Bill Nygren Commentary on Oakmark Fund, First Quarter 2013
Our best performing stock in the quarter was Dell, up 42%. Dell is in the midst of a bidding war between a group headed by its CEO, Michael Dell, and groups led by Blackstone and Carl Icahn. We have decided, for now, to maintain our holding as we believe there is a reasonable probability that a higher bid will emerge. A more detailed discussion of our Dell position can be found in the commentary for the Oakmark and Oakmark Select Funds.
Our worst performer was Apple, down 16%, but because our weighting was less than that of the S&P 500, it didn’t hurt our relative performance. We also had single-digit declines in Cenovus (7%), Capital One (5%), Oracle (3%) and Aflac (1%). None of these companies are performing meaningfully worse than we were expecting, so we continue to hold the stocks.
We eliminated two holdings during the quarter: Viacom and Heinz. Viacom’s stock reached our sell target despite ratings for its main cable channels that continue to disappoint. Heinz announced its acquisition, and because the stock price immediately matched the proposed acquisition price, we sold all of our shares. We are very pleased with the performance of Heinz management over the many years we owned the stock. For a more complete discussion, read the Heinz piece we posted on our website during the quarter. We added one new holding, Forest Laboratories.
Forest Laboratories (FRX - $37)
Forest Labs is a mid-sized pharmaceutical company. It sells at almost 40 times trailing earnings at a time when many pharmaceutical stocks are priced at multiples less than half that. So it is fair for our investors to ask how we can possibly call Forest undervalued. When we evaluate most companies, we don’t need to adjust P/E ratios to reflect differing mixes of new versus old products. Pharmaceutical companies, however, are different. Even very large pharmaceutical companies often produce most of their earnings from just a small number of drugs. When patents on those drugs expire, earnings largely disappear. So a very low P/E is justified for companies facing patent cliffs. The opposite is true when drugs are first introduced. Launch costs can wipe out most of a new drug’s early earnings, so a very high P/E ratio is deserved.
Forest is in the unusual position of launching seven important new drugs. This results in very low current earnings compared to the earnings we expect several years from now. Our valuation of discounted future cash flows indicates that Forest is currently selling for just over two-thirds of value. Further, if a large pharmaceutical company owned Forest, economies of scale would meaningfully reduce Forest’s expenses, which leads us to believe its ultimate value is even higher. Finally, many pharmaceutical stocks have been strong performers because they pay high dividends, which appeals to bond investors looking for income in the stock market. Because Forest does not pay a dividend, it has not enjoyed such attention. Instead, over the past decade, its management has repurchased nearly 30% of the company’s shares. When we believe a stock is selling at a large discount to its value, there are few things we like better than management increasing our ownership by reducing the outstanding shares.