January 20, 2016 - Robert Bierig
Robert Bierig is a Portfolio Manager and U.S. Investment Analyst at Harris Associates. Prior to joining Harris Associates in 2012, Robert was a Managing Principal at Amethyst Capital Management, Managing Director at GEICO Investments, Investor at Frist Capital, Investment Analyst at ESL Investments, and an Investment Banking Analyst at Morgan Stanley. He received a BA from Duke University.
For the last few years, many value investors have complained that finding cheap stocks has been especially difficult. One reason is that they tend to focus on traditional “value” metrics, such as a low price-to-earnings ratio, a low price-to-book ratio, or a high dividend yield. You might imagine that the problem has been due to the average stock looking overpriced on these metrics. In fact, however, the median P/E multiple of 16x for companies in the S&P 500 Index has not been far out of line with history over the last three years. Rather, the challenge has been that the distribution around the median has been unusually tight. As a result, the number of stocks meeting traditional “value” criteria has been smaller than is typically the case.
Since 2013, an average of only approximately 35 non-financial companies in the S&P 500 Index have sold below two-thirds of the median multiple at any given time whereas roughly 100 non-financial companies sold at a similar discount to the median in 2009 (the median itself was also only 11x in 2009). To make matters worse, several of the discounted companies in the last few years have been what we consider to be either low-quality businesses or former high-fliers that now face structural challenges from technological disruption. In light of this unusually tight distribution, it is no surprise that many value investors have had trouble finding enough stocks with which to build their portfolios. Moreover, it is also no surprise that these investors have held an elevated level of cash—a natural outcome of their dearth of investment ideas—even though cash offers a particularly low return in the current interest rate environment.
A broader definition of value
At Harris Associates, we take a different view. Like most value investors, we are pleased when the market offers us the chance to buy average-quality businesses at low prices. But we also recognize that a tight P/E distribution creates a set of opportunities that is equally compelling as long as the median multiple is not too lofty. When high-quality companies with unusually long runways for above-average growth—like Alphabet, Amazon, MasterCard, Monsanto, and Visa—were selling for an unusually small premium relative to the rest of the market, we made significant investments in them. We recently sold our position in Amazon (first purchased in 2014) because the stock quickly reached our estimate of intrinsic value, but we continue to hold Alphabet, MasterCard, Monsanto, Visa, and several other “growth” stocks in many strategies. Some market commentators may not view these stocks as “value” investments, but they were (and are) nevertheless cheap when considering growth as a component of value.
Warren Buffett has written that the distinction between “growth” and “value” is based on a false premise. We share this view and believe that the “growth” and “value” style boxes create more confusion than clarity. After all, we always think of growth as a variable—and a particularly important one—in our calculation of the intrinsic value of a given company. To use a simple example, if Company A grows its cash flows at 6% for 30 years and Company B grows at 3% over the same timeframe, Company A is worth nearly 65% more than Company B today assuming that both companies converge to a 3% growth rate thereafter1. Our appraisal of what any company is worth is based on quantitative factors like its growth rate and returns on incremental capital as well as on qualitative factors like its management quality and stability of cash flows.
Outperformance requires flexibility
The 12% sell-off in the S&P 500 Index since July 2015 has caused the median P/E ratio to decline and the distribution around the median to widen. As a result, in many of our strategies, we are once again finding opportunities in stocks like Ally Financial, Cummins, and Fiat Chrysler that are cheap on traditional “value” metrics while at the same time continuing to hold “growth” stocks that still do not trade at an appropriate premium. This broad approach to defining value—looking at low-growth companies, high-growth companies, and everything in between—is one of the reasons why we expect our strategies to continue to outperform their benchmarks. We believe that such flexibility is not merely “nice to have”—it is essential to generating outperformance across ever-changing market conditions.
1This calculation assumes an 8% discount rate.
The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable.
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.
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