Bill Nygren Market Commentary | 1Q12

Theme and Background

This chapter discusses whether investors have missed the window to enter the market following the sharp rally in U.S. stocks during the first quarter of 2012. The report notes that despite the S&P 500 surging 13% in a single quarter—exceeding the total return of a seven-year Treasury bond over its entire life—the author argues that stocks remain undervalued and that now is not the time to exit.

Core Thesis

The author’s central judgment is: it is not too late to invest in stocks now. The counterintuitive point is that, despite the market’s substantial rise, strong corporate cash flows and balance sheets will drive dividend growth, share buybacks, and mergers and acquisitions, enabling earnings per share (EPS) to achieve meaningful growth even in a no-growth economy. The author explicitly believes that stocks remain a superior choice relative to bonds.

Key Arguments and Data

1. Corporate cash flows have already begun to translate into shareholder returns: Using a sample of 56 companies in the Oakmark Fund portfolio, the report illustrates actual capital allocation behavior in 2011:

• Dividend growth: 75% of companies (42) raised dividends, with a median increase of over 11%.
• Share buybacks: 84% of companies (47) reduced their share count, with a median reduction of over 3%.
• M&A activity: Over 70% of companies (40) were net acquirers.
• Balance sheet strengthening: 27 companies further reduced net debt.

2. The mathematical logic of EPS growth: The author emphasizes that even with only 4% economic growth, combined with a 3% reduction in shares, EPS can achieve 7% growth. This mechanism is widely overlooked by the market.

3. Extremely low dividend payout ratio: In 2012, the consensus dividend expectation for the S&P 500 accounts for only 28% of expected earnings. Even if dividends grow 9% year-over-year, 72% of earnings remain available for buybacks and M&A.

4. Comparison between stocks and bonds:

• Bond yields are at historic lows, while stock price-to-earnings ratios are slightly below their long-term average (around 13x).
• The current yield on stocks already exceeds that of intermediate-term Treasuries, and dividends are expected to continue growing.
• Stocks provide a hedge against inflation (corporate earnings typically accelerate with inflation), while bonds are fully exposed to inflation risk.

Metric	Stocks	Bonds
Current yield	Higher than intermediate-term Treasuries	Historic lows
Inflation protection	Yes (earnings growth accelerates)	No
Valuation level	Slightly below long-term average P/E	Prices near historic highs

Companies/Assets Involved

• Northrop Grumman: Reduced its share count by 13% in 2011, one of the most aggressive buyback programs.
• DirecTV: Reduced its share count by 14%.
• Kohl's: Reduced its share count by 18%, the most aggressive buyback in the portfolio.
• Liberty Interactive and Discovery Communications: Cited as exemplary management teams, emphasizing per-share value enhancement through share reduction.
• All of the above are holdings in the Oakmark Fund; the report does not explicitly take a bullish or bearish stance but presents them as case studies in capital allocation.

Investment Implications

• Continue overweighting stocks and underweighting bonds: The report argues that even after the market’s rise, stocks still offer a better long-term return outlook than bonds, particularly in an inflationary environment.
• Focus on corporate capital allocation capabilities: Investors should prioritize companies that have the ability and willingness to enhance per-share value through dividends, buybacks, and M&A, rather than relying solely on economic growth.
• Beware of lagging market sentiment: Although industry data shows that money continues to flow out of equity funds and into bond funds, the author sees this as a contrarian opportunity—market sentiment has yet to reflect the improvement in corporate fundamentals.

---

Theme and Background

This chapter continues the core theme of the Oakmark report, namely that stocks remain significantly undervalued relative to bonds. The author further argues that even in a zero economic growth environment, corporate earnings per share (EPS) can still achieve considerable growth through dividend increases and share buybacks, so it is not too late to invest in stocks.

Core Thesis

The author believes that the current stock market is not overheated and investment opportunities still exist. The core argument is that even without economic growth, companies using excess cash flow to raise dividends and repurchase shares can drive EPS growth at an annual rate of approximately 7%. This judgment runs counter to market consensus, as many investors worry that the market has already risen too much and that the best entry point has been missed.

Key Arguments and Data

• Abundant Corporate Cash Flow: The report notes that corporate balance sheets are exceptionally strong and dividend payout ratios are low, resulting in a large amount of excess cash flow. These funds will be used for dividend increases, share buybacks, and mergers and acquisitions.
• Dividend Growth Examples: 75% of the companies (42 firms) in the Oakmark fund portfolio raised their dividends in 2011, with a median increase of over 11%.
• Share Buyback Examples: 84% of the companies (47 firms) reduced their share count, with a median reduction of over 3%. Specific cases include:
• Northrop Grumman: share count reduced by 13%
• DirecTV: share count reduced by 14%
• Kohl's: share count reduced by 18%
• EPS Growth Derivation: Through logical deduction, the author argues that even with zero nominal GDP growth, EPS can still achieve an annual growth rate of approximately 7% solely through dividend growth and share buybacks.

Indicator	Data
Proportion of companies raising dividends	75% (42 firms)
Median dividend increase	Over 11%
Proportion of companies reducing share count	84% (47 firms)
Median share count reduction	Over 3%
Northrop Grumman share count reduction	13%
DirecTV share count reduction	14%
Kohl's share count reduction	18%
EPS annual growth rate under zero growth	Approximately 7%

Companies/Assets Involved

• Northrop Grumman: Bullish. The company enhances EPS through large-scale share buybacks (share count reduced by 13%), serving as a typical case in the author's argument for efficient corporate capital allocation.
• DirecTV: Bullish. Share count reduced by 14%, also benefiting from an aggressive buyback strategy.
• Kohl's: Bullish. Share count reduced by 18%, one of the most aggressive repurchasers in the portfolio.

Investment Implications

• Stocks Are Still Buyable Now: The author believes that even without economic growth, stocks can provide an annualized return of approximately 7% through endogenous growth (dividends + buybacks), which is far superior to bonds. Investors should not hesitate because the market has already risen.
• Focus on Corporate Capital Allocation Ability: Investment should focus on companies with strong cash flows that actively return capital to shareholders through dividends and buybacks. Such companies can create value for shareholders even in a weak macroeconomic environment.
• Ignore Short-Term Economic Noise: The report suggests that excessive focus on macro indicators like GDP growth may mislead investment decisions. Micro-level corporate actions (such as the intensity of buybacks) are a more reliable source of returns.