A report which describes Professor Levi's dividend yield study,
Market Anomalies: Are They A Mirage Or A Bona Fide Way To
Enhance Portfolio Returns? by Michael Lenhoff, January 19, 1990,
notes that: "there is a near perfect inverse correlation between the
ratio of price to net asset value [i.e., book value] for the U.K. equity
market and yield. When price stands significantly at a discount
[premium] to the net asset value, the yield available from U.K. plc is
significantly above [below] the long run range." Mr. Lenhoff also
notes that the price/earnings ratio of high dividend yield companies
are usually low in relation to the price/earnings ratio of the entire
stock market and that the high yield companies are often takeover candidates.
...
In Tweedy, Browne's experience, high dividend yield on stocks in the
U.K. and throughout the world is often associated with stocks selling
at low prices in relation to earnings, book value and specific
appraisals of the value that shareholders would receive in a sale of the
entire company based upon valuations of similar businesses in corporate transactions.
...
In Tweedy, Browne's experience, stocks selling at low prices in
relation to cash flow are also often priced low in relation to book
value and earnings, and often have high dividend yields. Business
people in certain fields such as the newspaper, cable television,
broadcasting, and book and magazine publishing fields, frequently
describe valuations of debt-free businesses in these fields in terms of
multiples of pre-tax operating cash flow (pretax income from the
business itself before the deduction of depreciation). Stocks selling at
low prices in relation to cash flow, especially in comparison to other
companies in the same industry, are frequently undervalued relative
to the price which shareholders would receive if the entire company were sold.
...
For companies domiciled outside the United States, Tweedy, Browne
has frequently observed depreciation policies that result in larger
depreciation expenses, and lower earnings, than would be the case if
the same company prepared its financial statements in accordance
with U.S. generally accepted accounting principles. The Swiss
company, Nestle, for example, reports as an asset on its balance sheet
the estimated current cost to replace its property, plant and
equipment. This is a significantly larger figure than the historical cost
figure which would be required under U.S. generally accepted
accounting principles ("GAAP"), and results in higher depreciation charges versus U.S. GAAP.
...
Cash flow analysis and comparison to companies in the same industry
will frequently suggest "hidden value" in the form of understated
earnings and/or assets which have been written off to amounts which
are significantly less than true realizable values.
...
In Tweedy, Browne's experience, officers, directors and large
shareholders often buy their own company's stock when it is
depressed in relation to the current value which would he ascribable
to the company's assets or its ongoing business in a corporate
acquisition, or to the likely value of the company in the near to
intermediate future. Insiders often have "insight information":
knowledge about new marketing programs, product price increases,
cost cuts, increased order rates, changes in industry conditions, etc.
which they believe will result in an increase in the true underlying
value of the company. Other examples of insider insights are:
knowledge of the true value of "hidden assets", such as the value of a
money-losing subsidiary which a competitor may have offered to buy, or
the value of excess real estate not required in a company's operation,
or knowledge of the likely earning power of the company once heavy
non-recurring new product development costs stop. It is not uncommon to
see significant insider buying in companies selling in the stock market
at low price/earnings ratios or at low prices in relation to book value.
...
It has been Tweedy, Browne's experience that 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.
...
In more than one study we 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 the same way that Ben Graham did before us, we have established
"underwriting" criteria for stocks we are willing to buy. For example, we like
to buy stocks selling at two-thirds of net current assets, or stocks selling at
one-half of book value when equity is greater than all liabilities, or stocks
with fairly reliable earnings that are selling at an earnings yield 50% or
greater than the long-term bond yield. And like the insurance company that wants
to issue as many policies as it can that meet its criteria to achieve the
desired statistical result that such underwriting standards should produce, we
want to own a diversified portfolio of stocks meeting our criteria. A portfolio
that in total meets these criteria will be priced in total at a substantial
discount to intrinsic value.
Another method we employ to determine intrinsic value is the appraisal
method. This method is company specific; i.e., it is done company by company. It
is analogous to putting your house on the market. You call a real estate broker
and ask for an appraisal of your house based on recent comparable sales. A board
of directors does the same thing when it puts the company up for sale.
Basically, investment bankers are fancy real estate brokers dealing in high
priced merchandise. They track sales of similar businesses, or do discounted
cash flow analyses to come up with the value of a business. In this way,
intrinsic valuation models can be determined for different kinds of businesses.
For example, the average television station currently sells for 10 times cash
flow less any debt and plus any cash. Banks are currently being acquired for
approximately 15 times earnings. Branded consumer products companies are
currently being acquired on average for 10 times pre-tax earnings, again
adjusted for debt and cash. If we construct a portfolio of companies selling at
a 40% to 50% discount from what they would be worth in a sale of the entire
business, we end up making money. Value investors are successful primarily
because they set up their models before setting out to buy their stocks.
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Value investors also have the advantage of knowing what they CANNOT do.
We recognize the futility of trying to predict stock market movements, and the
absurdity of technical analysis with its shoulders and heads, etc. To us, this
is no more than garbage in, garbage out. We are sure that if someone gathered
the information, some correlation could probably be drawn between the weather
and the stock markets, such as 52% of the time the stock market declines
following five straight days of rain in the Mississippi Delta. The real beauty
of value investing, beyond its financial rewards, is that it is possible to be
successful without being a rocket scientist. If you have figured out what has
worked, and then do that, it can be relatively easy to succeed.
Last year we sent our shareholders a collection of academic studies that we
compiled on fundamental financial criteria that produced superior investment
returns. A total of 44 studies were included in our booklet, which is entitled
WHAT HAS WORKED IN INVESTING*. The studies are split fairly evenly between U.S.
stocks and foreign stocks and were not selected because they reached a
conclusion supporting value investing. These were all the studies we found.
However, the results are very similar. Low price to book value, low
price/earnings ratios, low price to cash flow, stocks that had declined
significantly, stocks with significant insider purchases, etc., all criteria
that on the surface seem logical, did in fact provide superior investment
returns.
One of our favorite studies, CONTRARIAN INVESTMENT, EXTRAPOLATION AND RISK,
by Professors Lakonishok, Vishny and Shliefer does not reach any investment
conclusions that surprise us after more than 25 years of value investing. What
is different and highly important about this study is that it addresses the
following question: If the empirical evidence, since Ben Graham's work in the
1930s through decades of numerous other studies, many of which we have included
in our booklet, demonstrates the superior performance of value investing, why
don't more people do it? The reason seems to be that it runs against human
nature to be a contrarian, which is key to value investing. We often buy out of
favor stocks, stocks that the investment community is avoiding because of past
poor performance. It is similar to drawing up a list of potential spouses and
saying you only want to see the ones that all your peers have rejected. In the
world of institutional money management, if you go against the consensus and
perform badly, you're dead. If you go with the consensus, you have a much better
chance of surviving even if you perform poorly because most others will have
performed poorly, too. Being a contrarian may simply be too great a risk despite
empirical evidence supporting this approach. We believe most investors who are
not contrarians have not taken the time to figure out how the game is played,
learn what has worked and build models for successful investing, so they lack
any convictions from which to draw the strength to go against the crowd. As John
Train wrote in his chapter on Ben Graham in THE MONEY MASTERS: "MANY PEOPLE,
INCLUDING EXPERIENCED BUSINESSMEN AND PROFESSIONALS, HAVE BEEN FINANCIALLY
SHIPWRECKED BECAUSE THEY TRUSTINGLY SET FORTH IN A LEAKY CRAFT CAPTAINED BY AN
INCOMPETENT. SOMEONE WHO SPENT THE FEW HOURS NECESSARY TO UNDERSTAND THE
INTELLIGENT INVESTOR WOULD BE UNLIKELY TO SUFFER THIS FATE. YET ALAS, FEW
STOCKHOLDERS, LET ALONE INVESTORS, HAVE DONE IT."
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--Browne's