Tweedy, Browne’s “What Has Worked in Investing”Download printable PDF
by Wayne Thorp
Many individual investors embody value investing—Benjamin Graham and Warren Buffett immediately come to mind. Among investment management firms, perhaps none other is as devoted to the principles of value investing as Tweedy, Browne Company. David Stevenson wrote in his book “Smarter Stock Picking” (Pearson Education, 2011), “Graham may have been 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 a paper outlining many of the key characteristics of their own long-term investment portfolios, called “What Has Worked in Investing: Studies of Investment Approaches and Characteristics Associated with Exceptional Returns.” This article, which was revised in 2009, is available for free from the Tweedy, Browne website: www.tweedy.com/resources/library_docs/papers/WhatHasWorkedFundOct14Web.pdf.
In this issue of Stock Investor News we discuss the characteristics Tweedy, Browne looks for in its investments and build a stock screen based on these elements using Stock Investor Pro.
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“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 stocks with low price-to-book-value ratios outperform stocks with high price-to-book-value ratios over the long term. 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 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 companies with a debt-to-equity ratio of 20% or less (considered unleveraged firms) performed somewhat better than companies with debt-to-equity ratios greater than 20%.
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 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 most profitable. 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 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 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, a 2006 Credit Suisse Quantitative Equity Research study showed that there is a direct correlation between low payout ratios and higher returns within the higher dividend yield universe.
A study by David Dreman also showed that between 1970 and 1996 high dividend–yield stocks outperformed stocks with low price-earnings, price-to-book-value, and 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.
|Hallwood Group Inc. (HWG)||22.90||0.50||2.10||0.00||4.50||-23.00||0.00||-62.00||34.90||textiles holding co.|
|Broadway Financial Corp. (BYFC)||2.21||0.20||5.00||1.80||31.10||-15.80||0.00||-60.00||3.90||bank holding co.|
|HQ Sustainable Maritime Indus (HQS)||2.78||0.30||4.10||0.00||0.00||42.50||4.00||-59.00||49.70||aquafarming|
|Meta Financial Group Inc. (CASH)||15.45||0.70||4.00||3.40||14.60||78.80||6.00||-51.00||48.10||bank holding co.|
|Books-A-Million, Inc. (BAMM)||4.25||0.60||4.70||4.70||0.00||7.30||9.00||-47.00||66.00||book retailer|
|Ever-Glory Int’l Group (EVK)||2.03||0.80||4.50||0.00||0.00||18.80||3.00||-42.00||30.00||apparel holding co.|
|Farmers Capital Bank Corp. (FFKT)||6.40||0.40||9.30||0.00||40.40||-20.40||1.00||-34.00||47.40||bank holding co.|
|Glen Burnie Bancorp (GLBZ)||7.96||0.80||10.30||5.00||0.00||-3.90||2.00||-33.00||21.50||bank holding co.|
|Addus Homecare Corp. (ADUS)||4.98||0.60||8.70||0.00||45.40||-57.30||7.00||-24.00||53.50||home med servs|
|National Western Life Ins. (NWLI)||160.08||0.50||8.00||0.20||0.00||-1.20||3.00||-23.00||581.20||stock life insurance|
|Premier Financial Bancorp (PFBI)||7.23||0.50||7.40||6.10||0.00||3.30||0.00||-23.00||57.40||multi-bank holding co.|
|United Bancshares Inc. OH (UBOH)||9.11||0.60||10.10||0.00||18.30||0.00||2.00||-19.00||31.40||bank holding co.|
|Key Tronic Corporation (KTCC)||5.10||0.80||5.20||0.00||27.40||13.80||3.00||-17.00||52.80||electronic mfg servs|
|Energy Services of America (ESA)||3.35||0.70||8.00||0.00||19.00||nmf||0.00||-14.00||40.50||contract energy servs|
|Servotronics, Inc. (SVT)||8.60||0.80||8.50||1.70||16.40||10.40||0.00||-11.00||19.20||advanced tech prods|
|Flexsteel Industries (FLXS)||15.64||0.90||9.80||1.90||0.00||11.90||3.00||-7.00||104.70||furniture|
|Tower Group, Inc. (TWGP)||23.38||0.90||8.60||2.10||34.40||20.70||5.00||-6.00||981.40||insurance prods & servs|
|EMC Insurance Group (EMCI)||24.32||0.90||10.10||3.10||0.00||-5.40||5.00||-5.00||314.50||insurance holding co.|
|Global Indemnity plc (GBLI)||21.50||0.70||7.70||0.00||13.10||-4.90||9.00||-3.00||652.70||insurance holding co.|
|Sussex Bancorp (SBBX)||6.10||0.60||9.20||0.00||35.10||-1.20||9.00||-3.00||20.50||bank holding co.|
|Horace Mann Educators (HMN)||17.11||0.80||8.70||2.60||22.70||2.60||7.00||-2.00||680.70||insurance holding co.|
|Valley Financial Corp. VA (VYFC)||4.80||0.60||8.90||0.00||43.00||-8.20||9.00||-1.00||22.50||bank holding co.|
|FBL Financial Group (FFG)||30.30||0.80||7.70||0.80||23.70||9.50||4.00||3.00||943.80||insurance holding co.|
|Giga-tronics, Inc. (GIGA)||2.71||0.60||1.00||0.00||0.00||8.40||1.00||4.00||13.50||test equip for wireless|
|Magyar Bancorp, Inc. (MGYR)||4.35||0.60||6.20||0.00||0.00||-0.30||3.00||4.00||25.20||bank holding co.|
|Universal Power Group (UPG)||4.00||0.90||7.50||0.00||0.00||-18.90||0.00||4.00||20.10||batteries & power accessor|
|Community Bank Shs of India (CBIN)||10.55||0.60||6.00||3.80||26.90||4.70||6.00||5.00||34.90||bank holding co.|
|LNB Bancorp, Inc. (LNBB)||5.70||0.50||10.40||0.70||19.20||-11.10||16.00||9.00||44.90||bank holding co.|
|National Security Group (NSEC)||14.42||0.80||7.20||4.20||27.60||6.30||0.00||12.00||35.60||insurance holding co.|
|CSP Inc. (CSPI)||4.63||0.90||8.10||0.00||0.00||4.40||4.00||15.00||16.20||info tech (IT) solutions|
nmf = no meaningful figure.
Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 4/8/2011.
Several studies 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. A Fortune Magazine study from 1974 to 1983 showed that companies purchasing large amounts of their own stock outperformed the S&P 500 on an annual basis?22.6% to 14.1%, respectively.
Stock 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 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. However, this outperformance 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, studies have shown excess returns from investing in small-cap stocks in the U.K, France, Germany, Australia, Canada and Japan, too.
Building a Stock Screen
Using Stock Investor Pro, 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 a strategy that is too restrictive, meaning too few stocks would pass on a regular basis to be useful to individual investors. The booklet, however, does provide several primary concepts on which a screen can be based. We have combined these concepts into our Tweedy, Browne “What Has Worked” screen. Figure 1 shows the Stock Investor Pro filters that make up the screen.
As of April 8, 2011, the Stock Investor Pro database consisted of 9,890 companies.
The first criterion of our What Has Worked” screen looks for companies whose assets are cheap relative to the stock price. We do this by isolating the companies that rank in the bottom quartile (25%) of the stock universe. This criterion eliminated all but 1,747 companies from the database.
Next, we focused on companies with a price-earnings ratio (P/E) that also ranked in the bottom quartile (25%) of the entire stock universe. In other words, earnings are relatively cheap given the current stock price. By itself, this criterion yielded 1,138 companies, while together with the other criteria 413 companies remained.
Looking at the balance sheet, the next piece of our “What Has Worked” screen requires companies to have a long-term-debt-to-equity ratio of no more than 50%.
From the entire stock database, 5,370 companies met this requirement, while the screen in its entirety left us with 349 companies.
In order to pass our “What Has Worked” screen, a company must have had more insider sell transactions than buy transactions over the last six months.
As of April 8, 2011, 5,681 companies satisfied this piece of criterion, while 200 companies passed the entire screen to this point.
Looking for smaller companies, our next filter limited a company’s market capitalization to $1 billion or less. This alone yielded 7,630 companies, while lowering our total number of passing companies to 185.
These criteria resulted in 3,810 passing companies, while our final “What Has Worked” screen showed 38 total passing companies.
Table 1 presents the 30 stocks with the lowest 52-week relative strength index values that passed our Tweedy, Browne “What Has Worked” screen as of April 8, 2011. (In all, 38 companies passed the screen.)