Forrest Berwind Bill and discounted stocks

James Boric - Thu 18 Nov, 2004

...Forrest Berwind Bill and discounted stocks...By investing in undervalued stocks (those trading for 30% of book value or less), you can expect to make about nine times more money than simply investing in the S&P 500...

It all started with Forrest Berwind ‘Bill’ Tweedy in 1920...

Bill was a strange fellow. No one really knows where he came from or when he was born. And if you saw him today, you would probably laugh.

The man wore braces, had a bushy moustache and a good-sized potbelly. He never married or had kids. He ate lunch at the same place at the same time every day. He was an oddball, to put it bluntly. And if you happened to walk past 52 Wall Street, New York, chances are, you would see Tweedy working at his cluttered desk - busy writing letters and looking through company reports.

Tweedy’s business was his life. And it was a successful one at that.

He owned a small niche stock brokerage that specialised in trading tiny illiquid securities. Day after day, Tweedy scoured the market for publicly traded US companies that had between 50 and 150 shareholders on the record. He attended their annual meetings, wrote down all the shareholders’ names and sent them personalised letters. His goal was to find out who wanted to sell their shares and who wanted to buy more. From there, Tweedy paired the buyers with the sellers and brokered the deals himself.

It was a brilliant idea.

Forrest Berwind Bill and discounted stocks: The broker of last resort

Bill Tweedy quickly became one of the only small- or micro-cap brokers in New York - the “broker of last resort”, as he was called by the many shareholders who couldn’t trade their shares anywhere else. And although I don’t know how many small-cap US stocks there were in 1920 relative to the number of major blue chip stocks, you can bet there were thousands more - just like there are today. That left Tweedy with a real monopoly in the market for brokering small-cap trades.

Tweedy’s business was successful throughout the 1920s and into the 1930s. Then he got his big break...

In the early 1930s, Tweedy developed a client relationship with Benjamin Graham - the father of value investing. At the time, Graham was a professor at Colombia University and had recently finished writing his now-famous books ‘Security Analysis’ and ‘The Intelligent Investor’. If you aren’t familiar with Graham, I strongly suggest you read both of these books. They are two of the best primers you’ll ever find on investing. But in case you don’t have time to read the books right now, I’ll give you an abbreviated version of his main points...

Graham - who, among other things, is famous for teaching Warren Buffett the ropes of value investing - proved you could make a fortune investing in companies that were selling for a huge discount to their intrinsic value. In other words, if a company was trading far below what its assets were worth - minus all liabilities, things like debt and accounts payable - Graham was confident that, over time, the company’s true worth would be discovered...and anyone who invested while it was cheap would walk away much richer.

Think of it like this...if you went to a flea market and saw a rare three-legged 1937D Buffalo nickel selling for $900, you would buy it. I mean, if you knew what you were looking at, you’d know that the real value of the nickel was somewhere between $3,000 and $4,000. In other words, if you sold it later and ONLY got the nickel’s fair value, you would still make about 233% to 344% on your investment.

Not a bad deal, right?

Well, that’s exactly the philosophy that Graham used to buy shares of a company. He studied companies until he knew what he was looking at...and then looked for bargains - companies selling for 60% to 70% LESS than they were worth. And it just so happened that many of the small, illiquid companies Tweedy tracked fit Graham’s “value” model simply because they received no coverage on Wall Street and were undervalued.

Thanks to their shared investment strategy, Tweedy quickly became Graham’s “go-to” broker. And Graham became Tweedy’s largest customer - so big that he moved his office right next to Graham’s office on 52 Wall Street so they could work together more efficiently.

Over the years, Tweedy’s business grew. Howard Browne (who started his career as a runner on Wall Street at the ripe old age of 16) became Tweedy’s partner in 1945. And the company slowly grew from a simple brokerage house (with about $88,000 in capital) to a full-fledged investment advisory business...that currently manages over $10 billion in assets.

Although Tweedy, Browne is a large money manager today (not the same small niche broker it was in 1920), one thing has NOT changed in its 84-year history. The company still looks to buy stocks that are trading for huge discounts to their real worth.

Here’s how it’s done...

Forrest Berwind Bill and discounted stocks: Cheap companies

One of the surest ways to spot an undervalued stock is to look at its price relative to the value of its assets. If a company is priced LESS than its assets are worth, you want to own the stock. It is undervalued. And you want to stay away from the companies that are selling for a huge premium to their asset value.

So how can you tell if a company is cheap relative to its assets?

The easiest way is to scan the market for companies that have a low price-to-book value. A company’s book value is its net asset value minus its intangible assets, current liabilities, long-term debt and equity issues. Divide the market-cap by the book value and you get the price-to-book ratio.

If a company has a P/B value under 1, it is said to be undervalued. And if a company has a P/B value above 1, it is selling for a premium.

You want to own stocks that are undervalued and have room to grow. Historically, these are stocks that provide investors with the highest returns. For instance...

Tweedy, Browne looked at all the stocks trading on the major indexes from 1970 through 1981 that had a market cap of at least $1 million and traded for no more than 140% of book value. They ranked the 7,000 companies into nine groups - ranging from those that were overvalued (trading between 120% and 140% of book value) to those that were undervalued (trading between 0% and 30% of book value). What they found was incredible.

The lower the P/B ratio was, the higher the returns you could expect - without fail.

Stocks that traded between 120% and 140% of book value rose an average of 15.7% in a single year. The stocks that only traded for 80% to 100% of book value rose 18.5%. And the truly undervalued stocks, those trading between 30% and 0% of book value, rose an average of 30% a year.

That’s pretty impressive when you consider the S&P 500 only returns you about 8.5% a year. And in dollar terms the numbers are equally impressive.

If you had invested $1,000 in all the companies trading for 30% of book value or less in 1970 (and rolled that money over each year into the next group of stocks that were trading for 30% of book value or less) it would have been worth $23,298 by 1982. That same $1,000 invested in the S&P 500 would have grown to $2,662. In other words...

By investing in undervalued stocks (those trading for 30% of book value or less), you can expect to make about nine times more money than simply investing in the S&P 500.

Who said investing was hard?


Best regards,

James Boric
for The Daily Reckoning

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