THE OAKMARK AND OAKMARK SELECT FUNDS

At Oakmark, we look for stocks with prices less than 60% of intrinsic value, with intrinsic value that is likely to grow and with management that acts in the interest of outside shareholders. The combination of these factors creates our biggest competitive advantage—the ability to be more patient than most investors.

Last quarter was brutal! As measured by the 17% decline in the S&P 500², the market lost more last quarter than in any quarter in the past fifteen years—and this quarter followed a couple of very tough years. The New York Times publishes daily a list of the twenty most widely held stocks and shows their recent performance. That list shows an average loss of 38% over the last year and 58% since the March 2000 peak. Back at the peak, research reports were arguing that stocks would go higher, primarily because they had gone up so much already, which sounded backwards to us. This week I read a report on one of our holdings that used the same rear-view mirror logic: "We have lowered our price objective based on the recent weakness in the stock." Effectively, the shell-shocked analyst is saying that his model projects a price that makes the stock look too attractive, so he is going to ignore the model. Media reports are not any better as story after story points out that over the past five years, the average equity investor has lost money, and then goes on to question why anyone would own stocks today. Those articles are like the weather forecast made by Bill Murray's character, Phil Connors, in Groundhog Day: "It's gonna be cold... it's gonna be gray... and it's gonna last for the rest of your life!"

As we watch the market go down, seemingly every day, it's hard to keep the perspective that business values are much more stable than are stock prices. Just as business value growth did not match the 250% gain the S&P 500 achieved from 1995 to March of 2000, business values have not subsequently declined 45% as the S&P 500 has. The observation that business values are relatively stable (but generally grow over time) leads to our conclusion that the more extreme stock price moves become, the more likely they are to reverse. As the bull market of the 90's neared its end, investor surveys showed expectations of long-term annual percentage gains in the teens. We all knew that was not achievable. Now, after the market has fallen sharply, return expectations have also fallen, with many investors now uncomfortable projecting future returns greater than zero. Historical returns and future returns necessarily have an inverse relationship. The more stock prices fall, the greater the opportunity is for above-average returns.

Highlights

Business values are much more stable than are stock prices.

We estimate the highest price a buyer could pay to own a business and still earn an adequate return, and then we buy at 60% of that number.

Owning stocks that sell below our intrinsic value estimate provides a margin of safety.

John Burr Williams was one of the first to represent mathematically the value of a stock as the present worth of all its future dividends. In his 1938 classic The Theory of Investment Value he states:

That approach defines value investing—estimating the intrinsic value of businesses and only purchasing them when negative opinions cause prices to reach discounts to value. Value investing is what we do across The Oakmark Family of Funds. The basic premise of value investing is that the return achieved while owning a stock can be broken down into two components: the change in business value during the holding period, and the change in the stock price relative to its business value. We attempt to identify stocks selling below 60% of business value, anticipating that the narrowing of the price-to-value gap will be a significant positive contributor to our return.

All value investors share this basic approach of buying at a discount to value, but how value is estimated differs widely. Benjamin Graham was one of the early developers of the value investing style. In his book with David Dodd, Security Analysis, he states that "asset values are virtually ignored in the stock market." He considered the best investment opportunities to be "those cases in which the market price ... is less than the net current assets."

Following Graham's work, a generation of value investors focused on the balance sheet and accounting book value as the primary indicator of intrinsic value.

One of Graham's students, Warren Buffett, is generally viewed as today's most successful value investor. Buffett broadened the value investing perspective. In his 1996 Berkshire Hathaway annual report he wrote: "My own thinking has changed drastically from thirty five years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic goodwill. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring goodwill and that utilize a minimum of tangible assets."

With this approach, value investors moved from a balance sheet focus to an income statement focus. The intangible assets Buffett looks for don't get included on the balance sheet but represent competitive advantage that allows companies to sustainably earn high returns on equity. Using that thought process, the P/E⁷ ratio became the favorite metric of most value investors for estimating business values.

At The Oakmark Family we are not believers in a "one size fits all" approach to estimating business values. For some companies, a book value⁸ or asset value based approach provides a good estimate of value. Natural resource companies, such as Burlington Resources, are a good example—a large number of transactions suggest that there is a fairly consistent price paid per MCF of natural gas. On the other hand, an asset-based approach would be nearly useless for valuing the consistently growing tax preparation business of H&R Block. For H&R Block, a price-to-earnings ratio is much more useful than a price-to-book⁹ ratio for estimating value. And for a company in many different businesses, like AOL Time Warner, we value each business unit using the measure we find most appropriate, sum up all the values, then deduct net debt to reach an estimate of the equity value.

What we do on an industry-by-industry and company-by-company basis is to look at acquisitions to gauge the most appropriate summary statistic for estimating business value. For any given business, book value, earnings, cashflow, sales, subscribers, or barrels of oil might give the best indication of value. For a different business, a different measure may be most useful. When we develop the rules-of-thumb that explain previous acquisition prices, we apply them to the stocks we are analyzing. For each stock we try to figure out the highest price a buyer could pay to own the entire business and still earn an adequate return on their investment. Then we wait for the stock to sell below 60% of that value. When prices of the stocks we already own exceed 90% of our value estimates, we sell them.

Benjamin Graham summed up his investing approach with the phrase "margin-of-safety." Owning stocks that sell below intrinsic value provides a margin-of-safety that "is available for absorbing the effect of miscalculating or worse than average luck." Buying below intrinsic value not only lowers the risk, it increases the expected return. When we succeed at buying at 60% and selling at 90% of value, we achieve a return on our investment of not just the growth in business value, but an additional 50%. Our long-term track record shows that despite many mistakes, we have achieved above average returns with below average risk. We believe the primary reason behind this result is our disciplined approach to purchasing only undervalued stocks.