May 3, 2017 - Bill Nygren
Bill Nygren has been a manager of the Oakmark Select Fund (OAKLX) since 1996, Oakmark Fund (OAKMX) since 2000 and the Oakmark Global Select Fund (OAKWX) since 2006. He joined Harris Associates in 1983 and served as the firm's Director of Research from 1990 to 1998. He holds an M.S. in Finance from the University of Wisconsin's Applied Security Analysis Program (1981) and a B.S. in Accounting from the University of Minnesota (1980).
Over the past 50 years, the trailing price-to-earnings ratio for the S&P 500 has averaged 16.1x. At the end of 2016, that ratio was 20.6x. Many investors have used that number or other variations to conclude that the current market is expensive and have therefore shifted their asset allocation away from equities.
We aren’t market timers at Harris. We have faith that the long history of the equity asset class outperforming other asset classes is likely to continue. Sure, there will be years here and there when the return on equities is negative, but over the long run, equities have dominated other asset classes and we see no reason for that to change. Other investors, despite professing the same faith in the long-term prospects of corporate America, spend a tremendous amount of time trying to guess when those down years will occur, believing their returns could be enhanced by moving to cash before the anticipated price corrections.
We don’t think there are many successful market timers. We’ve seen a lot of investors draw lines in the sand when they thought the market was overvalued: Some of the most conservative value investors thought stocks were overvalued when they could no longer fill a portfolio with companies priced below net-net working capital. Others drew that line at book value, or double-digit P/E ratios, or when stocks rallied so that dividend yields were less than bond yields. In all those cases, the investors who pronounced stocks as overvalued ended up missing out on substantial returns. Instead of retreating from their positions, they spent most of their time looking for more evidence that their negative calls were correct, just early. Given that we don’t try to time the market, and instead spend all of our time analyzing individual companies, we aren’t well positioned to win a debate with these market bears.
When we are confronted by these people, in addition to simply stating that “now” is always a good time to buy stocks, we will often introduce some contra-evidence in an attempt to make them a little less certain that they can time the market. Because many of our shareholders today are highly certain that we should be negative on the market, perhaps it is a useful time to introduce a bullish argument.
GM is one of our firm’s holdings. Last month, the activist investment firm Greenlight Capital put forth a plan suggesting that GM split its stock into two pieces: an income share that would receive the current annual dividend in perpetuity (or a lesser amount in any given year that GM cut its dividend below the current level), and a second share to which all growth would be attributed. Greenlight showed that based on its forecast of where the GM income and growth shares would be priced, GM stock would go up substantially. When we saw this, we wondered if there were broader implications.
What do you see if you apply the thought behind the GM proposal—separating the value of the current dividend yield from the value of future growth—to the S&P 500, and look at today’s pricing relative to long-term averages?
Greenlight suggested that the market would price GM income shares at a yield that is about 1.5x the yield on GM’s long-term bonds. That assumption seems logical because the income shares are lower in the capital structure, are perpetual, and bear the risk of dividend cuts. For our analysis, we assumed that the S&P income share would require a premium to Moody's Aaa Corporate Bond index, but because the exposure to dividend cuts is likely much less for the S&P than for GM, we arbitrarily decided to use a multiple of 1.33x the bond yield. Because we apply that ratio consistently across the entire period, the ratio we pick isn’t that important. What is interesting is to see is the historical variance in the percentage of the S&P price that can be attributed to income versus the percentage attributed to growth.
At year-end 2016, the Moody’s Aaa index stood at 4.1%. Taking a one-third premium to that, we assume the theoretical S&P 500 income shares would yield about 5.5%. Given a trailing dividend of $45.03, the estimated value of that income share would be $834. The S&P ended 2016 at 2239, so 37% of the value resided in the income share and 63% in the growth share. We performed that same calculation for the prior 50 years and found that, on average, investors paid 70% for the growth share.
The highs and lows of the historical graph make intuitive sense. The market paid less for growth—a mid-50s percentage of the total S&P price—near market lows in 1974 and 1977, then again in 2008 and 2012. In 1999, near the end of the highly speculative Internet bubble, the price of the growth share reached 89%, meaning that only 11% of the price reflected the value of current dividends. A regression analysis shows that forward five-year returns tended to be above average when the price of the growth share was low and below average when it was high.
Based on the year-end 2016 price for the growth share being 10% below average (63% vs 70%), this model suggests that stocks presently could be more attractive than usual. Additionally, it is worth adding that dividend payout ratios continue to be below historical levels. Over the 50-year period, the dividend payout ratio averaged 43%, meaning that 57% of earnings were being invested to support future growth. In 2016 the payout ratio was 41%, so 59% of earnings were invested for growth. Not only is growth cheaper today, but it is benefiting from more retention of earnings.
There are certainly many reasons to challenge this indication that stocks are cheap. Most importantly, interest rates could rise, directly lowering the value of the income shares. Future growth rates may fall short of historic growth, meaning the growth shares don’t deserve to sell where they did in the past. But remember, our goal is not to lead you to the conclusion that stocks are cheap today. The goal is simply to put a dent in the certainty that you know stocks are overvalued. Yes, P/E ratios are somewhat elevated relative to history, but given low interest rates, they might be at the appropriate level. We don’t profess to know. That’s why at Harris we continue to spend all our time trying to identify undervalued stocks, and remain invested, so that we can fully participate in the long-term returns of the equity asset class.
Writer’s Note: I want to make sure that using this example is not perceived as endorsing Greenlight’s proposal or its nominees for directors. There are a lot of practical questions surrounding this proposal, and we will cast our votes for GM directors based on the strength of their individual resumes and our assessment of GM’s needs, not the plusses and minuses of the share split.
Additionally, I want to again say that what is written above is not an attempt to show that we know how to time the market. Please take it as intended—a different way to look at the data that shows stock prices today might look more attractive than usual, just as the current P/E ratio suggests they might look less attractive. Might look attractive, not are attractive. The goal is to make you less confident that you know the future direction of the stock market. Our advice is never “buy now” or “sell now” but rather to consider your long-term asset allocation targets and periodically rebalance your portfolio to those targets.
Bill Nygren, CFA
Partner, Portfolio Manager and Chief Investment Officer - U.S. Equities
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