4Q11 | Bill Nygren
Bill Nygren - December 31, 2011
Something crazy happened the morning of December 13. When I turned on CNBC, the S&P futures were exactly unchanged from their December 12 close. Dead flat. Zero movement. In a normal year, no change would be common or even expected. But in 2011, especially during the second half of the year, days frequently started with stock prices at very different levels from where they were just hours earlier. It became the norm for pre-market prices to be up or down 1% or 2%. Late in the year, S&P 500 volatility exceeded 30%, more than three times the volatility levels of five years ago.
If you’ve read our letters before, you’ve no doubt read our comments that equate volatility with opportunity. We try to capitalize on extreme price movements that we believe are disconnected from business value. In volatile markets our portfolio turnover often increases: We dispose of those stocks that reach our sell targets and then use the resulting funds to purchase new stocks that have fallen beneath our buy targets. But in our September annual report we disclosed that 2011 portfolio turnover actually decreased in each of our Funds. What happened?
First, the volatility in 2011 was directionless. Typically, volatility spikes when markets move way down, as they did in late 2008, or way up, as they did in 2009. In 2011, however, the S&P finished closer to unchanged than in any previous year, and its high for the year was only 24% higher than its low. For the previous 20 years, the average of that range was 31%. So, by that measure, 2011 provided less opportunity than normal for exploiting price changes. Further, the daily correlation between individual stocks was unusually high. As reported in The Wall Street Journal, there were more days in the second half of 2011 when 90% of the S&P 500 stocks moved in the same direction than there were during the entire five years from 2002 through 2006. We attempt to exploit price movement when some stocks move up while others move down. Despite 2011’s high volatility, there weren’t significant opportunities for adding value by swapping one stock for another.
How should individual investors deal with high volatility? I’d say they should pretty much ignore it. The financial media have business reasons to make investors believe they need to follow every zig and zag of the market and of their portfolio, but I don’t believe one needs to. And for some investors, the more often they look at their portfolios, the more nervous they get, which can be counterproductive.
We believe today’s investors have a once-in-a-generation opportunity to use asset allocation to add to their investment returns. It would be a shame to let anxiety about volatility get in the way of capitalizing on this opportunity. Stocks appear to us to be significantly undervalued relative to bonds. Despite that, many individual investors have been increasing their assets in bond funds and decreasing their assets in stock funds. Investors see how much more money they've made in bonds than in stocks over the past decade and regret not having been more heavily invested in bonds than they were. To make sure that doesn't happen again, they sell their stocks and buy more bonds.
A skeptical reader might ask, “Didn’t you say almost the same thing a year ago? And didn’t bonds blow stocks out of the water in 2011?” Yes and yes. We did think stocks were cheap a year ago. But companies now have higher earnings than they did a year ago, have fewer shares outstanding (meaning EPS grew even more than earnings), pay higher dividends and have even more cash on their balance sheets. We believe the average stock is worth more today than it was worth a year ago, yet it sells at about the same price. Bonds, on the other hand, had a yield a year ago that we believed offered insufficient reward for exposure to the risk of future inflation. Bonds today have a lower yield than they did a year ago – the yield is less than 2% on a 10-year Treasury. We believe bonds are even more overvalued than they were a year ago.
In our view, extrapolating past bond market returns into the next decade is a huge mistake. Matching the 74% returned by a 10-year zero coupon Treasury over the past decade is today a mathematical impossibility. A 10-year bond yielding under 2% cannot produce a return higher than 20% either over a short time period or over the entire life of the bond, even if interest rates go to zero. Equities, on the other hand, had a lousy return over the past decade despite good corporate earnings growth. That growth was offset by P/Es that fell from far above average to somewhat below average. Over the next decade, we believe earnings growth will continue, but P/Es are more likely to increase to their historical average than to continue declining.
So, I again encourage you to start the New Year by comparing your current asset allocations to your asset allocation targets. If you began 2011 right at your target levels, the bond market’s strong performance has almost certainly lifted your current bond allocation above your target level. And if you did what many investors did during 2011 – sold stocks to buy more bonds – you are even more overexposed to bonds. We believe that most investors need to sell bonds and buy stocks in order to return their portfolios to their target levels. This recommendation isn’t made just to reduce risk: We believe that from today’s price levels, equities will deliver much higher long-term returns than bonds will.
William C. Nygren, CFA
At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.
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.
Lauricella, Tom. “Stocks Have a Fever, and the Only Prescription Is More Correlation.” Wall Street Journal, October 20, 2011.
EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.
The Price-Earnings Ratio (“P/E”) is the most common measure of the expensiveness of a stock.
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.