Theme and Background
This chapter begins with the author’s personal experience of purchasing tickets through a middleman named Earl in his early years, exploring how the internet systematically undermines intermediaries that profit from information asymmetry by reducing the cost of accessing information. The author extends this logic to the investment management industry, arguing that passive strategies (such as index funds and ETFs) are challenging actively managed funds in a similar manner, and uses this to illustrate the value of Oakmark’s active management approach.
Core Thesis
The author’s core investment argument is: The internet enables the free flow of information, posing a fundamental threat to intermediaries, while consumers (investors) emerge as the ultimate winners. Counterintuitive judgments include:
- Actively managed funds are not necessarily destined to lose to passive strategies; through risk-adjusted returns (e.g., smaller declines in bear markets) and deep value discovery, active management can generate excess returns.
- The labels of “value stocks” and “growth stocks” are misleading; true value investing should be based on a complex assessment of an asset’s intrinsic value, rather than simple price-to-earnings ratios.
Key Arguments and Data
The author supports the thesis with multiple industry cases and specific data:
1. Cases of the Internet’s Impact on Intermediaries:
- Ticket brokers: StubHub replaced Earl, reducing information search costs from “high” to “free.”
- Travel agencies: TripAdvisor’s reviews replaced travel agents who conducted on-site inspections.
- Limousine services: Uber reduced the cost of matching drivers and passengers from “half the fare” to “a small fraction.”
- Retail: Amazon made price comparison from “time-consuming” to “instantaneous,” squeezing the survival space of high-margin retailers.
- Recruitment industry: LinkedIn replaced traditional headhunters’ fee model of “a percentage of the new hire’s salary” with “cheaper subscription fees,” offering a “better talent pool” and “faster service.”
2. Analogy in the Investment Management Industry:
- 40 years ago, actively managed funds commonly charged a “1% management fee” and held portfolios of large-cap high-quality stocks.
- Index funds replicated the same portfolio at “nearly zero cost,” and later ETFs and passive funds further subdivided into “value” and “growth” sub-indices.
- The author notes that Oakmark funds “never fell as much” in years when the S&P 500 declined, yet some advisors considered them riskier due to tracking error.
3. Complexity of Value Investing:
- Using Alphabet (Google) as an example: Its P/E ratio and growth rate are above average, but this does not account for non-earning assets (e.g., cash balances, venture portfolios like autonomous driving cars, YouTube). If valued like a cable TV network, YouTube’s per-share value would be “hundreds of dollars.” After adjustments, Google’s search business valuation is “below average.”
- Using LinkedIn as an example: Despite rapid revenue growth, if early-stage investments in adjacent businesses are excluded, its profit margins should be consistent with or higher than other internet/commercial service companies. Valued at the market P/E ratio for employment services, LinkedIn’s stock price is “below its implied value.”
Companies/Assets Involved
| Company/Asset |
Role |
Key Data |
Bullish/Bearish |
| LinkedIn |
Newly purchased target |
Rapid revenue growth; subscription fees far lower than traditional headhunters; Microsoft acquisition offer suggests recognized value |
Bullish |
| Alphabet (Google) |
Value investing case |
P/E ratio above average, but after adjusting for non-earning assets, search business valuation is below average |
Bullish |
| Bank stocks |
Market opportunity |
Investors overly remember a “once-in-a-generation financial collapse,” leading to cheap stock prices |
Bullish |
| Commodity-related stocks |
Market opportunity |
Commodity prices need to rise to meet demand, but stock prices are based on current low prices |
Bullish |
| Emerging market companies |
Market opportunity |
Growth will outpace developed markets, but related companies do not command a premium |
Bullish |
| Value ETFs |
Comparison target |
Passively track low P/E stocks but cannot identify complex value |
Bearish |
Investment Implications
- Active management still holds value: Investors should not blindly shift to passive strategies. Active management can generate excess returns by reducing downside risk (e.g., Oakmark’s smaller declines in bear markets) and uncovering overlooked assets (e.g., Alphabet’s non-earning businesses, LinkedIn’s potential profit margins).
- Beware of label-based investing: Avoid equating “value stocks” with low P/E stocks or “growth stocks” with high P/E stocks. True value investing requires in-depth analysis of a company’s intrinsic value, including non-earning assets and future growth potential.
- Focus on undervalued areas: Currently, bank stocks, commodity-related stocks, and emerging market companies may be undervalued due to market sentiment or short-term prices, presenting potential investment opportunities.
Theme and Background
This chapter focuses on misconceptions surrounding the definition of "value stocks" and the survival strategies of active management funds amid the wave of passive investing. The author argues that characteristics traditionally associated with value stocks (such as low price-to-earnings ratios and high dividends) can be misleading in the current market environment, and that active management must be genuinely "active" rather than merely mimicking indices.
Core Views
- Value stocks cannot be judged solely by P/E ratios or industry labels: Energy stocks exhibit low P/E ratios (appearing cheap) when oil prices are high, and high P/E ratios or losses (appearing expensive) when oil prices are low. However, actual value assessment requires considering the normalization of cyclical earnings. Traditional value stocks such as utilities, packaged foods, and mature pharmaceuticals, which serve as bond substitutes due to high dividends, now have P/E ratios far above historical levels. The author believes they are no longer value stocks.
- Active management must go beyond indices: Index funds and ETFs cannot truly replicate active management portfolios because computers are not yet capable of judging earnings normalization and intrinsic value like human analysts. Active managers must do what computers cannot easily replicate, justifying their fees through higher returns or lower risk.
- Selecting fund managers based solely on historical performance is foolish: Even funds with outstanding long-term performance have significant periods of underperformance in rolling cycles of 1, 5, or even 10 years. Investors who chase winners and sell losers will achieve poor returns, while periods of underperformance actually present opportunities.
Key Arguments and Data
- Misleading nature of P/E ratios: Energy stocks show low P/E ratios (appearing cheap) when oil prices are unsustainably high, and high P/E ratios or losses (appearing expensive) when oil prices are unsustainably low. The author believes that when P/E ratios are high or negative (as with many energy stocks currently), they may actually be cheap, while low P/E ratios may indicate expensiveness.
- Valuation changes in traditional value stocks: Utilities, packaged foods, and mature pharmaceuticals, which historically traded at below-market P/E ratios due to low growth, now have P/E ratios far above historical levels as they have become bond substitutes due to high dividends. The author explicitly judges they are not value stocks at present.
- Performance of Oakmark Fund (as of June 30, 2016):
| Metric |
Oakmark Fund (OAKMX) |
S&P 500 Total Return |
| 1 Year |
-2.99% |
3.99% |
| 3 Year |
8.65% |
11.66% |
| 5 Year |
11.32% |
12.10% |
| 10 Year |
8.20% |
7.42% |
| Since Inception (Aug 5, 1991) |
12.28% |
9.27% |
| Expense Ratio (as of Sep 30, 2015) |
0.85% |
— |
- Proportion of underperformance in rolling cycles (based on monthly data):
- 1-year rolling cycle: Over half (>50%) of periods underperform.
- 5-year rolling cycle: Nearly one-third (~33%) of periods underperform.
- 10-year rolling cycle: Over 20% of periods underperform.
- Conclusion: Even with long-term outperformance (25 years), short- and medium-term underperformance is the norm; chasing winners and selling losers destroys returns.
Companies/Assets Involved
- Oakmark Fund (OAKMX): The author's own fund, used as a case study of active management. Over 25 years (as of 2016), it has consistently outperformed the S&P 500 (12.28% vs 9.27%), but with high short-term volatility. The author considers its fee (0.85%) reasonable and views periods of underperformance as creating opportunities.
- S&P 500 Total Return: Used as a passive benchmark for comparison.
- Energy stocks: Used as a case study of cyclical value stocks; the author believes they may be cheap when P/E ratios are high or negative.
- Utilities, packaged foods, mature pharmaceuticals: Used as examples of traditional value stocks that are now overvalued; the author is bearish on their investment value as value stocks.
Investment Insights
- Beware of the P/E ratio trap: For cyclical industries (e.g., energy), a low P/E ratio may indicate peak earnings (expensive), while a high P/E ratio or losses may indicate trough earnings (cheap). Investors should focus on valuations based on normalized earnings rather than surface-level numbers.
- Avoid "index huggers": Active management funds that mimic indices but charge higher fees should be replaced by index funds. True active management must deliver differentiated returns or lower risk.
- Do not abandon excellent active managers due to short-term underperformance: Funds that outperform over the long term have significant periods of underperformance in 1-year, 5-year, and even 10-year rolling cycles. Investors should make decisions based on investment philosophy and process, not recent returns, and consider adding to positions during periods of underperformance.