Tweedy, Browne: 10 Ways to Beat an Index (Part 2)

This article is a continuation of the 10 ways to beat an index by Tweedy, Browne. If you have no idea what Tweedy, Browne is and what they do, we strongly advise you to refer to the previous article for a complete story.

Before we proceed with the remaining 5 ways, we would like to provide you with a short summary of what we have shared with you in the previous article:

1. Invest in companies with characteristics that have produced market-beating returns in the past
2. Invest in both big- and small-cap stocks
3. Statistics and Specifics – Each company has different characteristics
4. No index mimicking – focus on the right metrics
5. Stay as fully invested as possible

10 ways to beat an index (Part 2)

The first 5 points focused on practical tips to beat the market and mistakes to avoid while the last 5 points would have a greater emphasis on the right attitude value investors should adopt.

The following two factors are silent killers of your portfolio. By ignoring them, they will quietly devour any hard-earned active returns you have made.

Keep turnover low

Turnover refers to how often stocks within your portfolio is being bought or sold. A high turnover would increase commission costs as a percentage of the portfolio’s value and the impact of buying or selling can have on share prices. Having a lower turnover not only reduces commission costs but may also result in a greater deferral of taxable gains if you invest in the markets like in the U.S.

Keep net transaction costs low

Many investment mutual funds charge a huge range of costs such as management fee, front-end load fee, back-end load fee, account fee and shareholder service fee. While many investors are fixated on the gross return, what truly add value to your wealth is the net of fees return.

Assuming you have invested $100 in year 0. At 10% returns per annum, the $100 is worth $259, 10 years later. With a management fee of 3%, your remaining 7% returns would only yield $196 at the end of 10 years. Between the 2 scenarios, it is a difference of 32%!

The last three points shape the attitude and mindset you ought to have to be a successful value investor. By treating your investments right, you are less prone to psychological mistakes the majority tend to commit.

The above 7 points have been straightforward and can be replicated easily. However, it takes years of conscious effort and discipline to cultivate the optimal mindset to invest.

Act like an Owner

Tweedy, Browne has been taking an active interest in the development of the firms under their portfolio. They have encouraged share buybacks, spin-offs, restructuring and liquidation whenever it is value-enhancing.

Value traps are seemingly cheap companies with values that may never unlock. Several such value traps are due to incompetent management. In this case, the value can be unlocked by either changing the management or to influence the management. That is precisely what Tweedy, Browne has done to unlock the value of their investments.

You may say,

“But, which management is going to listen to me? I don’t even trust my own expertise, what makes you think they will.”

While it is true that having access to the top management can be an advantage, it can also be a drawback. Management has the interest to present themselves as impeccable and attribute any poor performance to bad luck. Often, investors not only are able to gain anything constructive from the meet-up, they may also be subjected to upward bias.

However, with careful observation, individual retail investors can monitor the activities of companies and evaluate whether such actions are indeed value-enhancing for shareholders. While everyone is busy looking out for superficial signs, you will be evaluating whether the management’s interests are for the shareholders. This can only be done if you act like an owner and think like an owner.

Focus, focus, focus

Tweedy, Browne only manages equities, not bonds not options or anything else. The three managing directors have most of their net worth invested with the clients’ money, giving room to no conflict of interests at all.

Such an environment forces the top management to treat clients’ assets as their own and has the sole purpose to grow it sustainably. Given the huge amount of personal capital at stake, the managing directors must find a grounded philosophy and focus on picking the right stocks. With the sole focus on only equities, they can channel all their research and skills into making the best decision for only one form of securities.

Yes, the situation and environment matters. If you are a hedge fund manager with nothing at stake, you will most likely be tempted to (over-) leverage to generate the highest returns possible in the shortest period.

Continuous improvement

While transaction costs and taxes are silent killers of your returns, complacency will decimate your wealth. Thinking that you have already know everything you need to and that you are ready for anything will lead you to discover that you aren’t, and by the time it happens, it may already be too late.

Tweedy, Browne’s ability to maintain its leadership in the difficult fund management industry is contingent on its desire to keep learning more. Recently, their shift towards analyzing empirical data has increased their knowledge about investment characteristics and patterns associated with above-market returns.

Do not be mistaken, this is a stark contrast to what the academics do. While we have no access to their proprietary research, we are sure that several conventional definitions of terms such as risk are aligned to value investing instead.

Golden rule: Look at the long run odds and stick with it

It has been proven again and again that in order to beat the market in the long run, you must develop a long-term focus. While it is exhilarating to be betting on news and momentum of the market, it is not the smartest way to grow your wealth.

So why are there not many value investors out there even though it obviously works? That’s because most can’t withstand paper losses for months to years before realizing the reward. People desire instant gratification.

The other reason would be that it is potentially boring. While the stock market keeps beating previous high again and again but your value remains locked, there is a tendency to join to crowd and forsake all that you have counted on. It may be dull and too simple for the stock market but it works.

Know what you are going after and pick a side.