Graham & Doddsville Newsletter Fall 2018: Tweedy, Browne Company

Graham & Doddsville (G&D): How relevant is Ben Graham’s philosophy today?

Tom Shrager (TS): The collateral value of an equity investment is the intrinsic value of the business. The value of the business could be its net asset value, it could be its book value, or it could be an earnings-based valuation. By thinking in terms of business value and buying at a discount from that value, a diversified portfolio of undervalued securities should earn an adequate return. That framework hasn't changed.

G&D: What types of valuation metrics do you use?

John Spears (JS): We look for “a satisfactory owner earnings yield.” For example, if you take a company’s operating income after tax and divide that by its enterprise value, and that produces an owner earnings yield of 8-10%, you’re getting a pretty good return.

G&D: How is the process for earnings-based valuation different?

Bob Wyckoff (BW): Earnings are less predictable. In conducting our analysis on earnings-based businesses, we spend a lot more time today on qualitative factors, factors that might impact that earnings stream over time. We try to estimate the earnings power of the business, the sustainability of that earnings power, and what the growth of that earnings power might look like over time.

G&D: How has this impacted valuation?

BW: The valuation framework remains the same – we’re still trying to buy companies at significant discounts from a conservative estimate of the underlying intrinsic value of the business. We tend to be pretty conservative appraisers. Today, we often value businesses at 10 -13x pre-tax operating income – compared to 6-8x when I first started at Tweedy in 1991 – and try to buy those businesses somewhere between 6-9x.

G&D: What other recent changes have you seen in the markets?

BW: Over the past 25 years we’ve become more of an international investor – our client portfolios were primarily made up of U.S. equities up until the early ‘90s. Today, most of our assets under management are invested outside the US, as we often find greater pricing inefficiency in non-domestic markets. Another thing that has changed in the past half-dozen years is our increased allocation to technology stocks. We have owned technology stocks in the past, however, they were often businesses under pressure that were trading at discounts to book value. We bought Google in 2012 at a very attractive valuation – somewhere around 9-10x forward EV to EBITA and 12- 13x forward earnings. It was also compounding its value at over 20%. It was cheap.

G&D: Can you talk about your recent purchase of AutoZone?

JH: AutoZone is the largest aftermarket auto parts retailer in the US and has a fabulous long-term track record. When we study a company, one thing we like to examine is the longterm historical value compound of the business. Let's say we think AutoZone is worth 12x EBIT. To find the value compound, take EBIT, multiply by 12, subtract the net debt, and divide by the number of diluted shares outstanding. We apply that same valuation methodology over say the last 10 years and observe how that value has changed over that period, and how much volatility there was from year to year. To avoid a flawed analysis, you need to make certain that the first year and the final year of the period do not represent trough or peak earnings. What you’re essentially trying to determine is, if you owned this business over a long time, how would the value have grown?

In AutoZone’s case, if you look over the previous 11-year period, its intrinsic value grew by 16% per annum, with a significant percentage of that growth driven by share buybacks. The historical record also revealed a stable and defensive business. Same store sales at AutoZone have grown in 19 out of the last 20 years, including in 2008 and 2009. AutoZone has also historically produced high returns, with a 14% ROA (return on assets) and a roughly 30% lease adjusted ROIC (return on invested capital). Free cash flow is important to us, particularly free cash flow conversion. One of the things we consider is how well a company converts its net income into free cash flow over time... We also like that they take every free dollar of cash flow and use it to buy back stock.

We saw things differently, ultimately concluding that the slowdown was more likely the result of weather and car demographics than competition from Amazon. Amazon’s major point of differentiation is price. But for AutoZone customers, there are a few factors that are even more important than price. Consider the do-it-yourself segment which represents 80% of AutoZone’s revenue. In this segment, there are three things more important to the customer than price. First is the urgency of the need. Second is the convenience factor. Third is the technical assistance AutoZone provides.

G&D: You are long Unilever and Nestle, right?

BW: Yes, as well as Heineken. They’ve almost become semipermanent holdings. We have owned them for 15-20 years. They have durable competitive advantages that allow them to compound their underlying intrinsic values at an attractive and predictable rate. It's a very tax efficient way to invest. We’ll sometimes trade around their intrinsic value, meaning we’ll trim the position if the stock price moves ahead of intrinsic value and add to the position if the stock price drops below. These companies also give us exposure to faster growing parts of the world. When growing middle classes around the globe get more discretionary income, they want a better beverage and a better food product. These companies are serving that demand, which is growing all the time.

G&D: Do you have any advice for MBAs who want to break into the industry?

BW: Yet our advice would be to not sell short the traditional, long only way of investing. It’s not a lost art. As the world becomes more passive, we think the market will ultimately present more opportunities for people like ourselves. Our advice is to think longterm. If you do that, your competition will be more limited. Think about getting rich over a lifetime by doing something that’s repeatable and sustainable. Investing on a highly concentrated and leveraged basis may allow one to beat the market by a substantial margin from time to time with great subsequent reward, but the risks and stress are considerable and sometimes consequential.

TS: Coming back to success. First, you have to be lucky. It's better to be lucky than smart. Next comes hard work. It means working as hard as you possibly can, finishing before you are expected to, having all your t’s crossed and all your i’s dotted. It means having a passion for what you do, even if you may not be initially rewarded.

JH: I would add: be persistent.

RD: The greatest gift is just curiosity about what the dynamics of the business are. This keeps you going during dry patches, instead of simply thinking that you have to find a stock to buy or sell. Discipline is essential. If you can combine that sort of curiosity with the right temperament, you’re in a lucky spot.


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