, the stocks that pass our Tweedy, Browne “What Has Worked” screen have underperformed the S&P 500 index by 9% over the last 52 weeks. While not part of our screen, we do rank the passing companies in Table 2 in ascending order by their 52-week relative strength index value. Tweedy, Browne cites research where underperforming stocks tend to outperform going forward. By contrast, the typical exchange-listed stock has performed in line with the S&P 500 over the last 52 weeks.
Stocks on the List
Table 2 lists the 30 companies passing the Tweedy, Browne “What Has Worked” screen as of March 4, 2011, with the lowest 52-week relative strength. These companies are ranked in ascending order by relative strength.
|First South Bancorp, Inc. (FSBK)||5.16||0.58||8.9||0.0||11.8||-10.4||1||-62||50.3||bank holding co.|
|HQ Sustainable Maritime (HQS)||4.05||0.50||6.0||0.0||0.0||42.5||4||-54||72.5||aquatic prods/foods|
|Hallwood Group Inc. (HWG)||26.25||0.61||2.4||0.0||4.5||-23.0||0||-48||40.0||textiles holding co.|
|Addus Homecare Corp. (ADUS)||5.02||0.61||8.8||0.0||45.4||-57.3||3||-47||54.0||home health servs|
|Ever-Glory International Grp (EVK)||2.28||0.92||7.6||0.0||0.0||8.1||3||-45||33.6||apparel holding co.|
|Farmers Capital Bank Corp. (FFKT)||7.19||0.36||10.4||0.0||0.0||-20.4||2||-37||53.2||bank holding co.|
|QC Holdings, Inc. (QCCO)||3.89||0.93||5.0||5.1||23.6||20.6||2||-34||66.4||short-term loans|
|Books-A-Million, Inc. (BAMM)||5.63||0.79||6.3||3.6||0.0||7.3||0||-32||87.5||book retailer|
|Key Tronic Corp. (KTCC)||4.58||0.73||4.6||0.0||27.4||13.8||3||-30||47.4||electronic mfr|
|Glen Burnie Bancorp (GLBZ)||8.10||0.83||10.5||4.9||0.0||-3.9||2||-29||21.8||bank holding co.|
|Meta Financial Group Inc. (CASH)||18.12||0.80||4.7||2.9||14.6||78.8||6||-29||56.4||financial hold’g co.|
|Bank of Commerce Hold’gs (BOCH)||4.21||0.83||9.8||2.9||18.1||-0.7||4||-28||71.5||real estate & gas|
|MOD-PAC CORP. (MPAC)||5.09||0.71||7.7||0.0||8.2||-20.9||3||-27||15.8||cartons & printing|
|AeroCentury Corp. (ACY)||16.61||0.59||5.8||0.0||0.0||84.9||0||-23||25.6||aircraft leasing|
|Magyar Bancorp, Inc. (MGYR)||4.05||0.53||5.8||0.0||0.0||-0.3||3||-22||23.4||bank holding co.|
|Virginia Commerce Bancorp (VCBI)||5.90||0.95||10.4||0.0||36.8||-4.9||11||-20||170.5||bank holding co.|
|National Security Group (NSEC)||12.60||0.69||6.3||4.8||27.6||6.3||0||-18||31.1||insur holding co.|
|First Community Bancs (FCBC)||12.46||0.82||10.1||3.2||0.0||-12.1||1||-16||222.2||financial hold’g co.|
|National Western Life Ins (NWLI)||168.92||0.50||9.4||0.2||0.0||-7.9||2||-15||613.0||life insurance|
|United Bancshares Inc. (UBOH)||9.25||0.57||10.3||0.0||18.3||0.0||5||-14||31.9||bank holding co.|
|Premier Financial Bancorp (PFBI)||7.68||0.54||5.7||5.7||0.0||28.3||0||-12||60.9||bank holding co.|
|Sussex Bancorp (SBBX)||5.65||0.51||8.6||0.0||35.1||-1.2||9||-9||18.9||bank holding co.|
|CommerceFirst Bancorp (CMFB)||8.41||0.69||9.2||0.0||0.0||-22.6||3||-8||15.3||bank holding co.|
|Giga-tronics, Inc. (GIGA)||2.55||0.55||0.9||0.0||0.0||8.4||1||-7||12.7||test equip|
|EMC Insurance Group Inc. (EMCI)||24.19||0.83||6.6||3.1||0.0||25.6||1||-4||312.5||insur holding co.|
|Flexsteel Industries, Inc. (FLXS)||15.03||0.82||9.4||2.0||0.0||11.9||6||-2||100.6||furniture|
|Lakes Entertainment, Inc. (LACO)||2.75||0.52||6.1||0.0||4.4||22.7||6||0||72.5||casinos|
|CSP Inc. (CSPI)||4.26||0.79||7.5||0.0||0.0||4.4||4||1||14.9||IT solutions|
|Horace Mann Educators (HMN)||16.56||0.67||8.4||2.7||20.5||2.7||0||3||658.6||insur holding co.|
|Global Indemnity plc (GBLI)||22.41||0.73||8.0||0.0||13.1||-4.9||9||10||680.4||insur holding co.|
|*S&P 500 index = 0|
|Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 3/4/2011.|
First South Bancorp, Inc. (FSBK) has the lowest relative strength, underperforming the S&P 500 by 62% over the last 52 weeks. This North Carolina–based bank holding company has seen its shares drop 55% for the 52-week period ending March 4, 2011. The company reported its first quarterly loss since at least 2008 for the period ending December 31, 2010, and at that time announced it was suspending its quarterly dividend, which it had cut by 55% the previous quarter. Over the last five years, earnings per share has fallen an average of 10.4% per year. Despite this, the company’s price-earnings ratio of 8.9 puts it near the top among all of the passing companies.
Among the 30 companies listed in Table 2, Global Indemnity plc (GBLI) has the highest relative strength, outperforming the S&P 500 by 10% over the last 52 weeks. The insurance holding company hit a new 52-week high on March 2, as its shares have risen 30% over the last year. However, the company’s price-earnings ratio is right in the middle of the pack of passing companies at 8.0. Earnings have fallen by an average of 4.9% over the last five years. Global Indemnity has seen one of the largest number of net buy trades (buys less sells) by insiders over the last six months—nine in all.
Virginia Commerce Bancorp (VCBI) has seen the most net insider buy trades over the last six months: net insider buy trades stand at 11. This has done little for the share price, however, which has fallen 5% over the last year and risen only 2% over the last six months. On a relative basis, VCBI shares have underperformed the S&P 500 index by 20% over the last 52 weeks. VCBI shares fell over 15% in the days following a secondary stock offering in late September of last year.
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.