Oakmark Capital's Bill Nygren (Trades, Portfolio) just released his fourth-quarter 2019 commentary, and it is very interesting.
Nygren is a value investor, one that invest in companies for the long term believing their portfolio trades at a substantial discount to true business value. The firm focuses on free cash flows, intelligent investment of excess cash and a high level of manager ownership.
The Oakmark Fund returned 27% in 2019, but that’s actually a 4% underperformance to the S&P 500. In my book that’s nothing to worry about, but Nygren chose to focus his letter on the “why” behind this underperformance as it is the third year in a row the fund has trailed the benchmark index. With Warren Buffett (Trades, Portfolio) having his worst decade in a while, he’s in good company.
Nygren started off by looking at how a typical “value” strategy performed:
"You’ve probably heard of the 'Dogs of the Dow' theory, which states that the 10 cheapest stocks in the Dow Jones Industrial Average (based on dividend yield) tend to outperform that index over the following year. And from 2000 through 2018, this held true: the 'Dogs' outperformed the Dow by an average of 150 basis points per year. But in 2019, the 10 “Dogs” underperformed the other 20 stocks in the Dow by a whopping 1770 basis points, returning 13% versus 30%."
He also ran another test:
"Using another value measure, if, at the beginning of 2019, you had bought the 50 cheapest S&P 500 stocks based on price-to-book value, you would have underperformed the rest of the S&P 500 by over 500 basis points for the year. Similarly, if you bought the 50 stocks with the lowest expected 2019 EPS growth, your portfolio would have underperformed the 50 highest expected growth stocks by 830 basis points over the year. Consistent with that, the Russell 1000 Value Index, an index composed of lower priced stocks relative to earnings and book value, underperformed the Russell 1000 Growth Index by 990 basis points in 2019. Given these results, it’s no surprise that Morningstar reports1 thatlarge-cap value funds as an aggregate underperformed large-cap growth funds by 690 basis points in 2019."
This is actually a historical anomaly. Value has a decades-long track record of outperforming value and rarely, if ever before, underperformed for as long as the current stretch.
But Nygren highlighted the opportunities, pointing out that with the gap between value and growth wider than ever, there is a lot of opportunity within the style.
"As value investors, we pay close attention to P/E and base most of our investments on the premise that a stock’s current P/E ratio is too low. If a stock moves to what we believe is a fair multiple, the result is a higher price. Occasionally, we have a strong non-consensus view on earnings potential, such as when we believed that Baxter’s (BAX, Financial) new management team had an opportunity to nearly double margins. Likewise, as the 2008 recession came to a close, we believed that earnings would get back to 'normal' over our seven-year time horizon—a decidedly more positive outlook than most investors had at the time."
I really liked how Nygren went into how the fund primarily looks at multiple expansion and not as much at earnings growth. This is the sign of a true value investor, looking at what is there “now” and heavily discounting fantasies about earnings in the future. That sets him apart from the rest of the investment landscape that often heavily relies on supposed earnings growth. More often than not, it doesn’t show up. Nygren continued:
"Usually, however, we don’t quarrel much with consensus earnings forecasts. Instead, we believe that our stocks will benefit from higher P/E multiples. That was our view in 2000 when we avoided technology stocks that were selling above the S&P 500’s 30 times multiple and instead owned single-digit P/E stocks, such as consumer packaged goods, industrials and financials. Today, you can see this same logic at work in our bank and cyclical holdings, with many selling at single-digit P/Es, and our avoidance of utilities, consumer packaged goods and REITs that trade at P/Es in the 20s."
It is very interesting to me that Nygren doesn’t quibble much at all with earnings forecasts, and instead looks at stocks that get valued by applying an unfairly low multiple. Almost by design, this means they will concentrate into industries. Behavioral science shows herd behavior and, consequently, the market is discounting consumer packaged goods, industrials and financials too heavily. I will add that energy also trades at a low price-earnings multiple. Here's a table with GuruFocus data:
Nygren wrote:
"Although the formula P=P/E x EPS highlights that estimating future P/E is just as important as forecasting EPS, investors typically alternate being obsessed with one factor and then the other. The collapse of the tech bubble in 2000 was a time when investors stopped paying higher and higher prices for the fastest growers and quickly pivoted to low P/E stocks. And today, just like during the height of the tech bubble, analysts are focusing much more on a company’s earnings than on the company’s appropriate P/E multiple. It’s not the analysts’ fault. After all, their job is to earn commissions from their clients, and today, most of their clients are paying them to focus on earnings predictions."
The guru paints the picture that today, just like in 1999, analysts are mostly focusing on earnings predictions. I see that trend as well. You also hear a lot about addressable markets and disruption. It doesn’t feel as massive a bubble as it did back in '99, but things are definitely different. Perhaps we are in the melt-up phase GMO predicted back in 2018. But Nygren thinks that focusing on earnings instead of what an appropriate “long term multiple” looks like leads people astray. He focused on some analyst reports that discussed some of Oakmark's holdings:
- "One analyst wrote that he believed, as we do, that DXC’s (DXC, Financial) new CEO will restructure the company and largely eliminate the quality gap between DXC and its public peers over the next three years. Yet, in the same report, the analyst set the company’s target P/E at a 30% discount to its peers—unchanged from its historical average, despite its improved competitive stance.
- An in-depth report on Lear (LEA, Financial) highlighted the company’s many advantages compared to other auto parts businesses that sell for between 5 and 11 times EBITDA. But then the analyst computed Lear’s new target price using a multiple of 4.8 times EBITDA. Why? That was left to the reader’s imagination.
An in-depth report on Lear highlighted the company’s many advantages compared to other auto parts businesses that sell for between 5 and 11 times EBITDA. But then the analyst computed Lear’s new target price using a multiple of 4.8 times EBITDA. Why? That was left to the reader’s imagination.
- A report on CBRE Group (CBRE, Financial) touted the company’s improved business mix. Over the past few years, CBRE’s maintenance outsourcing segment has grown rapidly compared to its more cyclical brokerage segment—historically the larger part of the business. Importantly, the market tends to value recurring income, like that from service businesses, at a much higher P/E than businesses based on one-time transactions. Nevertheless, this still concluded that CBRE is fairly priced because its current P/E is approximately at its 15-year average.
A report on CBRE Group touted the company’s improved business mix. Over the past few years, CBRE’s maintenance outsourcing segment has grown rapidly compared to its more cyclical brokerage segment—historically the larger part of the business. Importantly, the market tends to value recurring income, like that from service businesses, at a much higher P/E than businesses based on one-time transactions. Nevertheless, this still concluded that CBRE is fairly priced because its current P/E is approximately at its 15-year average.
- A report on Constellation Brands (STZ, Financial) kept the company’s target P/E the same—at 17 times—despite the company’s recent purchase of a large interest in Canopy Growth Corporation (CGC, Financial). Canopy’s losses reduce Constellation’s reported EPS by about $0.85 so the analyst is inadvertently valuing Constellation’s Canopy investment at negative $-14 per Constellation share, despite its market value being positive $14.
A report on Constellation Brands kept the company’s target P/E the same—at 17 times—despite the company’s recent purchase of a large interest in Canopy Growth Corporation. Canopy’s losses reduce Constellation’s reported EPS by about $0.85 so the analyst is inadvertently valuing Constellation’s Canopy investment at negative $-14 per Constellation share, despite its market value being positive $14.
- Another report noted that big banks are safer and more competitively advantaged today than at any time in recent history. Yet it concluded that these banks are fully valued at their current price of 10 times earnings—which is a P/E roughly the same as their 30-year average. The report never explained why the improved business fundamentals shouldn’t be rewarded with a higher P/E multiple."
Another report noted that big banks are safer and more competitively advantaged today than at any time in recent history. Yet it concluded that these banks are fully valued at their current price of 10 times earnings—which is a P/E roughly the same as their 30-year average. The report never explained why the improved business fundamentals shouldn’t be rewarded with a higher P/E multiple.
It also leads to things like analysts valuing a company and then coming to a conclusion about its future earnings. In addition, they look at the peer group and slap an average peer group multiple on the stock. This is a self-reinforcing cycle that leads low price-earnings sectors lower and high price-earnings sectors higher. Nygren noted:
"The largest industry weighting in our portfolios, financials, demonstrates why we believe our Funds will benefit when valuations become a bigger determinant of prices. In the Oakmark Fund, for example, we own 10 stocks in the financials sector, comprising about 30% of the portfolio. Their median P/E on expected 2021 earnings is 9 times, compared to the S&P 500 at 16 times. Median price-to-book is 1.2 times and the dividend yield is 2.3%, compared to the S&P 500 at 3.6 times book and a 1.9% yield. So, on earnings, assets and yield, the banks appear much cheaper than the S&P 500. Normally, stocks that look that cheap are expected to grow much slower than the market or even experience declining earnings. In this case, however, we expect our median financial stock to have annual EPS growth of 8%, which exceeds the consensus expectation for the S&P 500. To us, faster growth, higher yield and cheaper price translate to win, win and win. We believe that the market will eventually reflect our view by narrowing the gap between the S&P 500’s and the financials sector’s P/E ratios."
The guru also laid out why his portfolio, as well as Buffett’s portfolio, is loaded with financials. Nygren has gone up to 30% financials now. Quite a contrary position as still no one likes financials after the 2008 crisis. Nygren thinks his portfolio is going to do well in the years to come based on the fund's extremely strong historical performance.
The GuruFocus data below shows the fund's top holdings, including Alphabet (GOOG, Financial) (GOOGL, Financial) as its largest position and many financials as advertised by Nygren.
Disclosure: No positions.
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