2Q11 | Bill Nygren
Bill Nygren - June 30, 2011
Big is Beautiful
Every week seems to bring a new story about how much money is flowing into mutual funds. If we stopped after the headlines, we might wrongly conclude that mutual fund investors are once again positive about the stock market. And, because mutual fund inflows have historically been a contrary indicator, this trend might worry investors. During the first five months of 2011, investors poured about $135 billion into mutual funds, according to Morningstar. Funds that are typically lower risk, including bond and balanced funds, accounted for $82 billion, or over 60% of those inflows. Equity funds received just over half of that amount, or $43 billion. International funds and sector funds captured the majority of these flows, over $28 billion, followed by domestic small- and mid-cap funds at over $15 billion. Despite strong flows into mutual funds, large-cap domestic funds continued to experience net redemptions: investors have pulled out over a billion dollars so far this year. Given that large-cap domestic funds accounted for 30% of mutual fund assets at year-end, had they achieved their “fair share” of inflows, investors would have added over $40 billion, but instead they redeemed.
We watch fund flows to help determine which asset classes appear to be becoming popular and, perhaps, overpriced, and which asset classes seem so scorned that their valuations might have become compelling. You can’t blame investors for being fed up with U.S. large-cap equities. Many investors who bought large-cap stocks at their peak in 2000, as measured by an equal-weighted portfolio of the 50 largest cap companies in the S&P 500, lost 12% of their initial investment and wasted more than 11 years. Those investors also sacrificed the returns they could have earned if they had owned mid- and small-cap stocks (as measured by the S&P 400 and S&P 600), which each earned over 125%. Looking back, these investors regret that they hadn’t owned more small-cap equities, so many attempt to “fix” that problem by redeeming their large-cap funds and purchasing small-cap funds.
When investors focus just on past returns, they do not consider that such extreme divergence in returns can radically alter valuations and ultimately sow the seeds of a reversal. In March 2000, the 50 largest companies in the S&P 500, as measured by market capitalization, traded at about 40 times earnings. The other 450 companies in the S&P had an average P/E of just over 16 times. The largest were priced at a premium of 150%. Back then, many investors argued that large-caps deserved their very high premium because of their economies of scale, diversified businesses, superior access to capital, greater liquidity and their ability to capitalize on global growth opportunities. At that time, we argued that this huge large-cap premium was indefensible, so the Oakmark portfolio contained none of the 50 largest companies.
Today, the 50 largest companies sell for 14 times expected 2011 earnings, which is a 7% discount to the other 450 companies in the S&P 500. Today, most investors argue that large-cap companies deserve a discount because they tend to be less focused, less nimble and are less likely to be acquired. Again, we disagree with that rationale. Balancing the advantages and disadvantages of large-cap companies, we conclude that large businesses deserve a moderately higher P/E than small businesses because they tend to be less risky. Over generations, large-caps have cycled from big premiums to small discounts relative to small-caps. Today, large-cap equities as a class are priced at a 7% discount, so we believe that they are poised to achieve better long-term performance than the small- or mid-cap categories. In the Oakmark Fund, we currently own 10% of the stocks in the S&P 500, but we own 36% of the 50 largest capitalization stocks.
Cash is Not Trash
One investment characteristic that we believe equity investors have undervalued, especially in the largest companies, is strong corporate balance sheets. Last September, we wrote about balance sheet strength as measured by the ratio of net debt to trailing EBITDA (for non-financial companies). We cited Credit Suisse data for the S&P 500 showing that debt averaged 1.7 times EBITDA over the past 20 years, but stood at only 1.3 times EBITDA in mid-2010. We commented that, as corporate earnings recovered, it was likely that the 20-year record low of 1.2 times EBITDA might be broken. Indeed, Credit Suisse’s 2010 year-end data shows that a new record was achieved—net debt to trailing EBITDA for the S&P 500 fell to just 1.16 times.
Why do we care? Because strong balance sheets represent hidden earnings power. During the 2008–09 recession, access to credit became restricted and companies became unusually cautious. Managements consequently responded by strengthening their companies’ balance sheets. Now, as earnings are recovering, we expect managements to put their balance sheets back to work. Given today’s low interest rates and below-average P/E ratios, earnings typically increase when managements invest their cash or borrow to invest. By our estimates, if corporate borrowing increases to historically average levels, and if managements use that capital to repurchase stock, EPS should increase by about 7%. Effectively, the P/E ratio of the market is nearly a full point higher now than it would be if balance sheets had historically normal levels of debt.
We’ve written previously about how balance sheet strength and low dividend payout ratios set the stage for above-average dividend increases, as well as enhanced EPS growth from share repurchases. Companies can also use their cash for acquisitions, an action that the market is increasingly greeting with approval. During most of my career, when a company announced an acquisition, its share price would fall by nearly as much as the premium it paid to the acquired company. For example, if a company offered $5 billion to purchase a publicly traded company that the market was valuing at $4 billion, the acquirer’s stock would typically fall by about $1 billion. But in today’s market, acquisitions have boosted both the seller’s and the buyer’s share prices. So far this year, publicly traded companies have announced 40 acquisitions of over $1 billion in size, with at least part of the purchase price paid in cash. On average, the acquiring company’s stock price increased 2.5% on the day the acquisition was announced. Given today’s modest valuation of cash, most of the time when managements put that cash to work - whether as a dividend, share repurchase or acquisition - it is viewed as good news.
At the end of the quarter, investors were worried about Greece’s debt problems, the end of QEII and the stalled political negotiations over the U.S. borrowing limit. We are focused instead on modest P/E ratios (especially for big businesses), strong corporate balance sheets, improving earnings, share repurchases, higher dividends and low returns on competing investments. I believe that business fundamentals and valuations will be more significant drivers of long-term returns than the crisis du jour.
William C. Nygren, CFA
As of 6/30/11, Credit Suisse Group represented 0% of the Oakmark Fund’s total net assets and 0% of the Oakmark Select Fund’s total net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Source: Morningstar DirectSM Fund Flows.
The S&P 500 Index is a broad market-weighted average of U.S. blue-chip companies. This index is unmanaged and investors cannot actually make investments in this index.
The S&P MidCap 400 Index is an unmanaged broad market-weighted index of 400 stocks that are in the next tier down from the S&P 500 and that are chosen for market size, liquidity, and industry group representation. This index is unmanaged and investors cannot invest directly in this index.
The S&P SmallCap 600 Index is an unmanaged broad market-weighted index of 600 stocks that are in the next tier down from the S&P 500 and that are chosen for market size, liquidity, and industry group representation.
This index is unmanaged and investors cannot invest directly in this index.
The Price-Earnings Ratio (“P/E”) is the most common measure of the expensiveness of a stock.
EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.
The discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.