What has worked in investing :Study by Tweedy Browne


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This is a small summary of the study by Tweedy Browne company -It is Timeless treasure

This is not my work i have only captured the things which appeals to me as a learner and student of value investing. Fellow VP’s and seniors might find some pat of the article which may be beneficial to the peers and VPs You all requested to go through the material compiled and add some missed points to increase its value
Objective: To explore and know the things which has worked in value investing in the Past and sharing the same among VPs to know some hidden message and excavate hidden diamonds in the Article

At the time of purchase one or more of the following characteristics should be observed

  1. Low Price in Relation to Asset Value : Find stocks selling at discounts to net current assets (i.e., cash and other assets which can be turned into cash within one year, such as accounts receivable and inventory, less all liabilities), a measure of the estimated liquidation value of the business

  2. Low Price in Relation to Earnings :The earnings yield is the yield which shareholders would receive if all the earnings were paid out as a dividend .A company priced low in relation to earnings, whose earn ings are expected to grow, is preferable to a similarly priced company whose earnings are not expected to grow. Price is the key. Included within this broad low price in relation to earnings category are high dividend yields and low prices in relation to cash flow (earnings plus depreciation expense).

  3. A Significant Pattern of Purchases by One or More Insiders (Officers and Directors: Look for significant insider buying in companies selling in the stock market at low price/earnings ratios or at low prices in relation to book value.

  4. A Significant Decline in a Stock’s Price :It is found that, more often than not, companies whose recent performance has been poor tend to perk up and improve.

  5. Small Market Capitalization: Try to held and continue to hold significant numbers of smaller capitalization companies as these can be these companies are often associated with higher rates of growth and can be more easily acquired by other corporations.

So in nutshell the highlight of stock picking should be around following criteria in order to achieve Margin of Safety
A: ASSETS BOUGHT CHEAP
B: EARNINGS BOUGHT CHEAP
C: INVESTING WITH THE INNER CIRCLE
D: STOCKS THAT HAVE DECLINED IN PRICE
E: STOCKS WITH SMALLER MARKET CAPITALIZATIONS

BENJAMIN GRAHAM’ S NET CURRENT ASSET VALUE STOCK SELECTION CRITERION
The net current assets investment selection criterion calls for the purchase of stocks which are priced at 66% or less of a company’s underlying current assets (cash, receivables and inventory) net of all liabilities and claims senior to a company’s common stock (current liabilities, long-term debt, preferred stock, unfunded pension liabilities). For example, if a company’s current assets are $100 per share and the sum of current liabilities, long-term debt, preferred stock, and unfunded pension liabilities is $40 per share, then net current assets would be $60 per share, and Graham would pay no more than 66% of $60, or $40, for this stock

Point to note :
a} The firms operating at a loss had slightly higher investment returns than the firms with positive earnings: 31.3% per year for the unprofitable companies versus 28.9% per year for the profitable companies.
b) companies satisfying the net current asset criterion have not only enjoyed superior common stock performance over time but also often have been priced at significant discounts to “real world” estimates of the specific value that stockholders would probably receive in an actual sale or liquidation of the entire corporation.

LOW PRICE IN RELATION TO BOOK VALUE
Point to note :
a}Stocks with a low price to book value ratio had significantly better investment returns over the 18-year period than stocks priced high as a percentage of book value (study)
in study of Average Earnings Per Share for Companies in the Lowest and Highest Price/Book Value Quintiles
Where lowest quintile of price/book value (average price/book value equalled .36 and highest quintile of price/book value companies (average price/book value equalled 3.42),In the three years prior to the selection date, companies in the lowest quintile of price/book value experienced a significant decline in earnings, and companies in the highest quintile of price/book value experienced a significant increase in earnings. In the fourth year after the date of selection, the companies with the lowest price/book value experienced a larger percentage increase in earnings (+24.4%) than the companies with the highest price/book value, whose earnings increased 8.2%. The authors suggest that earnings are “mean reverting” at the extremes; i.e., that significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.
**Note :**Tweedy, Browne, using the same methodology over the same period, examined the historical returns of the stocks of (i) unleveraged companies which were priced low in relation to book value and (ii) unleveraged companies selling at 66% or less of net current asset value in the stock market. The sample included only those companies priced at no more than 140% of book value, or no more than 66% of net current asset value in which the debt to equity ratio was 20% or less.The results for the unleveraged companies were somewhat better than the investment results for the companies in which debt to equity exceeded 20%.

Similar to net current asset stocks, other characteristics frequently associated with stocks selling at low ratios of price to book value are:
(i) low price to earnings ratios,
(ii) (ii) low price to sales ratios, and
(iii) (iii) low price in relation to “normal” earnings assuming a company earns the average return on equity for a given industry or the average net income margin on sales for such industry.\

Current earnings are often depressed in relation to prior levels of earnings. The stock price has often declined significantly from prior levels. The companies with the lowest ratios of price to book value are generally smaller market capitalization companies. Corporate officers and directors often buy such stock because they believe it is depressed relative to its true value. The company also frequently repurchases its own stock.

SMALL MARKET CAPITALIZATION LOW PRICE TO BOOK VALUE COMPANIES AS COMPARED TO LARGE MARKET CAPITALIZATION LOW PRICE TO BOOK VALUE COMPANIES
Study by Eugene L. Fama and Kenneth R. French examined the effects of market capitalization and price as a percentage of book value on investment returns in The Cross-Section of Expected Stock Returns, Working Paper 333, Graduate School of Business, University of Chicago, January 1992

Steps in study : Firstly stock price as a percentage of book value and sorted into deciles. Then, each price/book value docile was ranked according to market capitalization and sorted into deciles and secondly stock price as a percentage of book value and sorted into deciles. Then, each price/book value docile was ranked according to market capitalization and sorted into deciles. and the result was indicates, smaller market capitalization companies at the lowest prices in relation to book value provided the best returns also shows that within every market capitalization category, the best returns were produced by stocks with low prices in relation to book value and the final conclusion made is "Price to book value "is consistently the most powerful for explaining the cross-section of average stock returns.”

Five-Year Holding Period Year-By-Year Investment Returns for Low Price to Book Value Companies as Compared to High Price to Book Value Companies

Are Low Price to Book Value Stocks’ Higher Returns, as Compared to High Price to Book Value Stocks, due to Higher Risk?

Note ;
a) In an attempt to examine whether the higher returns of low price to book value stocks were due to greater risk, Professors Lakonishok, Vishny and Shleifer measured monthly investment returns in relation to price as a percentage of book value between April 30, 1968 and April 30, 1990 in the 25 worst months for the stock market, and the remaining 88 months in which the stock market declined. In addition, monthly returns were examined in the 25 best months for the stock market and the 122 remaining months in which the stock market increased. The professors conclude: "Overall, the value strategy [low price to book value] appears to do somewhat better than the glamour strategy [high price to book value] in all states and significantly better in some states. If anything, the superior performance of the value strategy is skewed toward negative return months rather than positive return months

b) The low price to book value stocks outperformed the high price to book value stocks in the market’s worst 25 months, and in the other 88 months when the market declined. In the best 25 months for the market, the low price to book value stocks also beat the high price to book value stocks

EARNINGS BOUGHT CHEAP
LOW PRICE IN RELATION TO EARNINGS
Note :
a) Companies with low price/earnings ratios are also frequently priced at low price to book value ratios relative to other companies in the same industry

b) Stocks of companies selling at low price/earnings ratios often have above average cash dividend yields. Additionally, the remaining part of earnings after the payment of cash dividends, i.e., retained earnings, are reinvested in the business for the benefit of the shareholders. Retained earnings increase the net assets, or stockholders’ equity, of a company. The increase in stockholders’ equity from retained earnings often equates to a specific increase in the true corporate value of a company, especially when the retained earnings result in a similar increase in a company’s cash or a decrease in its debt. Reinvestment of retained earnings in business assets and projects which earn high returns can increase true corporate value by amounts exceeding the actual retained earnings. A company with a low price/earnings ratio, by definition, must provide the investor with either an above average cash dividend yield, or an above
average retained earnings yield, or both. Similar to stocks selling at low prices in relation to net current asset value and book value, the shares of a company with a low price/earnings ratio are often accumulated by the officers and directors, or by the company itself. The company’s stock price has frequently declined significantly.

BENJAMIN GRAHAM’S LOW PRICE/EARNINGS RATIO STOCK SELECTION CRITERIA
a) Purchase of securities of companies in which the earnings yield (i.e., the reciprocal of the price/earnings ratio) was at least twice the AAA bond yield, and the company’s total debt (i.e., current liabilities and long-term debt) was less than its book value.
b) Graham also advised that each security which met the selection criteria be held for either two years, or until 50% price appreciation occurred, whichever came first.

SMALL MARKET CAPITALIZATION LOW PRICE/EARNINGS RATIO COMPANIES AS COMPARED TO LARGE MARKET CAPITALIZATION LOW PRICE/EARNINGS RATIO COMPANIES
A) 1963 through 1980 Annual Investment Returns for Low versus High Price/Earnings Ratio Stocks According to Market Capitalization within Each Price/Earnings Ratio Category for New York Stock Exchange Listed Companies:
Prof Sanjay Basu study’s findings :One million dollars invested in the smallest fifth of the companies listed on the New York Stock Exchange, which were priced in the bottom fifth in terms of price/earnings ratios, would have increased to $19,500,000 over the 17-year study period. By comparison, $1,000,000 invested in the largest market capitalization stocks with the lowest price/earnings ratios would have increased to $8,107,000 over the same period. During the period, the annual investment returns for the market capitalization weighted and equal weighted NYSE Indexes were 7.68% and 12.12%, respectively. One million dollars invested in the market capitalization weighted and equal weighted NYSE Indexes would have increased to $3,518,000 and $6,992,000, respectively.
and

B) Dreman Value Management & Professor Michael Berry Study Finding :Small is Better: Annual Investment Returns for Low versus High Price/Earnings Ratio Stocks within Market Capitalization Categories for the 20 1/2-Year Period ended October 31, 1989: One million dollars invested in the lowest price/earnings ratio companies within the lowest market capitalization group in 1969 would have increased to $29,756,500 on October 31, 1989. By comparison, $1,000,000 invested in the highest price/earnings ratio companies within the smallest market capitalization group would have increased to $2,279,000 over this 20 1/2 - year period. One million dollars invested in the largest market capitalization, lowest price/earnings ratio group over this period would have increased to $12,272,000

INVESTING WITH THE INNER CIRCLE
A company will often repurchase its own shares when its management believes that the shares are worth significantly more than the stock price. Share repurchases at discounts to underlying value will increase the per share value of the company for the remaining shareholders. When officers and directors are significant shareholders, the money which the company uses to buy back its own stock is, to a significant extent, the officers’ and directors’ own money. In this circumstance, the repurchase of stock by the company is similar to insider purchases.

Companies selling in the stock market at low price/earnings ratios or low prices in relation to book value frequently repurchase their own shares. Share repurchases at a pre-tax earnings yield which exceeds what the company earns on its cash or what it pays on debt incurred to fund the share repurchase will result in an increase in earnings per share. Share repurchases at less than book value increase the per share book value of the remaining shares.

Conclusion :
Most studies which have examined the relationship between investment returns and investment characteristics such as price to book value, price to earnings, price to cash flow, dividend yield, market capitalization, insider purchases, or company share repurchases have compared the relationship between only one investment characteristic and subsequent returns. Occasionally, two investment characteristics, such as price to book value and market capitalization, or price to earnings and market capitalization have been examined in relation to returns.
In more than one study, it is noted that investments screened for one of the characteristics had several of the others, which corresponded to Tweedy, Browne’s own investment experience. Companies selling at low prices in relation to net current assets, book value and/or earnings often have many of the other characteristics associated with excess return. “Current earnings are often depressed in relation to prior levels of earnings, especially for companies priced below book value. “

The price is frequently low relative to cash flow, and the dividend yield is often high. More often than not the stock price has declined significantly from prior levels. The market capitalization of the company is generally small. Corporate officers, directors and other insiders have often been accumulating the company’s stock. The company itself has frequently been repurchasing its shares in the open market. Furthermore, these companies are often priced in the stock market at substantial discounts to real world estimates of the value that shareholders would receive in a sale or liquidation of the entire company. Each characteristic seems somewhat analogous to one piece of a mosaic. When several of the pieces are arranged together, the picture can be clearly seen: an undervalued stock.
In all of the preceding studies, there was a correlation between the investment criterion or characteristic and excess return. In most of the studies, the return information presented was a single average annual percentage return figure which summarized the investment results over a very long measurement period (54 years in the case of Rolf Banz’s study of small capitalization stocks). This summary average annual return figure encompassed, and was mathematically determined by, the separate investment returns of the many smaller periods of time which comprised the entire length of time of each study. The studies, with one exception, did not present information or conclusions concerning the pattern, sequence or consistency of investment returns over the shorter subset periods of time which comprised the entire measurement period. Questions such as whether the excess returns were generated in 50% of the years, or 30% of the years, or in a seven year “run” of outperformance followed by seven “dry years” of underperformance, or whether the excess returns were produced primarily in advancing or declining stock markets, etc. were only addressed in one study, Contrarian Investment, Extrapolation and Risk, by Professors Lakonishok, Vishny and Shleifer. Their study, over the 1968 through 1990 period, indicated fairly consistent results over 1-year holding periods, and increasingly consistent results over 3-year and 5-year holding periods for low price to book value and low price to cash flow stocks, as their performance edge accumulated with the passage of time. This performance edge was attained through outperformance in the months when the stock market was declining, which was 43% of the 22-year period, and in the months when the stock market had its largest percentage advances, which was 10% of the entire period.
“it is possible to invest in publicly traded companies at prices which are significantly less than the underlying value of the companies’ assets or business. “
Two very plain examples of undervaluation are: a closed-end mutual fund whose share price is significantly less than the underlying market value of its investment portfolio, or a company whose shares are priced at a large discount to the company’s cash after the deduction of all liabilities. These types of easy-to-understand bargains do appear in the stock market recurrently. However, it cannot be said with certainty that a clear-cut bargain investment will produce excess investment returns, and it is impossible to predict the pattern, sequence or consistency of investment returns for a particular bargain investment. It can only be stated with certainty that repeated investment in numerous groups of bargain securities over very long multi-year periods has produced excess returns.
“There can’t be an investment formula that always produces an exceptional return over every period of time. “ Investment returns, and likely favourable or unfavourable perceptions of progress on the part of many investors, have tended to vary greatly over periods of time that are quite long by human standards, but probably too short in terms of statistical measurement validity. However, as this paper has indicated, there have been recurring and often interrelated patterns of investment success over very long periods of time, and we believe that helpful perspective and, occasionally, patience and perseverance, are provided by an awareness of these patterns.
The investments which will generate exceptional rates of return in the future, over long measurement periods, will possess one or several of the characteristics mentioned above
Important References in the article:

Objective : Strategies exploit the mistakes of the typical investor : Dr. Josef Lakonishok (University of Illinois), Dr. Robert W. Vishny (University of Chicago) and Dr. Andrei Shleifer (Harvard University) presented a paper funded by the National Bureau of Economic Research entitled, Contrarian Investment, Extrapolation and Risk, May 1993
Objective :examined the investment results of stocks selling at or below 66% of net current asset value during the 13-year period from December 31, 1970 through December 31, 1983.: “Ben Graham’s Net Current Asset Values: A Performance Update,” Henry Oppenheimer, an Associate Professor of Finance at the State University of New York at Binghamton,

Objective: Author studied the relationship between stock price as a percentage of book value and investment returns: Decile Portfolios of the New York Stock Exchange, 1967 - 1984, Working Paper, Yale School of Management, 1986

Objective : Author studied effect of price as a percentage of book value on investment returns : Contrarian Investment, Extrapolation and Risk, Working Paper No. 4360, National Bureau of Economic Research, May 1993 by Josef Lakonishok, Robert W. Vishny and Andrei Shleifer

Objective : Author studied and examined the investment performance of the low price/earnings ratio stock selection criteria developed by Benjamin Graham : Henry Oppenheimer, in “A Test of Ben Graham’s Stock Selection Criteria,” Financial Analysts Journal, September-October, 1984

Objective : Author studied and examined the effects of market capitalization and price/earnings ratios on investment returns by:Sanjoy Basu “The Relationship Between Earnings Yield, Market Value and Return for NYSE Common Stocks,” Journal of Financial Economics, December 1983

Objective : Author studied and examined effects of inside buyers: a) Donald T. Rogoff, "The Forecasting Properties of Insider Transactions," Diss., Michigan State University, 1964;b) Gary S. Glass, “Extensive Insider Accumulation as an Indicator of Near Term Stock Price Performance,” Diss., Ohio State University, 1966;c) Charles W. Devere, Jr., “Relationship Between Insider Trading and Future Performance of NYSE Common Stocks 1960 - 1965,” Diss., Portland State College, 1968;d) Jeffrey F. Jaffe, “Special Information and Insider Trading,” Journal of Business, July 1974; and e) Martin E. Zweig, “Canny Insiders: Their Transactions Give a Clue to Market Performance,” Barrons, July 21, 1976.
Marc Reinganum, in “Portfolio Strategies Based on Market Capitalization,” The Journal of Portfolio Management, Winter 1983: “Stock Return Seasonalities and the Tax-Loss Selling Hypothesis” by Philip Brown, University of Western Australia, Donald B. Klein, University of Pennsylvania, Allan W. Kleidon, Stanford University and Terry A. Marsh, Massachusetts Institute of Technology, Journal of Financial Economics, 1983, the relationship between market capitalization and investment returns is examined for Australian stocks

Donald Keim, Professor of Finance at the Wharton School, University of Pennsylvania, examined the interrelationship among price/book value, market capitalization, price/earnings ratio and average stock price for all New York Stock Exchange listed companies from 1964 through 1982 in Stock Market Anomalies, edited by Elroy Dimson, Cambridge University Press, 1988