Tweedy Browne, the deep value investment firm established in 1920, has updated its booklet, What Has Worked In Investing (.pdf). First published in 1992 and now updated for 2009, the booklet discusses over fifty academic studies of investment criteria that have produced high rates of investment return. Our interest in the booklet stems from its examination of a group of investment styles falling under the rubric, “Assets bought cheap,” in particular, Benjamin Graham’s “Net current asset value” method and the “Low price to book value” method.
Graham’s “Net current asset value” method
Says Tweedy Browne of Graham’s “Net current asset value” method:
The net current asset value approach is the oldest approach to investment in groups of securities with common selection characteristics of which we are aware. Benjamin Graham developed and tested this criterion between 1930 and 1932. 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. Graham used the net current asset investment selection technique extensively in the operations of his investment management business, Graham-Newman Corporation, through 1956. Graham reported that the average return, over a 30-year period, on diversified portfolios of net current asset stocks was about 20% per year
The booklet discusses a study conducted by Henry Oppenheimer, an Associate Professor of Finance at the State University of New York at Binghamton, in which he examined the returns of such stocks over a 13-year period from December 31, 1970 through December 31, 1983. Oppenheimer’s study assumed that all stocks meeting the investment criterion were purchased on December 31 of each year, held for one year, and replaced on December 31 of the subsequent year by stocks meeting the same criterion on that date. The total sample size was 645 net current asset selections. The smallest annual sample was 18 companies and the largest was 89 companies.
Oppenheimer’s conclusion about the returns from such stocks was nothing short of extraordinary:
The mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983. By comparison, $1,000,000 invested in the NYSE-AMEX Index would have increased to $3,729,600 on December 31, 1983. The net current asset portfolio’s exceptional performance over the entire 13 years was not consistent over smaller subsets of time within the 13-year period. For the three-year period, December 31, 1970 through December 31, 1973, which represents 23% of the 13-year study period, the mean annual return from the net current asset portfolio was .6% per year as compared to 4.6% per year for the NYSE-AMEX Index.
Perhaps most intriguing, though, was Oppenheimer’s conclusion about the relative outperformance of the loss-making stocks over the profitable ones:
The study also examined the investment results from the net current asset companies which operated at a loss (about one-third of the entire sample of companies) as compared to the investment results of the net current asset companies which operated profitably. The companies operating at a loss had slightly higher investment returns than the companies with positive earnings: 31.3% per year for the unprofitable companies versus 28.9% per year for the profitable companies.
We believe that Oppenheimer’s study presents a compelling argument for such an investment approach.
Low price in relation to book value
The second investment method falling under the rubric of “Assets bought cheap” is the “Low price in relation to book value” method. The booklet discusses a study conducted by Roger Ibbotson, Professor in the Practice of Finance at Yale School of Management and President of Ibbotson Associates, Inc., a consulting firm specializing in economics, investments and finance. In “Decile Portfolios of the New York Stock Exchange, 1967 – 1984,” Working Paper, Yale School of Management, 1986, Ibbotson studied the relationship between stock price as a proportion of book value and investment returns. To test this relationship, all stocks listed on the NYSE were ranked on December 31 of each year, according to stock price as a percentage of book value, and sorted into deciles. Ibbotson then measured the compound average annual returns for each decile for the 18-year period, December 31, 1966 through December 31, 1984.
Ibbotson found that 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 proportion of book value. Tweedy Browne set out Ibbotson’s results in the following Table 1:
A second study conducted by Werner F.M. DeBondt and Richard H. Thaler, Finance Professors at University of Wisconsin and Cornell University, respectively, examined stock price in relation to book value in “Further Evidence on Investor Overreaction and Stock Market Seasonality,” The Journal of Finance, July 1987. DeBondt and Thaler ranked all companies listed on the NYSE and AMEX, except companies that were part of the S&P 40 Financial Index, according to stock price in relation to book value and then sorted them into quintiles on December 31 in each of 1969, 1971, 1973, 1975, 1977 and 1979. DeBondt and Thaler then calculated the investment return against the equal weighted NYSE Index over the subsequent four years for all of the stocks in each selection period. The four-year returns against the market index were then averaged.
The stocks in the lowest quintile had an average market price to book value ratio of 0.36 and an average earnings yield (the inverse of the P/E ratio) of 0.10 (indicating a P/E of 10). DeBondt and Thaler found a cumulative average return in excess of the market index over the four years of 40.7%. Meanwhile, the stocks in the highest quintile, those with an average market price to book value ratio of 3.42 and an average earnings yield of 0.147 (a P/E of 6.8), returned 1.3% less than the market index over the four years after portfolio formation.
Perhaps the most striking finding by DeBondt and Thaler, and one that accords with our view about the difficulty of predicting earnings with any degree of accuracy, was the contrast between the earnings pattern of the companies in the lowest quintile (average price/book value of 0.36) and the highest quintile (average price/book value of 3.42). Tweedy Browne set out DeBondt and Thaler’s findings in Table 3 below, which describes the average earnings per share for companies in the lowest and highest quintile of price/book value in the three years prior to selection and the four years subsequent to selection:
In the four years after the date of selection, the earnings of the companies in the lowest price/book value quintile increase 24.4%, more than the companies in the highest price/book value quintile, whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to the phenomenon of “mean reversion,” which Tweedy Browne describes as the observation 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.”
The booklet continues to discuss Tweedy Browne’s own findings confirming those of the studies described above, and a range of other studies that confirm the findings over different periods of time and in different countries. The findings form a compelling argument for an investment philosophy rooted in deep value and focused on assets, such as Greenbackd’s.