Though periods of high volatility are nerve-wracking, they have historically not been a predictor of poor forward returns, says the Oakmark manager.
Bill Nygren, CFA, is portfolio manager of Oakmark OAKMX, Oakmark Select OAKLX, and Oakmark Global Select OAKWX. He recently answered our questions on corporate cash hoards, opportunities in large caps, the recent market volatility, and the fund's consumer cyclicals stake.
1. Many companies have built up their balance sheets because of market uncertainty. What do you expect management to with all this cash?
The credit crunch in 2008 scared companies--they feared they'd be unable to roll over their debt. For that reason, we've seen companies get very conservative with their debt. Today, S&P 500 Debt/EBITDA ratios are the lowest in 20 years, and at many companies, near-term maturities have been pushed out to where they can be paid off with expected cash flow instead of requiring refinancing. Some degree of conservatism is admirable but, like many things, in excess a virtue becomes a vice.
Companies today are underearning because of their excess liquidity. We estimate that the S&P 500 P/E could be a point lower (11 instead of 12) if companies simply returned their balance sheets to historically normal debt levels.
For most companies, the preferred way to put cash to work is to invest in their own businesses to accelerate organic growth. But in today's weak economy, most companies don't believe they can increase sales by increasing their capital spending. This has led many economists to forecast dismal gross domestic product growth, which implies dismal corporate profit growth. One of the reasons we are more optimistic is that we believe that outlook ignores the EPS growth we will see as corporate excess liquidity gets invested. Just because capital spending isn't projected to produce good rates of return doesn't mean that companies can only amass piles of cash that produce almost no interest income. They can use that cash to repurchase their stock, make acquisitions, and increase their dividends.
Many companies are already putting their cash to good use, and we expect that trend not only to continue but to accelerate. In the Oakmark Fund OAKMX, we hold 56 stocks. Compared with a year ago, 40 are paying a higher dividend, 37 have fewer shares outstanding, and 30 have done both. Let me give a couple of examples of what our companies are doing with their cash.
At the end of 2009, DirecTV DTV had 933 million shares outstanding. It has decided to put all of its excess capital, along with some additional borrowing, into share repurchase. Shares outstanding are expected to fall to about 720 million by the end of this year. As a result, each share of DirecTV will own 30% more of the business than it did two years ago.
Another company, TE Electronics TEL is doing a little bit of everything. Over the past year, it raised its dividend from $0.64 per share to $0.72, a 13% increase and a level that about matches a 10-year U.S. Treasury bond. It also bought back 4% of its stock, and it purchased a connector company that added about 10% to its sales and gave it a stronger product line. Even with all that activity, TE Electronics has less debt outstanding than it did three years ago during the credit crunch.
2. Looking across the market-cap spectrum, where do you see the best opportunities today? Why?
Large-cap equities are, in my opinion, extremely attractive. Valuations today are not demanding. The S&P 500 P/E is about 12 times, compared with a historical average of about 15 times, and would fall to 11 times if balance sheets weren't so cash-heavy. Dividend yields are also very attractive relative to bond yields. Typically, equity investors have had to sacrifice current income relative to bond investors in order to participate in expected earnings growth. Today, an S&P 500 investor can collect a current dividend yield that exceeds a 10-year U.S. Treasury's yield and still get the upside of expected growth. Not since the 1950s has that opportunity existed. And with companies paying out only about a fourth of their earnings, we believe the three fourths they retain can be used to produce EPS growth that significantly exceeds corporate profit growth.