If you’ve been reading the financial press over the last six years or so, you’ve likely noticed a steady drumbeat of negative articles on banks and, in particular, large U.S. banks. As a result, we often get questions about our relatively large positions in institutions such as JPMorgan (NYSE:JPM), Citigroup (NYSE:C), and Bank of America (NYSE:BAC). The short answer is we find their risk profiles are much improved, along with management (where needed), and the valuations are quite attractive.
Although the negative press hasn’t stopped, a thoughtful look reveals that the debate has changed from one of survival, to guesswork as to what the next fine will be or how much excess capital will be returned to shareholders in the next stress test. Furthermore, after 2008 many investors decided they didn't want to invest in banks – ever. They concluded that banks were unanalyzable. We disagree. In our view, banks were over-levered and focused on revenue growth instead of per-share value growth. They had almost no underwriting standards and they were lending primarily against an overheated real estate market. The problem wasn't that banks had become uniquely opaque and impossible to analyze, the problem was their bets were too big and the real estate market they had bet on underwent an unprecedented collapse. We don't see similar conditions in place today.
For the last several years banks have been improving the quality of their balance sheets (record capital levels and liquidity), tightening their underwriting standards, and growing underlying earnings power by adding deposits at a nice clip. Furthermore, where needed, the largest banks have changed their management teams. These teams strike us as prudent risk managers who take a rational approach to returns and are focused on growing per share value. In recent years, true earnings power has been somewhat obfuscated by transitory, “legacy” expenses such as legal and excess mortgage servicing costs as well as historically low interest rates, which have squeezed net interest margins. In our view, neither of these issues will remain a headwind forever. With minimal help from higher interest rates, we believe JPMorgan, Citigroup, and Bank of America are all selling for roughly 8x normalized EPS and are, or will be, in a significant excess capital position within the next 12 months. At this price, the banks are theoretically in a position to grow their EPS at a high single-digit rate through share repurchase alone while increasing their dividend to a more normal 30% payout ratio, without loan growth, a normalization in interest rates, or release of any existing excess capital – all of which would only add to earnings power. This scenario would provide an attractive total return even before well-deserved multiple expansion. We say “theoretically” because these banks are currently restricted from returning 100% of their earnings to shareholders, though we believe it is just a matter of time before regulators will allow for higher total payouts. The capital isn’t gone; its return is merely delayed.
Occasionally, we make large investments in controversial industries. It may look like we are contrarian investors, but we are not; we are value investors. At Oakmark, this means investing in companies that sell for large discounts to growing per share values with shareholder-friendly management teams. Today, large U.S. banks such as JPMorgan, Citigroup, and Bank of America meet these criteria — negative headlines notwithstanding.
Thank you for your interest in the Oakmark Funds.
Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks
The Oakmark and Oakmark Global Funds' portfolio's tend to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund's will have a greater impact on the Funds' net asset value than it would if the Fund invested in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Fund’s volatility.
Because the Oakmark Select and Oakmark Global Select Funds are non-diversified, the performance of each holding will have a greater impact on the Funds’ total return, and may make the Funds’ returns more volatile than a more diversified fund.
The Oakmark Equity and Income Fund invests in medium- and lower-quality debt securities that have higher yield potential but present greater investment and credit risk than higher-quality securities. These risks may result in greater share price volatility. An economic downturn could severely disrupt the market in medium or lower grade debt securities and adversely affect the value of outstanding bonds and the ability of the issuers to repay principal and interest.
Investing in foreign securities presents risks that in some ways may be greater than U.S. investments. Those risks include: currency fluctuation; different regulation, accounting standards, trading practices and levels of available information; generally higher transaction costs; and political risks.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.
The discussion of the Funds' investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds' investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.