Nygren’s recent commentary (Aug. 8, 2012): A shareholder recently inquired about our funds’ higher volatility this year and was wondering why they were now riskier than they were in the past. The short answer is, “We don’t believe they are riskier,” but I think the explanation is worth thinking about.
Using Oakmark Fund as an example, we looked at how it performed on high volatility days over the 20-year period from its inception in 1991 until the end of 2011. On days when the S&P 500 was either up or down more than 1%, the Oakmark Fund was less volatile than the market 75% of the time. That wasn’t a big surprise. For one thing, the Fund has averaged about 5% in cash, which somewhat lessened the portfolio’s change relative to the stock market change. Further, since we generally owned out-of-favor companies, our equity holdings were not usually the first on traders’ minds when the market was moving.
However, things were quite different in the first half of 2012. On days when the S&P 500 moved more than 1%, the Oakmark Fund was less volatile only 17% of the time. Clearly the shareholder’s observation was correct; the Fund has been more volatile than usual this year.
I think two things explain our higher volatility:
- Frustrated by low yields on bonds, investors searching for income have begun to pay nearly unprecedented prices for stocks that distribute most of their earnings as dividends. Effectively, those stocks – exemplified by electric and telecom utilities – are trading almost as much like bonds as like stocks. In the second quarter, for example, when the S&P 500 was down and bonds were up, telecom and electric utilities together gained about 10% in value. Since Oakmark Fund didn’t own any utilities in the first half of 2012, we had no exposure to a sector that was moving in the opposite direction from most stocks. Exposure to utilities reduced the S&P 500 volatility, but since Oakmark Fund owned none, we didn’t have a similar reduction in our volatility.
- Investors today are less willing to accept cyclical risk than usual. Not surprisingly, it is the companies with cyclical exposure that seem to have the most day-to-day volatility, swinging up or down based on the words of various European politicians. The financials, technology and industrial stocks react more sharply than do the utilities, health care and consumer staples. Because valuation differentials have seldom been larger, we own a lot more of the former group than we do the latter.
Based on our criteria, risk is highly dependent on the price paid for a stock. When a stock is priced at a premium to its business value, risk is high. When the price is at a large discount to value, risk is low. In 1999, when tech stocks were going up most every day and traditional businesses were declining, we believed that investments outside of the technology area were becoming less and less risky while the risk level within technology was growing higher and higher. After a decade of poor performance by technology stocks, we now believe their risk level is much lower. Contrast that to today’s strong performing utilities sector. Historically, utilities have been slower-growth companies, and therefore traded at lower P/E multiples than growth companies. That has now flip-flopped. Today, investors are paying a slightly higher P/E for utilities than for the rest of the S&P 500. Despite utilities having a relatively predictable business model, the current valuation level makes utility stocks, in our opinion, risky investments.
The Oakmark Fund portfolio, as always, is invested in stocks that we believe are selling at large discounts to business values that we expect to grow, and that are managed to maximize long-term per-share value. We believe risk reduction is inherent in each of those criteria. We don’t believe our higher day-to-day volatility is anything more than an annoyance. We believe our portfolio is as attractive as it has been in the past, and that we have avoided investing in the stocks that we deem to have the highest risk of loss.
A lot has flip-flopped recently. Bonds have historically returned less than stocks, but over the past decade, they have performed much better. Bonds are thought to be lower-risk investments; we believe that, at today’s prices, long-term bonds are very risky. Low-growth, high-yield stocks are thought to be among the least risky stocks; we believe, at today’s prices, they are among the most risky stocks. Investors who simply extrapolate recent trends without comparing current price to value run the risk of buying near highs and selling near lows. As investors today are running away from anything that used to be thought of as risky, we believe they are creating a new class of low-risk, high-return opportunities. We believe Oakmark is well-positioned to capitalize on those opportunities.
Link to source: http://www.oakmark.com/opennews.asp?news_id=600&news_from=h