2007 was a tough year for value investors. With Washington Mutual as the largest holdings, Bill Nygren was hit hard by the banking industry meltdown. This is his most recent commentary: “So we ask ourselves, where are we now seeing fear, and where are we seeing greed?”
Bill Nygren commentary:
In previous reports we’ve written about the great investor Michael Steinhardt. Michael ran a hedge fund back when the term “hedge fund” was unknown outside of the investment profession. As both a great stock picker and macro thinker, Steinhardt used the freedom to go long or short stocks, bonds, or currencies to amass an amazing record. For twenty-eight years, from 1967 to 1995, Steinhardt Partners LP averaged an annual return of thirty percent.
One of our founding partners is friends with Michael, and that gave us exposure to his investment process. As a result, some of Michael’s tactics influenced the development of our investment process. Steinhardt was well-known for inviting to lunch the most bullish and the most bearish Wall Street analysts who covered a given stock that he owned. He would then listen to them argue in order to help him decide whether or not he would continue to own the stock. This technique provided the basis for our own Devil’s Advocate reviews, in which an analyst is responsible for compiling and presenting the negative case against a stock we already own.
Steinhardt also held the belief that a stock recommendation should be elegant in its simplicity. In his book No Bull – My Life In and Out of Markets he states that an analyst “should be able to tell me in two minutes, four things: 1- the idea; 2- the consensus view; 3- his variant perception; and 4- a trigger event.” We, too, have preferred highly focused reports from our analysts. They tend to be only a couple of pages long, but fully explain what matters to us: why we believe the stock is undervalued, why we believe the business value is likely to grow, and why we believe we should have confidence in management.
Perhaps Steinhardt’s most interesting tactic was selling his entire portfolio when he was frustrated with his performance. As he explained: “I did not think we were in sync with the market, and while there were various degrees of conviction on individual securities, I concluded we would be better off with a clean slate…. In an instant, I would have a clean position sheet. Sometimes it felt refreshing to start over, all in cash, and build a portfolio of names that represented our strongest convictions and cut us free from wishy-washy holdings.” Our desire at Oakmark to defer taxable gains compels us to use this technique only as a hypothetical exercise, but I still find the thought process very helpful.
Obviously we were out-of-sync in the second half of 2007. So let’s forget the current holdings, forget our analysts’ recommendations and start with the very basics. Our investment approach is centered on the belief that one can estimate the intrinsic value of a stock by making long-term projections about that company. Further, we believe that many investors will become too emotional and sell price-indiscriminately when they are fearful, and buy indiscriminately when they are greedy. Finally, we believe that emotionally-driven price swings are so large, that despite the lack of precision in intrinsic-value estimates, a disciplined long-term investor can take advantage of this volatility.
So we ask ourselves, where are we now seeing fear, and where are we seeing greed? A value investor we respect, who has also had a tough year, Rich Pzena, stated in a recent Barron’s interview that “…the most common question we get from clients in any market environment is ‘don’t you read the paper?’” We frequently get the same question in shareholder e-mails. In general, we have found that by the time news stories are prevalent, it is too late to invest, and often, such stories are contrary indicators. It is no surprise where the media’s attention was focused at year-end. Our local paper, the Chicago Tribune, ran a year-in-review story ranking the year’s top 10 national stories. Can you guess number one? “The housing market suffered its worst slump since the depression and foreclosures soared as the collapse of the subprime mortgage market rattled banks around the world.” And number two? “Petroleum prices, which traded as low as $50 a barrel in January, spiked past $98 in November.”
We believe we see greed in those who have been successfully betting on commodities. Partly due to the weak dollar, businesses that benefit from higher commodity prices, exports from the U.S., or non-U.S. based income streams have performed exceptionally well, and those who are invested in such businesses now depend on that continuing. At the other extreme, fear of a bigger housing meltdown has caused weak performance in home-builders, retailers and financials. The question for these depressed stocks is no longer whether business conditions will get worse, but rather, will they ever get better. It shouldn’t surprise you that many of our holdings and most of our analysts’ new ideas have come from these miserably performing industries. That’s what we always do. When the media and the market become so focused on recent negative trends, we often see an opportunity to invest. Though it is certainly possible that current trends will persist, we believe that economic pressures almost always work toward ending—and often reversing—existing trends.
Our problem in the second half of 2007 was, having done this clean slate exercise six months ago, we had identified the same groups as being depressed and the same groups as being inflated. The business fundamental trends persisted, and the stock price performance—good and bad—amplified those trends. In fact, the second half of 2007 was an extremely powerful momentum market, an environment that is always challenging for value investors. In most times, investing based only on recent price moves, either up or down, doesn’t create meaningful outperformance. In 2007, however, it was the most important factor. Imagine on June 30, 2007 creating two portfolios: for the first, equal weighting the fifty S&P 500 companies that went up the most in the first half of the year, and for the second, equal weighting the fifty worst performers. In most years, the subsequent price performance differential of those two portfolios has been trivial. In 2007, however, the portfolio of winners kept winning, and the losers kept losing, creating a 33 percentage point spread (up 11% versus down 22%) between the two portfolios over the second half of the year. It’s not that we seek out underperformers. However, to purchase only stocks that sell at large discounts to value, we often buy stocks that have recently fallen in price. We don’t use a rear-view mirror method to select our stocks, and this has served us well for a long time. The last six months, however, was one of those rare periods when the view out of the windshield was the same as the one in the rear-view mirror.
We like our current portfolios. We don’t like how the stocks have recently performed, but we like the long-term positioning of the businesses in which we have invested. We think it is highly likely that when reviews of 2008’s most important business stories are written, they will lead with something other than more mortgage meltdown and further skyrocketing of oil prices. What usually happens is that suffering industries begin to recover, the next crisis comes from somewhere least expected, and the cycle of creating new investment opportunities starts anew. We have no reason to believe it will be different this time.