Bill Nygren of Oakmark Releases His Second Quarter Letter to Investors
The Oakmark Fund decreased slightly more than 3% last quarter, a fraction of a percent more than the S&P 500 lost. The loss reduced our return for the calendar year to 10%, slightly above the 9% gain for the S&P 500. The best performing sector of the S&P last quarter was utilities, including electric, gas and telecom. Despite the down market, income-hungry investors pushed those stocks up an average of 10%. As discussed in the Commentary on the Oakmark and Oakmark Select Funds, we think utilities are unattractively priced and therefore have no investments in them.
Our strongest holdings for the quarter, each up more than 10%, were eBay, Wal-Mart and Disney. All three reported very good earnings and positive outlooks for the year. On the downside, four stocks lost more than 20% -- Cisco (which we sold), Dell, Goldman Sachs and JP Morgan. Dell investors seem to be focused more on its deteriorating PC business than on the growth of its more valuable non-PC businesses. Financial stocks were weak in general, but JP Morgan captured the brunt of investors’ selling, due to the company’s announcement of an unusual trading loss. We believe investors grossly overreacted to this news. Trading is a “win some, lose some” business and, despite this significant loss, JP Morgan still wins much more often than it loses.
During the quarter, we eliminated our positions in Allstate, Cisco, Encana, H&R Block and Tyco. Tyco was a strong performer over the past year and was approaching our sell target, whereas many attractive stocks were well beneath our buy targets. The other sales were all due to varying degrees of fundamental disappointment. We initiated three new positions, which are described below.
American International Group (AIG-$32)
AIG is a large insurance company operating in both property and casualty (Chartis) and life (SunAmerica). It is a poster child of the financial crisis, having required over $180 billion in government aid, and the government still owns over half of its outstanding shares. While the rescue measures still dampen its current valuation, we believe AIG has made remarkable progress under the leadership of CEO Robert Benmosche. The government loans have been completely repaid, and the stock currently trades above the government’s breakeven point of $29. Two years ago, we found it almost impossible to estimate the value of AIG’s equity. The analysis involved guessing at proceeds from sales of businesses and valuing large, opaque, levered loan portfolios. Today the analysis is the same as it would be for any insurer: What is its future earnings outlook? How good are its reserves? How will its capital be invested? Chartis went through a difficult period of writing unprofitable business just to grow revenues. That has stopped, and we believe that for the past several years Chartis has focused on only writing profitable business even if growth suffers. Reserves have been boosted to a level that we think is consistent with other high-quality insurers. Capital is being invested primarily in share repurchase -- with AIG selling at just over half of book, this is nicely accretive to the company’s per-share book value. We believe that AIG should earn over $3 per share this year and is on track to earn in excess of $5 per share within a few years. We believe that AIG is priced as if its future looks like its past. We expect the current discount to other insurers will diminish as the memory of the financial crisis fades.
AON PLC (AON-$47)
As one of only three insurance brokers with a global platform, AON’s market position should allow the company to directly benefit from global economic growth. AON stock surpassed $50 in 2007 when it earned just over $2 per share. In 2012, after a restructuring that improved margins, AON is expected to earn over $4 per share after adding back goodwill amortization from recent acquisitions. Despite the growth in earnings and the potential for further margin improvement, the stock has been stagnant. As a result, the P/E ratio for AON has fallen from 25 times in 2007 to 11 times now, slightly less than the P/E ratio for the S&P 500. Unlike the insurance business, insurance brokerage is not capital intensive. Therefore, we believe AON has the ability to return most of its earnings to shareholders through share repurchases and dividends. An additional feature we value is AON’s potential to generate meaningful interest income. AON, as a fiduciary, holds its clients’ capital for a short period of time before it is turned over to the insurance companies. With today’s low short-term interest rates, there is little opportunity to generate returns on that capital. We don’t believe short-term rates will stay low forever and like getting the option for more rapid earnings growth when rates increase.
Devon Energy (DVN-$58)
Devon is a North American oil and natural gas exploration and production company. The stock has been a poor performer, down from a high of $94 last year and an all-time high of $127 in 2008. With nearly 60% of its reserves in natural gas, Devon is widely perceived to be a gas company, and its stock price has traded down with natural gas prices. However, 80% of Devon’s revenues and over 80% of our business value estimate stem from the company’s oil and liquids business. Based on our estimates, the stock is now trading at just over half of its 2013 asset value. And we are not assuming any oil price recovery in our numbers. An additional reason we are attracted to Devon is the way management allocates capital. It seems that most oil and gas managements have a “bigger is better” mentality. Devon instead focuses on per-share value. In the past two years, Devon has used excess cash to reduce its share base by 10%. Selling at less than 10x expected earnings, at half of estimated asset value, and with a history of repurchasing its shares, we are pleased to add Devon to our portfolio.