quarter. To put that drop in perspective, there have only been six calendar quarters during the past 50 years in which the S&P has moved more than 20%. Then, in our second fiscal quarter, the S&P lost another 11%. The S&P has experienced double-digit changes in only thirty-eight of the past two hundred quarters—or just 19% of the time. The combination of these two consecutive declines and a further drop at the beginning of the third quarter resulted in the S&P being down 41% from our fiscal year end through March 9. That loss was then followed by a series of positive moves: a recovery during the rest of March, a 16% gain in our third quarter, and a 16% gain in the fourth quarter to trim the full fiscal year loss to 7%. Again, to put these numbers in perspective, in the past fifty years, the S&P has never experienced four consecutive quarters of double digit price changes (though it came very close to happening in 1983).
Unprecedented volatility created great opportunity for observers to play games with statistics. My favorite storyline, which started after the market had rallied about 10% from March 9, was that stock prices were moving up faster than the economy and therefore investors should be cautious. Though it is true that the S&P 500 is now 58% higher than it was at the bottom (and the economy isn’t), the problem with that comparison is that it implies that the price at the bottom was rational. One could just as easily say that the S&P, without including dividends, is down 31% from two years ago, down 5% from five years ago, and down 18% from ten years ago. Given that many indicators suggest we are already recovering from the recession, those declines over longer time periods seem excessive. More important than where stock prices have been is where earnings will be in the future. It is true that the S&P 500 price-to-earnings ratio no longer appears low relative to expected 2009 earnings. However, we believe that 2009 was heavily affected by unusual loan losses and unsustainable inventory reductions. If you eliminate those, then the price-to-earnings ratio looks pretty reasonable. If you add in some rebound in end demand, then that ratio is meaningfully below historical averages. As the market has risen, the magnitude of undervaluation has lessened, but we continue to believe that stocks remain fundamentally undervalued.
Taxation
Although the volatility we experienced in 2009 was extremely unpleasant, one silver lining was the opportunity it gave us to improve our Funds’ tax positions. As you probably know, mutual funds are required to annually distribute net capital gains to shareholders. Shareholders are then taxed on those gains, even if they continue to hold their fund shares. It’s a tax rule that we believe should be changed – having fund shareholders simply pay their capital gains when they sell their shares would sharply reduce their record-keeping costs, would encourage them to invest for the long term, would level the playing field between mutual funds and ETFs and would have a negligible cost, if any, to the U.S. Treasury. But, unfortunately, we aren’t in charge of tax policy, so we have to maximize value under the current rules.
At Oakmark, we actively manage our portfolios with the goal of maximizing after-tax returns without reducing pre-tax returns. Extreme volatility in the past year gave us two ways to capture tax losses that will defer future capital gains distributions. First, when the market was in freefall, none of our holdings hit our sell targets. However, we actively sold stocks we believed were somewhat undervalued in order to provide the funds to purchase stocks we believed were significantly more undervalued. During a strong market, the tax gain that results from those sales would give us pause – the valuation gap needs to be wide enough to make it worth realizing a taxable gain. In the weak 2009 market, however, most stocks were selling below our cost, so capturing the tax loss became an incremental positive to an already attractive transaction.
The second way we captured losses was trading around core positions. Usually, we don’t want to eliminate holdings that are selling below cost, because, in the absence of bad fundamental news, we view those stocks as even more attractive than when we purchased them. So instead of eliminating them from the portfolio, we’ll add to some that we believe are the most attractive and reduce some that we believe aren’t quite as attractive. After 31 days, we can reverse the trade, restore our original position, capture the tax losses, and hopefully add modestly to pre-tax returns. This tax trading is an important reason that our Funds had higher turnover last year than in prior years. As an example, the Oakmark Fund had turnover of 32% in Fiscal 2008. That increased to 61% in 2009, despite selling only 7 of the 49 securities that we started the year with. The result of this tax trading is that every one of the seven Oakmark Funds today has a loss carry-forward that will reduce future taxable gains distributions. Financial advisers often warn mutual fund investors that they may have to prepay capital gains because of mutual fund tax rules, but today, because of the actions we took during a tough market, our Fund investors will enjoy deferral of future gains.
Rebalancing
In these reports we have often discussed why shareholders would benefit from rebalancing their asset allocations after extreme price shifts. The concept is simple: as the old timers in the business say, “Trees don’t grow to the sky.” In other words, extreme performance can’t continue indefinitely. Rebalancing helps to mechanize a task that is very difficult psychologically: reducing exposure to asset classes that have increased in value and increasing exposure to asset classes that have decreased. We believe that it is beneficial to periodically rebalance various aspects of one’s portfolio: stocks versus bonds, domestic versus international and small cap versus large cap. If extreme performance is indeed unsustainable—and we believe that to be true—then it follows that periodic rebalancing reduces risk and increases return.
As an over simplified illustration, let’s assume that two investors each met with a financial adviser two years ago, and the adviser wisely set them up with a 60/40 asset allocation, $60,000 invested in the S&P 500 and $40,000 in the Barclays U.S. Treasury 7-10 Year Bond Index. Each investor sleeps well that night, knowing that their portfolio is prudently diversified. On March 9 of this year, both check their accounts. The S&P had declined by 56% subsequent to the financial adviser visit, while the Treasury Index increased by 19%. Both were glad that their 26% loss was much smaller than what their friends who had only owned equities experienced.
Then their paths diverge. Investor one, let’s call him Goofus (if you don’t remember Highlights just Google “Goofus and Gallant”), closes his investment file, pats himself on the back and goes on his merry way. Gallant, on the other hand, checks his asset allocation and sees that stocks now represent only 36% of his portfolio, while bonds have climbed from 40% to 64%. Realizing that his portfolio is now invested very differently than he’d intended, he sells some of his bonds, uses the money to buy stocks and restores his target 60% stock, 40% bond allocation. At September 30 the two investors are now in very different positions. First, Gallant is now over-invested in stocks, which have grown to 70% of his portfolio, while Goofus remains way below his target, having only 47% of his portfolio invested in equities. Just as important, Gallant has fully regained his losses while Goofus is still down 10%.
Sadly, there should have been a third investor in this example who mimics the self-destructive behavior investors frequently exhibit. This investor checks his account on March 9, is angry and scared that he’s lost so much in equities while bonds increased in value, so to prevent making that mistake again, sells half his equities to buy more bonds. At September 30, this investor now has only 25% of his assets invested in stocks, and he has lost nearly 20% of his initial assets.
We continue to believe that equities are attractive and are likely to achieve higher, though more volatile, long-term returns than bonds. After any large price change, we encourage investors to restore their portfolios to their target asset allocations, and this time is no different. Because of the large stock market rebound, those who were wise enough, or lucky enough, to rebalance earlier this year are now above their target equity allocation. Restoring appropriate balance to their portfolios requires selling some stocks. Most investors, however, didn’t increase their equity exposure when stock prices were down. Their portfolios are far below their equity targets. Those investors need to purchase equities if they want to return to their target asset allocation. And even though the stock market has improved considerably, it’s not too late; it never is. That’s because rebalancing is not about correctly guessing the market’s short-term trends. Instead, rebalancing positions a portfolio for the future, the direction of which we can never be certain.
William C. Nygren, CFA
Portfolio Manager
oakmx@oakmark.com
oaklx@oakmark.com
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.
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.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
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.
