Bill Nygren Market Commentary | 2Q14

Theme and Background

This chapter discusses whether the current U.S. stock market is overvalued. Based on FactSet's consensus estimate of $133 in earnings per share for the S&P 500 in 2015, the current forward P/E ratio stands at approximately 15x, which is at the historical median level—neither a clear opportunity nor a risk. However, the market is broadly perceived as overvalued, and the author analyzes three main reasons behind this sentiment.

Core Thesis

The author argues that the market is not overvalued and that current valuation levels are reasonable. Counterintuitive judgments include:

• Historical prices have limited relevance for assessing current valuations; future earnings expectations are the key.
• Financial stocks have been shunned by investors due to the trauma of the crisis, but the industry's fundamentals have significantly improved.
• The narrowing of the P/E ratio distribution actually creates opportunities to buy high-quality companies, rather than signaling an overheated market.

Key Arguments and Data

1. Psychological Factors Behind Missing the Bull Market

• The S&P 500 bottomed in March 2009 and has more than tripled including dividends since then.
• At the market bottom, bearish investors were most numerous, but the rapid rebound made it difficult for bears to admit their mistake and re-enter.
• The author believes 2009 was a "once-in-a-generation buying opportunity," not the norm.

2. Systematic Avoidance of Financial Stocks

• After the financial crisis, many investors completely avoided financial stocks due to losses.
• However, the current financial industry has lower leverage, stricter underwriting standards, and is far less likely to face another real estate collapse.
• The Oakmark Fund's largest sector allocation is currently financial stocks.
• As of year-end, Berkshire Hathaway's publicly disclosed stock portfolio had over 40% in financial stocks; including Bank of America warrants, this figure rises to around 45%.

3. Narrowing P/E Distribution Creates Opportunities

Comparison of current P/E distribution with 2009:

Metric	2009	Current
S&P 500 forward P/E median	11x	17x
Number of stocks with P/E below 2/3 of median	117	39
Number of financial stocks among them	19	15
Number of non-financial "cheap" stocks	98	24

• Currently, only 24 non-financial stocks meet the "cheap" definition, far too few to build a portfolio.
• However, the author argues that when the market prices all stocks as "average," investors can buy high-quality companies (e.g., Google, Visa, MasterCard)—these trade at near-average multiples yet have above-average long-term growth prospects.

4. New Position in Amazon

• Amazon's stock fell from a January high of $408 to a May low of $284, a decline of $124.
• Consensus forward EPS is slightly above $1, which would imply a price of just over $20 based on the median P/E.
• But the author argues that P/E is not the only valuation metric: as an efficient retailer, Amazon's market cap-to-sales ratio has fallen from a historical range of 2-4x to under 2x.
• More importantly, third-party sales (not sold directly by Amazon) are growing faster, and accounting rules only recognize commissions as revenue (e.g., about $13 in revenue for a $100 item, almost entirely gross profit), causing traditional P/E to severely understate true profitability.

Companies/Assets Involved

Company	Role	Key Data	View
Berkshire Hathaway	Benchmark for value investing	Over 40% of public stock portfolio in financials; ~45% including Bank of America warrants	Bullish on financials
Google	Beneficiary of advertising moving online	Trades at near-average P/E	Bullish, believes growth is undervalued
Visa / MasterCard	Beneficiary of plastic currency replacing cash	Trades at near-average P/E	Bullish, believes growth is undervalued
Amazon	New position in Oakmark	Stock fell from $408 to $284; market cap-to-sales ratio below 2x; third-party commission revenue model undervalued	Bullish, believes traditional P/E is not applicable

Investment Implications

• Significant value opportunity in financial stocks: The current fundamentals of the financial industry are better than before the crisis, yet valuations remain shunned by investors. Focus on financial institutions with reduced leverage and improved underwriting standards.
• Focus on high-quality companies amid narrowing P/E distribution: When the market treats all stocks equally, prioritize companies with long-term competitive advantages (e.g., tech platform companies) rather than merely chasing low P/E ratios.
• Avoid judging current value by historical prices: The extreme lows of 2009 were an anomaly; current valuations are reasonable. Do not remain persistently bearish just because the bottom was missed.
• Look beyond P/E for special business models like Amazon: Pay attention to market cap-to-sales ratios and third-party business structures. Traditional P/E may severely understate true profitability.

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Theme and Background

This section focuses on the valuation controversy surrounding Amazon. The market generally views Amazon as a "growth stock" rather than a "value stock" due to its low profit margins and high price-to-earnings ratio resulting from high-growth investments. The author challenges this consensus by adjusting valuation metrics (price-to-sales ratio relative to total gross merchandise volume), arguing that Amazon is actually a "value stock" at its current price.

Core Thesis

The author's core investment argument is: Amazon's current stock price is not only not expensive, but is at its cheapest level in history. The counterintuitive judgment lies in the fact that, despite Amazon's high P/E ratio, when measured by an adjusted price-to-sales ratio (considering third-party total sales), its valuation is even lower than that of traditional brick-and-mortar retailers. The author believes Amazon's high-growth investments are a proactive value-creation strategy, not a sign of inefficiency.

Key Arguments and Data

1. Adjusted Price-to-Sales Ratio Comparison:

• Traditional metric: Amazon's price-to-sales ratio is 2 times the average of brick-and-mortar retailers.
• Adjusted metric (incorporating estimated third-party total sales): Amazon's price-to-sales ratio is only 80% of that of brick-and-mortar retailers.
• Conclusion: If Amazon's price-to-sales ratio were to match that of brick-and-mortar retailers, its stock price would need to rise by 25%.

2. Accounting Treatment Differences for Growth Investments:

• Asset-heavy companies: Growth investments are capitalized on the balance sheet and amortized over time via depreciation, having a minor impact on current profits.
• Asset-light companies (e.g., Amazon): Growth expenditures are directly expensed on the income statement, significantly depressing current profits.
• Author's estimate: If Amazon reduced its growth spending to the industry average, its operating margin would be comparable to that of other retailers.

3. Management's Value Creation Logic:

• The author argues that Amazon's management maximizes shareholder value through an investment strategy of supernormal organic growth, rather than pursuing short-term profits.

Metric	Traditional P/S Ratio (vs. Brick-and-Mortar Retailers)	Adjusted P/S Ratio (Including Third-Party Total Sales)
Amazon Relative Valuation	2x	0.8x
Implied Stock Price Adjustment	—	Needs to rise 25% to match

Companies/Assets Involved

• Amazon, Inc.: The core subject of analysis. The author is bullish, considering it a "value stock" at present. It represents 2.1% and 4.0% of net assets in the Oakmark Fund and Oakmark Select Fund, respectively.
• Google Inc.: Mentioned for comparison. It represents 2.1% and 4.1% of net assets in the Oakmark Fund and Oakmark Select Fund, respectively.
• Visa, Inc., Class A: Represents 2.0% of the Oakmark Fund and 0% of the Oakmark Select Fund.
• Mastercard, Inc., Class A: Represents 2.1% of the Oakmark Fund and 5.4% of the Oakmark Select Fund.

Investment Implications

Investors should re-evaluate the valuation framework for Amazon: Do not judge its expensiveness solely by P/E ratio or traditional P/S ratio. Amazon's high-growth investments are essentially converting current profits into future cash flows. The adjusted P/S ratio indicates a potential 25% valuation recovery relative to brick-and-mortar retailers. For long-term investors, the current price offers an opportunity to buy a "growth stock" at a "value stock" price.