20 May 2009 Tweedy Browne annual letter ( Portfolio )
...unprecedented flight to a “safe harbor” on the part of investors, with government bonds or money market funds being the preferred parking spot whether you were American, French, German or Singaporean. (Money market funds currently hold approximately $3.8 trillion dollars – a trillion dollar increase from 2007.) Investors quickly discovered the problem was not just a US problem as large quantities of these “toxic” debt securities were found on the balance sheets of financial institutions all over the world, particularly in Western Europe. In a matter of months, financial markets and economies experienced what Warren Buffett has termed “cardiac arrest,”...

There is no doubt that many economies face enormous challenges. There is not going to be a simple or quick fix to solving the economic problems, nor are economists likely going to be able to pinpoint which decisions started the economy on a recovery path once it begins. Today, the old adage in the media that “airplanes landing don’t make news; airplanes crashing make news” has never been truer. We are overwhelmed by negative news, which no doubt affects people’s behavior and makes a bad situation worse. Comparisons are routinely drawn between the 1930s on the one hand and Japan’s “lost decade” on the other. There is no dearth of “informed” opinion on these matters, only a dearth of consensus of opinion. Some observers even debate the future of capitalism. Without in any way suggesting we are trivializing the problems, we don’t subscribe to a 1930s or Japanese comparison.
The current environment is neither one. Nor do we subscribe to the end of capitalism. To paraphrase Winston Churchill, capitalism is the worst economic system except for all the others that have been tried. While no doubt there will be regulatory steps aimed at dampening some of the current excesses, there will be plenty of room to tempt the “animal spirits.” When all of the uncertainty associated with these problems is combined with unprecedented volatility in markets around the globe, the psychological stress can reach a breaking point. Without a framework to ground you in objectivity, the stock market will inform your investment decisions, which carries the risk that the volatility of your thinking will reflect that of the market. As Jeremy Grantham recently observed, this could also lead an investor to become paralyzed and unwilling to make any decisions...

Recent examples of companies whose stocks we have been accumulating in our Funds’ portfolios and which illustrate our thinking are Norfolk Southern Corporation (United States), Krones AG (Germany), Henry Schein Inc. (United States) and Guoco Group Ltd. (Hong Kong).

A stock that we own in the Tweedy, Browne Value Fund and have recently been buying for our Worldwide High Dividend Yield Value Fund is Norfolk Southern Corporation (“NSC”), which is one of the seven remaining Class I US freight railroads. (We have also made investments of late in both Burlington Northern Santa Fe Corporation and Union Pacific.) Norfolk Southern transports raw materials, intermediate products, and finished goods across a rail network covering primarily the Eastern and Southeastern part of the United States. It stands out not only because it is one of the statistically cheapest of the railroad stocks, but it also has a very attractive dividend yield.

Our interest in the rails is driven primarily by the pricing power they now have as a result of a significant reduction in rail capacity over the last 20 years. Since the rails were deregulated in 1980 they have consolidated, shed employees, and taken significant track out of the rail system which, when combined with slow but steady increments in traffic volume, has resulted in a tripling of track utilization. The pricing power of the railroads really emerged when volume growth resumed coming out of the 2001 recession. By then, the dust had settled on rail consolidation and integration issues had stabilized. The industry was left with only six Class 1 railroads (down from about 23 in 1980 and 76 in 1965) and it became apparent that the industry was capacity constrained. Today, the primary focus of the railroads is on improving returns on invested capital. They have shown that they are completely unwilling to sacrifice price for volume or invest in their networks unless they can earn economic returns on their investment. In addition to tight capacity, NSC’s ability to raise prices is aided by high levels of shipper captivity. Between 50% and 70% of NSC’s shippers have no alternative means of shipping their freight. Lastly, we like the fact that there are high barriers to entry and virtually no risk of technological obsolescence. These factors, when taken together, have allowed the rail industry to raise prices and thus increase returns on capital.

We think the railroads will be able to raise prices in the 5% to 6% price range for the next several years. With rail cost inflation averaging about 3%, we believe Norfolk Southern will experience increasing margins, returns on invested capital, and free cash flow. As volumes pick up, and the railroads continue to take market share from trucks, we think that Norfolk Southern should be able to grow operating income in the low double digits for the next several years. For these reasons, we think Norfolk Southern is intrinsically worth at least 10x EBIT, and feel comfortable buying it in the stock market at 6x to 7x EBIT...