Bill Nygren Commentary on the Oakmark and Oakmark Select Funds

We have often said that we believe investors spend too much of their time analyzing income statements and not enough time analyzing balance sheets and cash flow statements. And even their income statement analysis tends to be mostly at the top, trying to understand and then project changes in sales. Companies that have better than average projected sales growth tend to sell at above average

valuations. Our search for businesses that are growing but that also sell at cheap prices often leads us to companies that are large producers of free cash flow. Their sales growth might be a bit below average, but when supplemented by growth coming from their cash investments, their per-share earnings growth can match that of average companies. Because so many investors focus on sales growth, these cash-generating companies are often available at attractive prices. We believe that what has often been a stock-specific issue is today a stock market issue. Many investors are projecting slow or no growth for the economy and therefore slow or no growth for S&P 500 sales and profits. I believe that the single most under analyzed statistic today is the S&P 500 earnings retention ratio. That ratio computes the percentage of earnings that are being held by companies instead of being paid out in dividends. As the accompanying chart shows, through much of history, about half of earnings were paid in dividends, and about half were retained in order to invest for growth. When we use the current S&P 500 dividend and the average of next year’s earnings estimates from FactSet and Bloomberg, we see a record low payout, and a corresponding record high earnings retention rate of 75%.


The no-growth crowd believes that demand growth will be non-existent for some time, meaning that most companies who seek to drive growth by investing new capital will fail. And with interest rates so low, letting cash pile up on balance sheets will not produce meaningful earnings growth either. We believe that the economy will recover, but even if we agreed that the economy would stay sluggish indefinitely, we wouldn’t agree that is sufficient to imply a negative outlook for equities.


So if it is futile for a company to invest its excess capital in plant and equipment, then what should it do? There are only five things a company can do with the cash it earns:

1. Invest capital to grow its business
2. Acquire businesses
3. Build balance sheet strength
4. Pay dividends
5. Repurchase stock

Acquisitions are a possible use of cash, and we are already starting to see an increase. Many companies have recently made what the consultants call “add-on” or “strategic” acquisitions. These tend to be small relative to the size of the acquiring company and are designed to improve the company’s competitive position. We believe that these acquisitions generally deliver returns that are below projections, but in the end will still add some value. In addition, most companies don’t have enough of these acquisition opportunities to utilize all the cash they are producing.


We don’t think that cash will just sit on balance sheets. Corporate balance sheets are already strong—so much so that some now call them “lazy balance sheets.” In a research report this summer, Credit Suisse strategists looked at the history of borrowing by publicly traded non-financial companies. Net debt (debt less cash), as a multiple of trailing EBITDA (earnings before interest, taxes, depreciation and amortization), stood at 1.3x, compared to a 20-year average of nearly 1.7x and a 20-year low of 1.2x. Trailing EBITDA, even in the eyes of most pessimists, is now below trend levels due to the recession. If earnings recover as forecast, next year the debt ratio will easily fall beneath its 20-year low. Most managers recognize that their companies are already below optimum debt levels, and many boards are beginning to press management to either put cash to use or return it to their shareholders. (As an aside, if corporate debt returned to historically average levels with the funds used to repurchase equity, based on next year’s estimates about 9% of outstanding shares could be retired.)


Paying out more in dividends is also a likely outcome. Despite record low dividend payouts, dividend yields already exceed bond yields. Bond investors are tripping all over themselves to lock up 5-year Treasury bonds that yield 1.2%. The investor who buys a $1,000 bond today will, at maturity in 2015, have grown their capital by only $63, and that’s before paying taxes. The investor who puts $1,000 in the S&P 500 today, by 2015 will have collected over $100 in dividends, if dividends are unchanged. Though future dividends are uncertain, we believe the probability of them increasing far surpasses the probability of them decreasing. After a slowing of dividend increases during the recession, many companies have already increased dividend payments this year. Of the 56 holdings in the Oakmark Fund, 31 have raised their dividends in 2010. That’s a trend we believe will continue, but companies likely will still have substantial excess cash to invest.


That leaves us with share repurchase, which has taken quite a few knocks lately. Some say share repurchase is an indication of failure and that no competent management should admit they have nothing better to do with capital. Some CEOs, who used share repurchase to provide a short-term boost to their share price, now look back on it as a failure. To us, share repurchase should be evaluated no differently than any other investment opportunity. Like all opportunities, repurchase makes sense when the price is right. Managements that bought back stock at high P/Es had the same buyer’s remorse that managements had after they made overpriced acquisitions, or that built new plants to meet demand that didn’t materialize. A proper evaluation of share repurchase should be made side-by-side with other investment opportunities, and the one with the best risk-adjusted return should win out. Buying back stock is simply making an acquisition of part of one’s own company without having to pay a control premium. Since the number of shares outstanding decreases, per share metrics such as earnings-per-share and business value-per-share will increase. We applaud managements that always think in terms of maximizing per-share values as opposed to simply maximizing total business value.


I think it is interesting to combine the earnings retention ratio we looked at earlier with P/E ratios, in order to compute the potential growth from share repurchases. This answers the question, “How much would EPS increase if all retained earnings were used to repurchase stock at the current price?”

Time Period	Average DividendPayoutRatio	RetentionRatio	AverageP/ERatio	Earnings Yield (E/P)	% of SharesRepurchasable	ResultingEPS Growth
1930s	90%	10%	16.6	6.0%	0.6%	0.6%
1940s	59%	41%	11.0	9.1%	3.7%	3.8%
1950s	55%	45%	12.6	7.9%	3.6%	3.7%
1960s	56%	44%	17.6	5.7%	2.5%	2.6%
1970s	46%	54%	12.1	8.3%	4.5%	4.7%
1980s	49%	51%	12.1	8.3%	4.2%	4.4%
1990s	49%	51%	20.2	5.0%	2.6%	2.7%
2000s	41%	59%	19.2	5.2%	3.1%	3.2%
2011 Est.	25%	75%	12.5	8.0%	6.0%	6.4%

The column titled “% of Shares Repurchasable” is simply the retention ratio multiplied by the earnings yield. The final column shows the EPS increase from reducing the denominator (shares) in the EPS calculation. As you can see, potential growth from repurchase has never been higher, and it alone is even higher than most estimates we’ve seen for the S&P 500’s long-term earnings growth. I suspect that as most companies compare repurchasing their own stock at 12-13x projected earnings, versus earning less than 1% on higher cash balances, or paying premiums to make acquisitions, share repurchase will look like the best option. Over the past year, 25 of Oakmark Fund’s 56 holdings have reduced their shares outstanding. We expect even more to do so over the upcoming year.


We continue to believe that equities are attractively priced and are highly likely to dominate returns from more popular assets such as fixed income. Flows into bond funds continue to be abnormally high while equity funds experience outflows. We believe that investors have it backwards. We continue to encourage our investors and potential investors to revisit their asset allocations and make sure that they have as much invested in equities as their long-term asset allocation implies.


William C. Nygren, CFA


Portfolio Manager

[email protected]


The performance data quoted represents past performance. The above performance information for the Funds does not reflect the imposition of a 2% redemption fee on shares of all Funds, other than The Oakmark Equity & Income Fund, redeemed within 90 days. If reflected, the fee would reduce the performance quoted. Past performance does not guarantee future results. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Average annual total return measures annualized change, while total return measures aggregate change. To obtain most recent month-end performance data, view it here.