Finally some relief for value managers. Bill Nygren's Oakmark Fund increased in value by 23% last quarter compared to the 16% increase in the S&P 500. After a great run up in the stock market, is it now still undervalued?
To Bill Nygren, it is. This is what he said in his quarterly commentary.
... Further, we believe that the long-term return for stocks purchased today is likely to be higher than historical average returns. Here are a few of our main reasons for such optimism.
Valuation
For us, everything starts with valuation. The S&P 500 trades at about 900 with operating earnings in 2009 expected to be in the $60s. Many analysts are using those two numbers to claim that the market has recovered so much that we are already back at a normal mid-teens P/E ratio. I can’t argue with their math. However, the unanswered question is what level of earnings is normal. If 2009 earnings represent a “normal” base from which mid-single digit growth resumes, then expected returns from an investment today would be several percentage points above government bonds, which is consistent with historical averages. On that basis, one could conclude that today’s market level is in the ballpark of fair. But remember that S&P earnings back in 2006 were nearly $90 and that typically when a recession ends, earnings recover much more rapidly than would be implied by normal earnings growth. In our view, the biggest question concerning earnings is when they will recover, not if. Starting from a “normal” P/E level, we believe the market should increase from here more or less as much as earnings recover, which would lead to above-average returns.
High cash levels
For the market to go higher, new cash needs to be invested. Existing owners buying and selling to each other has no net effect. One measure of cash waiting to be invested is balances in money market funds. Certainly not all of that money is destined for the market, but when investors temporarily exit the stock market, money funds are often used as a parking spot. And, as you’d expect, when the market was falling in November and again in March, money market balances were growing. Recently, we’ve been interested in a statistic that measures the ratio of money market fund assets to the total market value of the S&P 500. (See chart below.) Before the 2008 bear market, that ratio had averaged about 18% since 1980, meaning that there was typically enough cash in money market funds to buy 18% of the S&P 500. In March 2009 it peaked at 65%, more than three times its long-term average and more than twice its prior peaks (1982, 2002). The subsequent stock market rally has resulted in a small reduction in assets in money market funds and a larger increase in the value of the S&P 500. The ratio has fallen from 65% to 46%. It no longer is as extreme as it was at the March bottom, but it is still much higher than the peak level prior to 2008. We conclude that there is still plenty of fire power waiting to invest in stocks.
Lots of skepticism
As value managers, we’re used to having people disagree with us. In fact, we prefer it that way. The consensus opinion, almost by definition, is usually reflected in current prices. So when we differ from consensus, we’re excited by the opportunity. We believe that today’s consensus stock market opinion is that the magnitude of the market increase since March has not been matched by fundamental improvement in the economy. The implication is that an investor should wait for the market to fall before increasing their investment in stocks. While we applaud the effort to tie stock price movements to fundamentals, we have to ask, where were these fundamentalists when the market was in freefall? We believe that panicked investors, momentum investors and short sellers all combined to drive the market far beneath the level that was justified by the economy’s cyclical decline. In our view, the March low —not today’s market— was disconnected from fundamentals. If the consensus comes around to our way of thinking, we believe the conversion of skeptics to investors will lead to higher prices.
We know that the past year has been an extremely trying time for our shareholders. Despite that — in fact because of that— we reiterate our advice from the previous two quarters: that shareholders should revisit their asset allocation and restore their percentage in equities to an appropriate level. With the S&P 500 still down over 25% in the past year, for most investors, returning to their target equity percentage requires increasing their stock investments. Approaching that decision statistically instead of emotionally can help avoid the trap that snares so many, buying high and selling low. One of the reasons we encourage rebalancing to a target asset allocation after a large market move is that it forces one to buy after prices have fallen and to sell after they have risen.
These are some of the companies he just bought:
3M Company (MMM – $60)
3M is a broadly diversified manufacturing company that tends to dominate niche markets in which technical superiority is valued, but average selling prices are low, making customers less sensitive to price. We believe 3M’s leading market positions are sustainable because of the company’s unique ability to apply a few core technologies across several niche markets and therefore leverage an R&D investment that less diversified competitors cannot justify. The result is an enviable record of growth in earnings and dividends. Five years ago, 3M stock surpassed $90 per share when earnings were $3.75. In 2009, with recession-level earnings still over $4.00, the stock fell to the low $40s. We believe 3M CEO George Buckley, a veteran of Brunswick and Emerson Electric, is a very thoughtful, capable leader. George is responsible for one of our favorite management quotes. When he was asked about the wisdom of continuing to spend on management training given the risk that young executives might leave the company, Buckley responded “What if we don’t, and they stay?” 3M is being managed with a focus on maximizing long-term value, and appears attractively priced at 11 times estimated recovery earnings.
Covidien (COV – $37)
We received shares of Covidien, the old Tyco Healthcare, when Tyco separated into three publicly traded companies in the third quarter of 2007. Less than a year later, Covidien stock surpassed $50 per share, with just over $2.50 of trailing earnings, for a P/E ratio of nearly 20 times, and we could no longer justify holding it. A year later, with the stock trading at just over $30 and projected 2009 earnings of over $3, the P/E ratio had been cut nearly in half to just over 10 times. Our admiration of Covidien’s businesses and management team goes way back. In 1992, during Oakmark’s first year, one of our most successful purchases was a hospital supply company, Kendall International. Two years later, Kendall was purchased by Tyco International and became the foundation for the Tyco Healthcare division. Richard Meelia became head of that segment when Kendall’s CEO retired. Kendall’s CEO spoke very highly of Meelia back then, and again recently, and Meelia’s track record of growth and operational efficiency supports those comments. Now selling at an unassuming valuation, this high quality hospital supply business is again, in our view, an attractive investment.
Oracle (ORCL – $21)
Oracle is the world’s largest enterprise software company. That means they sell the programs that comprise a company’s primary databases and applications. If you’ve ever hesitated to upgrade a program on your PC out of fear of unintended consequences, imagine how Chief Information Officers feel about changing their enterprise software provider. The idea is a non-starter. We believe that unusually high switching costs combined with dominant market share give Oracle as bullet-proof of a business model as exists in the technology industry. Oracle stock peaked at $46 in the tech-crazy market of 2000, when earnings were 35¢ per share, for a P/E ratio of 131. In 2010, just a decade later, Oracle is expected to have grown earnings to about $1.50 per share. Oracle stock, however, followed the opposite trajectory, and troughed earlier this year beneath $14. We’ve always been excited by Oracle’s business, but now with the decimal on its P/E moved a digit to the left, we are also excited by the stock.
Precision Castparts Corp (PCP – $73)
Precision Castparts produces metal components primarily for the aerospace industry. While one might be tempted to dismiss PCP as a pure commodity metal bender, that would be a significant error. PCP works with complex designs, using demanding metals with extremely small tolerances for mission-critical parts that must perform in adverse environments. Small local competitors can’t take PCP’s customers simply by cutting their prices. Despite PCP’s great reputation and track record, as well as its balance sheet that has more cash than debt, PCP has been a very volatile stock. PCP peaked in 2007 at $161 per share, with EPS of just under $7. Two years later, with EPS expected to be a little above $7, the stock traded under $50. We believe that PCP’s barely double-digit P/E provides an attractive purchase price for this high-quality manufacturer.
To Bill Nygren, it is. This is what he said in his quarterly commentary.
... Further, we believe that the long-term return for stocks purchased today is likely to be higher than historical average returns. Here are a few of our main reasons for such optimism.
Valuation
For us, everything starts with valuation. The S&P 500 trades at about 900 with operating earnings in 2009 expected to be in the $60s. Many analysts are using those two numbers to claim that the market has recovered so much that we are already back at a normal mid-teens P/E ratio. I can’t argue with their math. However, the unanswered question is what level of earnings is normal. If 2009 earnings represent a “normal” base from which mid-single digit growth resumes, then expected returns from an investment today would be several percentage points above government bonds, which is consistent with historical averages. On that basis, one could conclude that today’s market level is in the ballpark of fair. But remember that S&P earnings back in 2006 were nearly $90 and that typically when a recession ends, earnings recover much more rapidly than would be implied by normal earnings growth. In our view, the biggest question concerning earnings is when they will recover, not if. Starting from a “normal” P/E level, we believe the market should increase from here more or less as much as earnings recover, which would lead to above-average returns.
High cash levels
For the market to go higher, new cash needs to be invested. Existing owners buying and selling to each other has no net effect. One measure of cash waiting to be invested is balances in money market funds. Certainly not all of that money is destined for the market, but when investors temporarily exit the stock market, money funds are often used as a parking spot. And, as you’d expect, when the market was falling in November and again in March, money market balances were growing. Recently, we’ve been interested in a statistic that measures the ratio of money market fund assets to the total market value of the S&P 500. (See chart below.) Before the 2008 bear market, that ratio had averaged about 18% since 1980, meaning that there was typically enough cash in money market funds to buy 18% of the S&P 500. In March 2009 it peaked at 65%, more than three times its long-term average and more than twice its prior peaks (1982, 2002). The subsequent stock market rally has resulted in a small reduction in assets in money market funds and a larger increase in the value of the S&P 500. The ratio has fallen from 65% to 46%. It no longer is as extreme as it was at the March bottom, but it is still much higher than the peak level prior to 2008. We conclude that there is still plenty of fire power waiting to invest in stocks.
Lots of skepticism
As value managers, we’re used to having people disagree with us. In fact, we prefer it that way. The consensus opinion, almost by definition, is usually reflected in current prices. So when we differ from consensus, we’re excited by the opportunity. We believe that today’s consensus stock market opinion is that the magnitude of the market increase since March has not been matched by fundamental improvement in the economy. The implication is that an investor should wait for the market to fall before increasing their investment in stocks. While we applaud the effort to tie stock price movements to fundamentals, we have to ask, where were these fundamentalists when the market was in freefall? We believe that panicked investors, momentum investors and short sellers all combined to drive the market far beneath the level that was justified by the economy’s cyclical decline. In our view, the March low —not today’s market— was disconnected from fundamentals. If the consensus comes around to our way of thinking, we believe the conversion of skeptics to investors will lead to higher prices.
We know that the past year has been an extremely trying time for our shareholders. Despite that — in fact because of that— we reiterate our advice from the previous two quarters: that shareholders should revisit their asset allocation and restore their percentage in equities to an appropriate level. With the S&P 500 still down over 25% in the past year, for most investors, returning to their target equity percentage requires increasing their stock investments. Approaching that decision statistically instead of emotionally can help avoid the trap that snares so many, buying high and selling low. One of the reasons we encourage rebalancing to a target asset allocation after a large market move is that it forces one to buy after prices have fallen and to sell after they have risen.
These are some of the companies he just bought:
3M Company (MMM – $60)
3M is a broadly diversified manufacturing company that tends to dominate niche markets in which technical superiority is valued, but average selling prices are low, making customers less sensitive to price. We believe 3M’s leading market positions are sustainable because of the company’s unique ability to apply a few core technologies across several niche markets and therefore leverage an R&D investment that less diversified competitors cannot justify. The result is an enviable record of growth in earnings and dividends. Five years ago, 3M stock surpassed $90 per share when earnings were $3.75. In 2009, with recession-level earnings still over $4.00, the stock fell to the low $40s. We believe 3M CEO George Buckley, a veteran of Brunswick and Emerson Electric, is a very thoughtful, capable leader. George is responsible for one of our favorite management quotes. When he was asked about the wisdom of continuing to spend on management training given the risk that young executives might leave the company, Buckley responded “What if we don’t, and they stay?” 3M is being managed with a focus on maximizing long-term value, and appears attractively priced at 11 times estimated recovery earnings.
Covidien (COV – $37)
We received shares of Covidien, the old Tyco Healthcare, when Tyco separated into three publicly traded companies in the third quarter of 2007. Less than a year later, Covidien stock surpassed $50 per share, with just over $2.50 of trailing earnings, for a P/E ratio of nearly 20 times, and we could no longer justify holding it. A year later, with the stock trading at just over $30 and projected 2009 earnings of over $3, the P/E ratio had been cut nearly in half to just over 10 times. Our admiration of Covidien’s businesses and management team goes way back. In 1992, during Oakmark’s first year, one of our most successful purchases was a hospital supply company, Kendall International. Two years later, Kendall was purchased by Tyco International and became the foundation for the Tyco Healthcare division. Richard Meelia became head of that segment when Kendall’s CEO retired. Kendall’s CEO spoke very highly of Meelia back then, and again recently, and Meelia’s track record of growth and operational efficiency supports those comments. Now selling at an unassuming valuation, this high quality hospital supply business is again, in our view, an attractive investment.
Oracle (ORCL – $21)
Oracle is the world’s largest enterprise software company. That means they sell the programs that comprise a company’s primary databases and applications. If you’ve ever hesitated to upgrade a program on your PC out of fear of unintended consequences, imagine how Chief Information Officers feel about changing their enterprise software provider. The idea is a non-starter. We believe that unusually high switching costs combined with dominant market share give Oracle as bullet-proof of a business model as exists in the technology industry. Oracle stock peaked at $46 in the tech-crazy market of 2000, when earnings were 35¢ per share, for a P/E ratio of 131. In 2010, just a decade later, Oracle is expected to have grown earnings to about $1.50 per share. Oracle stock, however, followed the opposite trajectory, and troughed earlier this year beneath $14. We’ve always been excited by Oracle’s business, but now with the decimal on its P/E moved a digit to the left, we are also excited by the stock.
Precision Castparts Corp (PCP – $73)
Precision Castparts produces metal components primarily for the aerospace industry. While one might be tempted to dismiss PCP as a pure commodity metal bender, that would be a significant error. PCP works with complex designs, using demanding metals with extremely small tolerances for mission-critical parts that must perform in adverse environments. Small local competitors can’t take PCP’s customers simply by cutting their prices. Despite PCP’s great reputation and track record, as well as its balance sheet that has more cash than debt, PCP has been a very volatile stock. PCP peaked in 2007 at $161 per share, with EPS of just under $7. Two years later, with EPS expected to be a little above $7, the stock traded under $50. We believe that PCP’s barely double-digit P/E provides an attractive purchase price for this high-quality manufacturer.
