Slim pickings?
For the last few years, many value investors have complained that finding cheap stocks has been especially difficult. One reason is that they tend to focus on traditional “value” metrics, such as a low price-to-earnings ratio, a low price-to-book ratio, or a high dividend yield. You might imagine that the problem has been due to the average stock looking overpriced on these metrics. In fact, however, the median P/E multiple of 16x for companies in the S&P 500 Index has not been far out of line with history over the last three years. Rather, the challenge has been that the distribution around the median has been unusually tight. As a result, the number of stocks meeting traditional “value” criteria has been smaller than is typically the case.
Since 2013, an average of only approximately 35 non-financial companies in the S&P 500 Index have sold below two-thirds of the median multiple at any given time whereas roughly 100 non-financial companies sold at a similar discount to the median in 2009 (the median itself was also only 11x in 2009). To make matters worse, several of the discounted companies in the last few years have been what we consider to be either low-quality businesses or former high-fliers that now face structural challenges from technological disruption. In light of this unusually tight distribution, it is no surprise that many value investors have had trouble finding enough stocks with which to build their portfolios. Moreover, it is also no surprise that these investors have held an elevated level of cash—a natural outcome of their dearth of investment ideas—even though cash offers a particularly low return in the current interest rate environment.
A broader definition of value
At Harris Associates, we take a different view. Like most value investors, we are pleased when the market offers us the chance to buy average-quality businesses at low prices. But we also recognize that a tight P/E distribution creates a set of opportunities that is equally compelling as long as the median multiple is not too lofty. When high-quality companies with unusually long runways for above-average growth—like Alphabet (GOOGL, Financial), Amazon (AMZN, Financial), MasterCard (MA, Financial), Monsanto (MON, Financial), and Visa (V, Financial)—were selling for an unusually small premium relative to the rest of the market, we made significant investments in them. We recently sold our position in Amazon (first purchased in 2014) because the stock quickly reached our estimate of intrinsic value, but we continue to hold Alphabet, MasterCard, Monsanto, Visa, and several other “growth” stocks in many strategies. Some market commentators may not view these stocks as “value” investments, but they were (and are) nevertheless cheap when considering growth as a component of value.
Warren Buffett (Trades, Portfolio) has written that the distinction between “growth” and “value” is based on a false premise. We share this view and believe that the “growth” and “value” style boxes create more confusion than clarity. After all, we always think of growth as a variable—and a particularly important one—in our calculation of the intrinsic value of a given company. To use a simple example, if Company A grows its cash flows at 6% for 30 years and Company B grows at 3% over the same timeframe, Company A is worth nearly 65% more than Company B today assuming that both companies converge to a 3% growth rate thereafter1. Our appraisal of what any company is worth is based on quantitative factors like its growth rate and returns on incremental capital as well as on qualitative factors like its management quality and stability of cash flows.
Outperformance requires flexibility
The 12% sell-off in the S&P 500 Index since July 2015 has caused the median P/E ratio to decline and the distribution around the median to widen. As a result, in many of our strategies, we are once again finding opportunities in stocks like Ally Financial (ALLY, Financial), Cummins (CMI, Financial), and Fiat Chrysler (FCAU, Financial) that are cheap on traditional “value” metrics while at the same time continuing to hold “growth” stocks that still do not trade at an appropriate premium. This broad approach to defining value—looking at low-growth companies, high-growth companies, and everything in between—is one of the reasons why we expect our strategies to continue to outperform their benchmarks. We believe that such flexibility is not merely “nice to have”—it is essential to generating outperformance across ever-changing market conditions.
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. Harris Associates L.P., the Fund's adviser, contractually agreed to limit Oakmark Equity and Income Fund's annual expenses to 1% of its average net assets through January 31, 2002. Absent this expense limitation, the Fund's total return would have been lower.
Because Oakmark Select Fund and Oakmark Global Select Fund 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.
Oakmark Global, Oakmark Global Select, Oakmark International and Oakmark International Small Cap Funds: Investing in foreign securities presents risks which 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.
Oakmark, Oakmark Equity & Income, Oakmark Global, Oakmark International Funds and Oakmark International Small Cap: The Funds’ portfolios tend to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held will have a greater impact on the Funds’ net asset value than it would if the Funds invest in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Funds’ volatility.
Oakmark International Small Cap Fund: The stocks of smaller companies often involve more risk than the stocks of larger companies. Stocks of small companies tend to be more volatile and have a smaller public market than stocks of larger companies. Small companies may have a shorter history of operations than larger companies, may not have as great an ability to raise additional capital and may have a less diversified product line, making them more susceptible to market pressure.
The discussion of the Fund’s investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Fund’s investments and the views of the portfolio managers and Harris Associates L.P., the Fund’s investment adviser, at the time of this letter, and are subject to change without notice.
The Oakmark Funds are distributed by Harris Associates Securities L.P. Member FINRA. Before investing in any Oakmark Fund, you should carefully consider the Fund's investment objectives, risks, management fees and other expenses. This and other important information is contained in a Fund's prospectus and summary prospectus. Please read the prospectus and summary prospectus carefully before investing. For more information, please visit oakmark.com or call 1-800-OAKMARK (625-6275).
