Is Value Investing as Cheap as It’s Ever Been?

On this episode of The Long View, Bill Nygren, a partner at Harris Associates and longtime manager of several Oakmark funds, talks about value investing, financials, interest rates, and more.

Here are a few excerpts from Nygren’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Oakmark Fund’s Portfolio

Christine Benz: Oakmark Fund’s OAKMX portfolio appears to be heavier in cyclical names than is normally the case. Some of this is your large stake in financials, but it’s also consumer cyclicals like Magna International MGA. Do these names look as cheap as they have at other times that recession worries have taken hold? Or is it at least partly a function of defensive and tech looking expensive right now?

Bill Nygren: It’s certainly partly the latter. Investors are paying up a lot for perceived high growth in technology and for what I would call safety in the low-volatility, high-dividend yield names. We tend to find those sectors expensive and don’t own much of that. So, it naturally pushes us into these names that do have a little more economic sensitivity, where we believe the market is rewarding you much more than it typically does to accept that risk in your portfolio.

I think there are a couple of other things. Some sectors that we’re heavily invested in, such as financials, today they seem to be part of, for lack of a better word, the risk-on/risk-off movements in the market. We think that’s disconnected from business value. Early in my career, financial stocks were generally not thought of as cyclical, tended to have betas less than 1, and were considered part of the safer section of one’s portfolio. Really, since the global financial crisis in 2008-09, the wild swings that we’ve seen especially in bank stocks have elevated the betas and the perceived economic sensitivity of that sector. So, yes, our portfolio has a lot of that risk in it, but we think it’s really more a day-to-day volatility risk than it is that the business models have become so economically sensitive.

We’ve got a large position in the real estate company CBRE CBRE. Historically, that had been a very cyclical business because most of its revenue depended on transactions. And when real estate transactions cyclically fell, the company’s earnings would go to just about nothing. So, it was a very cyclical stock. Today, the services parts of its business, such as janitorial services for tenants in their buildings, aren’t cyclical at all, and those are becoming the more dominant part of the business value. So, again, I think that’s the difference between a backward-looking statistical analysis that would suggest unusual economic risk for this business and a forward look based on where they’re actually earning their money today that would say it really isn’t all that cyclical.

And then, before we leave this topic, I think it’s also important to look at what the word recession really means. If you’re under 40 and in the investment business, you’ve seen two declines that were called recessions. I think the first half of last year was a recession, even though it didn’t get called that. But the two that were called recessions were the COVID outbreak and the global financial crisis. And both of those are more what I would call generational downturns. Most of the recessions during my business career have been the type, much like the first half of last year, where you’re surprised the first quarter was actually down, then there’s a debate of will there be a second quarter that’s down or not. And by the time you know you’re in a recession, we’re already working our way out of it. That type of recession was never as negative, say, for financial services as the past two were. I think also if we are facing a recession soon, it’s pretty unusual to start with an auto sales number that’s maybe 20% below average. Typically, we go into a recession with auto sales above the trendline, and then sales fall 20%. Auto sales might not even fall in a recession. We’ve never seen that before the recession, sales are so far below trend.

And then, the last point is, recessions typically hit unskilled labor harder than they hit any other sector of the economy. And that’s where there’s been such a shortage lately. You still can’t drive down any rural road in a community that’s got lots of machine shops without seeing signs for unskilled labor wanted $20 an hour, plus health benefits, plus vacation. The bottom quartile has seen real wage increases. There’s very strong demand for labor. And that, too, just is very unusual for a prerecession environment. And I think that might be a real surprise that if we do go into a recession, that the marginal borrower—banks tend to call it nice names like slightly below prime—those borrowers, if they’re employed, they’re going to pay off their car loans and their credit card debt. So, I think if we do go into a recession, we’re unlikely to see the kinds of charge-offs that have typically accompanied recessions for the banking industry.

Double the Interest Rates

Jeff Ptak: One thing that’s changed since we last spoke in 2019 is interest rates. They’re twice as high as they were then, give or take. It seems like this should benefit the stocks of firms that aren’t expected to derive as much of their value from distant cash flows, yet growth stocks have still bested value stocks with maybe the possible exception of a relatively brief period that’s since passed. Why is that? Why has growth continued to do well versus value?

Nygren: No, you’re absolutely right. The experience we had in 2022, where finally the Russell Value outperformed Russell Growth—I think it was by like 2,200 basis points—we looked at that coming on the tail of a horrible decade for the Russell Value Index and thought maybe things have finally turned. And then, in the first half of this year, the Russell Growth has outperformed Value by 2,400 basis points. So, it’s already reversed everything that value had gained last year. And that is contrary to what you’d think the duration of equities would suggest. Low P/E stocks, because they’re returning more of their cash flow early on, are the equivalent of short-duration bonds. And the growth stocks that maybe aren’t even making money today but are expected to make a lot of money 20 years from now, those would be the equivalent of very long-duration bonds. And when rates go up, you would expect long-duration bonds to fall the most and growth stocks to fall the most. And clearly, that’s not what’s happened this year. Though, if we look back over the whole 18 months, the two sectors, growth and value, haven’t performed that differently.

We were talking a little bit earlier about some of the sectors that we find attractive, tending to have more economic sensitivity than those sectors that we think are less attractive today. So, the industries like banking, auto, oil and gas, those sectors, that’s where single-digit P/Es are available. They would be the shorter-duration names. But because recession fears have remained so strong, I think that’s what’s held those names back and had them perform beneath the level that you would have expected, given their durations.

Is Value as Cheap as It’s Ever Been?

Benz: Some have argued that value, as it’s traditionally defined, is as cheap as it’s ever been. Do you agree or do you think that’s maybe too simplistic of a view?

Nygren: Well, I think statistically we can, prove might be too strong a word, but at least show that growth is very highly priced relative to cheap stocks than it has been over the past 30 years. A metric we like to look at is, if you take the S&P 500 and rank order them from highest P/E multiple down to lowest, what’s the 50th rated one, so the bottom of the first decile, and what’s the P/E on the 450th one? So, 50 names are more expensive, 50 names are cheaper. And then, we look at the ratio of those two. Typically, your expensive stocks over the past 30 years have been about 4 times as expensive as the cheap stocks. So, if the 50th cheapest stock had a P/E multiple of, say, 10, and the 50th most expensive had a P/E multiple of 40, you’d say that ratio is 4. Today, that ratio is between 6 and 7. So, the spread between low P/E and high P/E is about 60% bigger than it has been on average over the past 30 years. That’s why we’re excited about the outlook for value, and we think the price-sensitive investor is going to have a much better-than-normal opportunity ahead of them.

Is it the cheapest it’s ever been? That same metric was a little bit higher after the market sold off after the COVID pandemic had just started, and it was significantly higher at the end of the internet bubble in 2000, where expensive stocks were 10 times as expensive as the cheap names. The expensive names back then were at about 90 times earnings, and the cheap names at about 9 times. So, yes, it’s a really attractive time to be looking at inexpensive stocks, but I think we’d be pushing it a little bit to say it’s the best ever.