Well 2020 sure didn't turn out the way we had anticipated!
We often joke that if only you could see the future, market timing would be so easy. But what if you could have seen this year's major events in advance? Would it have made investing any easier? Imagine knowing in January that restrictions in response to the worst pandemic in 100 years would cripple the global economy and lead to the sharpest one-quarter GDP decline ever recorded. Or that we'd spend most of the year locked in our houses and have the worst social and political unrest we've experienced in more than 50 years. I doubt you'd have said, "I'm all in." But those events didn't stop the S&P 500 from gaining 18% for the year. What's more, due to historically low interest rates and substantially increased use of technology for working remotely, the tech-heavy Russell 1000 Growth Index jumped by 38%. There was no better representative of this year's bullish, work-from-home day-traders than Barstool Sports' Dave Portnoy, who pounded his bullish green hammer while exhorting his followers with the refrain, "Stocks only go up!" Every market cycle has its guru, and from March through December, nobody nailed it better than Davey Day Trader himself.
Such widespread speculation is consistent with earlier market peaks, especially the internet bubble of 2000, a topic discussed in this quarter's Oakmark Equity and Income Fund report. But it is worth noting that when that bubble burst, unpopular and inexpensive stocks continued to perform well even as the broader market declined. Today, like in 2000, the valuation metrics we use for our portfolios bear little resemblance to the more speculative corners of the market. Financials are our largest exposure and most of them trade at single-digit P/Es. Though some of our portfolio companies have higher multiples, that is because we believe their GAAP income statements do not completely reflect their sources of value creation. I've written about this issue previously when explaining our per-subscriber valuation for Netflix and our sum-of-the-parts valuation for Alphabet. Now that regulators are calling for the split-up of both Alphabet and Facebook, I'd like to share our sum-of-the-parts valuation for Facebook.
Facebook (FB, Financial) currently sells at approximately $273 per share or 26 times consensus 2021 earnings estimates of $10.47 per share. That might not seem excessive for such a high-quality company, but it certainly would not meet our value criteria if that was the whole story. But it's not. For starters, Facebook is expected to have $29 per share of cash at the end of 2021, and, as we all know, cash currently earns almost nothing. Subtracting cash from the stock price, we are only paying $244 per share for the business or 23 times earnings.
There is more. Analysts believe that WhatsApp, a popular messaging service owned by Facebook, reports a GAAP loss, yet its subscribers have quadrupled since Facebook acquired the service in 2014. If WhatsApp's current subscriber base was valued at the same price-per-subscriber as in 2014, it would now be worth $31 per Facebook share. Using analyst forecasts for revenue several years out, that $31 per share seems reasonable as it roughly matches Facebook's current price-to-sales multiple.
In addition to WhatsApp, Facebook has also made significant investments in augmented reality/virtual reality (AR/VR)—about $5 per share by our estimate—and we believe those investments are, at a minimum, worth what they cost. AR/VR generates little revenue today and it is likely losing at least $1.00 per share. So, when we factor in both WhatsApp and AR/VR, we should deduct another $36 from Facebook's stock price and add to earnings the estimated $1.50 of losses they generate.
After these calculations are figured in, we are paying $208 for core Facebook/Instagram with consensus estimates of $12 in 2021—a P/E of only 17x. For a high growth, strong cash generator like Facebook, an adjusted P/E of less than the S&P 500 strikes us as a bargain. And, if you haven't yet tried the new $299 Oculus Quest 2 virtual reality gaming system (by Facebook), you're in for a treat.
Strong Opinions Weakly Held
Unlike many value investors, I believe I learn more from reading about successful growth managers, hedge fund managers and commodity traders than I do from reading more about other value managers. If you're going to read one book on investing, read about Warren Buffett (Trades, Portfolio). But if you're going to read 10, why read 10 about the same person or even about people who all invest like him? Long-time readers know that I'm a fan of Jack Schwager's book, Market Wizards (1989), which covers 17 successful investors with very different strategies. I find it interesting that regardless of their strategies—whether day trader or long-term investor, whether focused on fundamental or technical analysis—the most successful investors stress the importance of a disciplined strategy, knowing themselves, controlling emotions, having conviction and admitting mistakes early.
In November, Schwager released the latest in his "Wizards" series, Unknown Market Wizards. Like the original, this book contains interviews with successful investors who all act very differently than we do at Oakmark. I found the interview with commodity trader Peter Brandt most interesting. Brandt uses technical analysis to predict commodity price movements over the next two to six months. What could that possibly have in common with Oakmark? Brandt cites the importance of having "strong opinions weakly held" (also a popular Silicon Valley mantra). You might be saying, "Wait, that sounds like a contradiction." The very act of investing requires strong opinions. When you make an investment, you are asserting that your estimate of the proper price is better than the consensus opinion of all other investors. But why should that opinion be "weakly held?" Because there is a good chance you are wrong and the faster you correct your mistake, the less it is likely to cost you. Psychology makes it difficult to stay receptive to new information, especially when that information runs counter to your thesis. Yet overcoming this resistance to non-confirming information is essential to investment success.
So, what are the strong opinions that we hold weakly today? As value investors, we are used to believing that the world will return to "normal" faster than is implied by stock prices. That is especially true now, when everyone has an opinion about which 2020 changes will become permanent. With most health experts saying that all of us who want to get vaccinated will have that opportunity by midyear1, the constraints on normal behavior should soon be lifted. So what will the "new normal" look like? Some of the pandemic changes have led to real improvements—think of the transition to "touchless" everything, from doors to faucets to toilets to elevators. Why would we want to turn back from these changes? But apart from improvements like these, we think the new normal will be a lot like the old normal.
One example of the "new normal" that we think will persist is the growth of all things digital. During the lockdown months, video streaming gained share over linear television. As a result, several of our holdings benefitted, including obvious players like Netflix (NFLX, Financial) and Alphabet (GOOG, Financial) (YouTube), but also less obvious names like internet service providers Charter Communications (CHTR, Financial), Comcast (CMCSA, Financial) and T-Mobile (TMUS, Financial). Online retail also gained at the expense of brick-and-mortar shopping, which boosted holding Qurate Retail Group (QRTEA, Financial). The growth of digital also accelerated in the financials sector. Processing online transactions is much less expensive than in-branch banking, a trend that helped several of our holdings, including Ally Financial (ALLY, Financial), Bank of America (BAC, Financial), Capital One (COF, Financial), Citigroup (C, Financial) and Wells Fargo (WFC). We think that, across industries, the dominance of digital will continue because it is more convenient and there's little incentive to revert to the old way of doing things.
But what about travel? Both leisure and business travel fell to near zero in the spring. Business travel has barely recovered and leisure travel has primarily been limited to day trips or camping close to home. During a CNBC appearance when I talked about our investments that we believe would benefit from a travel recovery (American Express (AXP), Apache (APA), Booking Holdings (BKNG), Concho Resources (CXO), Diamondback Energy (FANG), EOG Resources (EOG), General Dynamics (GD), GE (GE), Hilton (HLT), MGM (MGM)), the interviewer responded that many people think it will take a decade for travel to recover. Did travel fall because consumers found a superior alternative? No. Therefore, we expect leisure travel to strongly rebound and think lots of trips cancelled in 2020 were just deferred. Since unused vacation days often carry over, leisure travel might even rebound to an above-trend level after restrictions are lifted. Are Zoom (ZM) calls superior to business travel? We believe video calls are superior to audio calls and will likely maintain importance as a substitute. But, paraphrasing investor Sam Zell, when everyone is connecting via Zoom, someone is going to get on a plane for a face-to-face meeting and they will win the business. We can't wait to resume travel to meet in person with our clients and management teams. We think business travel will be robust in 2022.
How about work from home? The media is full of stories about employees enjoying their time away from the office, such as the USA Today survey showing 44% of those working from home claiming an improved work-life balance. But work from home might be working better for employees than it is for their employers. While most of our companies were thrilled with how well the March emergency was handled, as time wore on, more of them expressed concern about failing to properly on-board new hires, not cross-training employees, inadequate career evaluation, limited performance measurement, deferred special projects and so on. We admire Reed Hastings and the corporate culture he has built at Netflix. Reed says corporate culture suffers when employees aren't together, so Netflix employees will be back in the office the day after they can be vaccinated. We agree. Our investment team has been back in the office since June and we want the other employees back as soon as possible. We think most businesses will ask employees to return to the office by the second half of 2021, a move that we believe would benefit our holdings Bank of America, Citigroup and Wells Fargo due to office building mortgages they own as well as CBRE Group (CBRE) because of its commercial real estate services, and Keurig Dr Pepper (KDP) for its breakroom coffee.
Other aspects of life that we expect will return to normal and benefit certain portfolio holdings include dining out (Booking Holdings's OpenTable reservation business, Constellation Brands (STZ) for on-premises consumption of beer, and banks, such as Bank of America and Wells Fargo that own mortgages on restaurants), advertising (Alphabet, Facebook), corporate IT projects (DXC Technology (DXC), Gartner (IT), Workday (WDAY)), discretionary hospital procedures (HCA Healthcare (HCE)), death rates (AIG (AIG), Reinsurance Group of America (RGA)), interest rates (financials), employment levels (banks) and economic activity (cyclicals).
In short, we think 2022 will look a lot more like 2019 than 2020 and we expect to start seeing signs of that in the second half of 2021. Believing the new normal will be a lot like the old normal may make us outliers, but "strong opinions weakly held" is business as usual for Oakmark. Our thesis for each investment, almost by definition, differs from consensus. Our responsibility is, and always has been, to monitor any new information to constantly challenge those theses. If we are correct that normal will return faster than others expect it will, we believe our stocks are well-positioned. But we know we could be wrong, so we will be carefully watching for any comments or data that would invalidate our thesis and call for altering our position.
Excitement about the vaccine led to a strong quarter relative to the S&P 500 for our "return to normal" portfolio. Some investors are even asking if we think it is too late to invest for a "value recovery." As I wrote last quarter, the longer term data suggests otherwise. If, four years ago, you invested in the Russell 1000 Growth Index instead of the Russell 1000 Value, you'd now have twice as much capital. Yes, the Russell 1000 Value outperformed the Russell 1000 Growth last quarter, but only by about five percentage points. On a long-term chart, last quarter's reversal is a barely noticeable blip. The Russell 1000 Value companies remain much cheaper than those in the Russell 1000 Growth Index and should also benefit much more from a return to normal. We believe that, generally, our portfolio companies will benefit even more.
In closing, be sure to read the report from my colleague Adam Abbas for the new Oakmark Bond Fund. We believe that the Oakmark Equity and Income Fund has demonstrated that our business valuation methodology is useful for valuing all corporate securities, not just equities. Further, we believe that the equity investment opportunities we've uncovered by adjusting GAAP income when it doesn't reflect our view of value creation also uncovers mispriced fixed income securities. While some firms have started bond funds because of how well the bond market has performed, we launched in spite of that. The Fund currently has a much lower duration than its peers, and we expect that to continue until interest rates (adjusted for inflation) increase to levels more in line with historic norms. I'm personally an investor, and in case you are wondering, I used cash to fund my purchase rather than reducing my equity investments.
Best wishes for a happy, healthy and prosperous 2021.
1Watson, Kathryn and Tillett, Emily. (2020, November 22). Gottlieb says vaccine will likely be widely available by middle of 2021. CNS News. https://www.cbsnews.com/news/scott-gottlieb-vaccine-available-general-population-middle-2021-face-the-nation/
Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change and may change based on market and other conditions and without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.
Certain comments herein are based on current expectations and are considered "forward-looking statements". These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.
