2Q14 | Bill Nygren
June 30, 2014
With 2014 now more than half over, it seems like a good time to look ahead to next year. The consensus S&P 500 earnings estimate for 2015, as computed by FactSet, is $133. That results in a forward P/E ratio of just less than 15x. Relative to the index’s long-term historical average, which is in the mid-teens, the current valuation level suggests to us neither unusual opportunity nor risk. Given that, why is there so much talk about the market being overvalued? I think three main reasons explain many investors’ negative outlook.
Missed the bull market
First, the market was much cheaper five years ago. The S&P 500 bottomed in March 2009, and, including dividends, it has more than tripled since then. Almost by definition, more investors were negative at the market bottom than at any other time. The speed of this stock market recovery has made it especially difficult for those bears to admit their mistake and get invested again. Instead of viewing March 2009 as an anomaly (we look back on it as a once-a-generation buying opportunity), they cite the unsustainable increase since then as a reason to remain on the sidelines.
A stock’s previous price rarely helps predict its future value. The market is clearly not as cheap as it was five years ago, and it is highly unlikely to triple in the next five years. Still, that fact is of little help to investors trying to decide whether or not they should own stocks now. Future earnings expectations are much more important than historical prices for assessing where a company should be priced today. And based on reasonably good earnings expectations, we don’t believe the case has been made for declaring the market overvalued.
Financials – never again
Second, many of the stocks that now have low P/Es on expected earnings are financials, and after their role in the crisis, many investors, including many value investors, have completely sworn off owning them. The argument usually goes something like this: “I lost a lot of money on my financial stocks during the crisis. The reason I lost money is that financial stocks have become very complicated and as a result are too difficult to value. To avoid future losses I will avoid investing in this industry.”
We also lost money in financial stocks during the crisis, but have come to a very different conclusion as to why. Financial companies had too much leverage, they let their underwriting standards decline, and most importantly, the real estate market crashed. Banks, as an example, collect deposits and lend them out, largely against real estate. If you had asked any investor in 2007 how their bank stocks would fare if real estate prices fell by 30%, I doubt that even one of them would have said, "I think they’d be fine." Our big mistake was that we didn't see the real estate crash coming. Today, financials are less levered, they have tighter underwriting standards, and most importantly, they do not seem likely to face another crash in real estate prices.
One of my co-managers for Oakmark Select, Tony Coniaris, posted an excellent piece on our website outlining our rationale for being so positive on financials. Today, the sector most of the Oakmark Funds are invested the heaviest in is financials, and I think we are in good company. As of year-end, Warren Buffett’s Berkshire Hathaway had invested over 40% of its public stock portfolio in financials, and, if you include its Bank of America warrants, that percentage increases to the mid-40s.
Nothing else is cheap
The third reason investors cite for not owning stocks is that it has become hard to find stocks selling at low P/E ratios. The median multiple on forward earnings estimates for the S&P 500 stocks today is 17x. (Low multiples on some mega-cap companies reduce the cap-weighted S&P 500 to 15x.) Though certainly higher than the 11x median in 2009, on its own, the level of 17x isn’t terribly problematic. A bigger issue is the distribution.
Back in 2009, not only was the median P/E much lower, but the distribution around that median was very wide. Of the 500 stocks in the S&P 500, 117 sold at less than two-thirds of the market multiple, and only 19 of those were financials. That universe is very common hunting ground for value managers. We all like to identify those companies we believe deserve to be priced like average businesses when we can buy them for less than two-thirds of the average multiple. If we are right, when the gap closes, we can make a 50% profit. With so many cheap stocks to choose from in 2009, even value managers who didn’t want to buy financials could easily build a portfolio full of cheap stocks and wait for regression to the mean.
Today, however, the distribution of P/Es around the median has become very tight. Only 39 of the S&P 500 companies sell at less than two-thirds of the median multiple. And 15 of those 39 are financials. For the investor who uses that as their definition of “cheap” and who has sworn off financials, that leaves only 24 stocks to consider. Throw out the poorly managed and structurally disadvantaged companies, and there aren’t nearly enough stocks left to build a portfolio. Many investors who follow an approach somewhat like that have simply concluded that the market is too expensive and have raised cash hoping for a market decline. (Note: The dispersion in 2009 was somewhat high, but not an extreme anomaly. In 2004, five years before the bottom, the S&P 500 median multiple was 21x, and 95 stocks sold at or below 14x earnings, two-thirds of the median multiple.)
Though we too are always looking for average businesses at great prices, we believe the tight P/E distribution creates a different opportunity. When the market is pricing everything as if it were average, we’ll happily buy great businesses. To us, buying great businesses at average prices is just as much value investing as is buying average businesses at great prices. So we see opportunity today in the other half of the distribution—companies selling at a smaller premium than usual. Investors today aren’t asked to pay much extra to own businesses that we believe will enjoy long periods of above average growth. A company like Google, which benefits from advertising moving online, or Visa and MasterCard, which benefit from plastic replacing cash, appear well positioned for an extended period of growth. Yet their stocks are priced as if investors will soon view them as only average businesses. We think that is exciting.
You bought what?
That brings me to our newest position, which will no doubt make some question our credentials as value investors: Amazon.
Consensus forward earnings for Amazon are a little over a dollar. At the median forward P/E multiple, Amazon would be priced in the low $20s. So, even though the stock fell $124 from its January high of $408 to a May low of $284, its P/E ratio remained in nosebleed territory. But we have never believed the P/E ratio was the be-all and end-all for valuation. Amazon is a retailer – a very efficient retailer. When we compare stocks in the same industry, we often compare their market caps to their sales rather than their earnings. Since 2001, Amazon has generally traded at a cap-to-sales ratio of two to four times that of the average bricks-and-mortar retailer. Having fallen to just under two recently, one might say that, as an advantaged retailer, Amazon looks somewhat attractive.
But that metric misses an important change in Amazon’s business. Third-party sales (sales on amazon.com where the seller is not Amazon) have grown more rapidly than Amazon’s direct business. And on those transactions, accounting rules credit only Amazon's commission as revenue. So if you buy a $100 item on amazon.com from a third party, Amazon is only allowed to show about $13 of revenue, nearly all of which is gross profit. For third-party sales, Amazon is effectively functioning as the mall owner, collecting a percentage of sales as rent. Amazon earns less gross profit on that sale than an average retailer would, but it is also a much lower risk endeavor. For that reason, we think a dollar of third-party sales should be worth about the same as a dollar that Amazon sells directly.
It gets interesting when we adjust our cap-to-sales ratio comparison to include estimated gross third-party sales. Instead of selling at twice the ratio to sales of the average bricks–and-mortar retailer, Amazon is selling at only 80%. So, relative to gross sales, Amazon's stock would have to increase 25% to be priced consistent with the very companies whose survival Amazon is threatening. On that metric, Amazon has never been cheaper.
Should Amazon sell at a discount on sales? The answer largely rests on what Amazon could earn if it wasn’t investing so heavily for future growth. For most asset heavy businesses, growth investment is primarily on the balance sheet, and is slowly expensed on the income statement as depreciation throughout its useful life. In an asset–lite business like Amazon, however, most growth spending gets directly expensed to the income statement, creating a much larger immediate reduction in income. We believe that if Amazon sharply curtailed its growth spending so that it only grew at the rate other retailers grow, it could produce similar operating margins. But we don't want them to do that. We believe that management is maximizing value by investing heavily for super-normal organic growth. So, yes, Amazon is a rapidly growing business. But at this price, we believe it is also a value stock.
William C. Nygren, CFA
View other commentary and letters from Bill here.
As of 06/30/14 Google Inc. represented 2.1% and 4.1%, Visa, Inc., Class A 2.0% and 0%, Mastercard, Inc., Class A 2.1% and 5.4%, and Amazon, Inc. 2.1% and 4.0% of the Oakmark Fund and Oakmark Select Fund’s respective portfolio of net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Click here to access the full list of holdings for The Oakmark Fund as of the most recent quarter-end.
Click here to access the full list of holdings for The Oakmark Select Fund as of the most recent quarter-end.
The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market. All returns reflect reinvested dividends and capital gains distributions. 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.
The Oakmark Fund’s portfolio tends to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Fund’s volatility.
Because the Oakmark Select Fund is non-diversified, the performance of each holding will have a greater impact on the Fund's total return, and may make the Fund's returns more volatile than a more diversified fund.
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.