Theme and Background
This chapter discusses whether the current high price-to-earnings (P/E) ratio in the market signals an overheated market. The author argues that despite the economic recovery lasting nine years and the P/E ratio being above historical averages, the market is not significantly overvalued. Instead, structural distortions present investment opportunities.
Core Argument
The author's central thesis is that the current high P/E ratio is not a sign of a market bubble but is distorted by several special factors, including the abnormal impact of the "Great Recession" on the CAPE ratio, the suppression of cash yields by near-zero interest rates, and the penalty imposed on growth investments by accounting standards. The market is not overheated, and investors should maintain long-term holdings rather than panic and exit.
Counterintuitive Judgments:
- The high CAPE ratio is significantly inflated by the extremely low earnings during 2008-2009. Excluding this anomaly would cause the CAPE ratio to drop substantially.
- Currently, the bond market (30-year Treasury P/E of 34 times) is more expensive than the stock market (S&P 500 P/E of 19 times), with a 90% premium over its historical average, while stocks are only 12% above their historical average.
Key Arguments and Data
1. CAPE Ratio Distorted by the "Great Recession"
- The past decade includes the 2008-2009 "Great Recession," during which corporate earnings were abnormally low, leading to an elevated CAPE ratio.
- If the market and corporate profits maintain current levels over the next two years (a result the author considers disappointing), the CAPE ratio would drop significantly simply by excluding the "Great Recession" data.
2. Near-Zero Interest Rates Push Up P/E Ratios
- In the early 1980s, after-tax cash yields were 8-9%, meaning $100 in cash corresponded to a P/E of about 12 times.
- Currently, $100 in cash yields less than $1 after tax, resulting in a P/E of over 100 times.
- The author believes it is more reasonable to estimate the value of cash appropriately rather than treating it as nearly worthless.
3. Accounting Standards Penalize Growth Investments
- Traditional capital expenditures (e.g., building a factory) are depreciated over 40 years, without immediately impacting current profits.
- However, costs for R&D and market expansion at companies like Amazon, Facebook, and Alphabet are immediately expensed on the income statement, depressing current earnings while their long-term value remains unreflected.
4. Bond Market Relatively More Expensive
| Asset Class |
Current P/E |
30-Year Average P/E |
Current Premium Over Average |
| S&P 500 |
19x |
17x |
+12% |
| 30-Year Treasury |
34x (yield 2.9%) |
18x (yield 5.5%) |
+90% |
5. Impact of FANG Stocks on Market P/E
- FANG (Facebook, Amazon, Netflix, Alphabet) accounts for over 7% of the S&P 500's weight, with a weighted average P/E of 39 times (based on 2017 consensus earnings).
- Excluding FANG, the overall P/E of the S&P 500 would drop by nearly one point.
- The author believes the P/E ratio severely undervalues these companies because growth expenditures are immediately expensed.
6. Netflix Case: The Cost of Growth Investments
- In 2011, Netflix's stock price was below $10 per share, and analysts recommended buying (based on per-user valuations far below HBO).
- The author declined to buy due to future uncertainty; at the time, Netflix had only one original series, House of Cards, and a high user churn rate.
- Currently, Netflix's stock price is $180 per share, with global users exceeding the entire U.S. pay-TV industry, content spending more than double that of HBO, and Emmy wins for original series doubling.
- On a per-user valuation basis, Netflix remains similar to AT&T's acquisition price for HBO parent Time Warner, but Netflix's user base has grown over fourfold in four years, while HBO's growth is less than one-third.
Companies/Assets Involved
| Company/Asset |
Role |
Key Data |
Bullish/Bearish |
| Alphabet (Google) |
Oakmark Fund's top holding |
Valuation not based on 40x P/E for search business |
Bullish |
| Amazon |
Representative of growth investments |
R&D costs immediately expensed, depressing current earnings |
Neutral (undervalued) |
| Facebook |
Representative of growth investments |
Limiting WhatsApp ad load to gain market share, sacrificing current revenue |
Neutral (undervalued) |
| Netflix |
Missed investment opportunity |
2011: <$10 → Current: $180; User growth >4x in four years; Content spending double HBO |
Bullish (but not held) |
| AT&T |
Acquired HBO parent Time Warner |
Implied per-user valuation similar to Netflix's current level |
Neutral (comparison reference) |
| 30-Year Treasury |
Comparison asset |
Current P/E 34x, historical average 18x, 90% premium |
Bearish (more expensive than stocks) |
Investment Implications
- Do not panic and exit due to high P/E: The current market P/E is distorted by multiple structural factors and is not a sign of a bubble. The bond market is relatively more expensive, and stocks are not clearly overvalued.
- Stick with long-term holdings: Oakmark recommends that investors set personal asset allocation targets and only moderately reduce equity positions when market gains push the equity ratio above the target, avoiding frequent trading.
- Focus on the true value of growth companies: Companies with earnings depressed by accounting standards (e.g., FANG) may be mispriced by the market, with their long-term value not fully reflected. Investors should look beyond P/E and assess intrinsic value.
- Beware of the "overdue recession" narrative: Over the past nine years, economic growth has been below normal levels, and there may not have been enough excess accumulated to require correction. A recession may not be imminent.
Theme and Background
This chapter uses Oakmark analysts' recommendation of Netflix (with a P/E ratio exceeding 100x at the time) as a starting point to explore whether high-P/E growth companies are worth buying for value investors. The report argues that relying solely on the P/E ratio to define value has flaws, and the overlap between growth and value investing may actually offer better investment opportunities.
Core Views
- High P/E does not equal high valuation: Netflix's pricing strategy (monthly fee of $10) is lower than that of competitors (HBO Now, Spotify, and Sirius XM are all $15). If the price were raised by 50%, the P/E ratio could drop to the low double digits. Therefore, the current high P/E is an active choice rather than a sign of market overvaluation.
- Scale effects create a moat: Netflix sacrifices short-term profits to rapidly expand its user base, which is a rational decision for its network-effect business. The larger the scale, the lower the content procurement cost per user, making it difficult for new entrants to overcome the barrier.
- Value investing should go beyond the P/E label: Oakmark believes that purely classifying growth or value styles by P/E can lead to missed opportunities. Companies like Alphabet and Netflix appearing in value portfolios precisely illustrate the limitations of the single P/E metric.
Key Arguments and Data
| Comparison Item |
Netflix |
HBO Now |
Spotify |
Sirius XM |
| Monthly Fee |
~$10 |
~$15 |
~$15 |
~$15 |
| Revenue per Viewing Hour (Subscription + Ads) |
Approximately half that of other video formats |
— |
— |
— |
- Price increase hypothesis: If Netflix raised its monthly fee from $10 to $15 (a 50% increase) with limited subscriber churn, the P/E ratio would drop from over 100x to the low double digits (approximately 13-15x).
- Scale advantage: Netflix has the most subscribers, allowing it to acquire content at a lower cost, creating a positive cycle of "scale-cost-pricing." The report does not provide specific subscriber numbers but emphasizes that its scale leads any other video service.
Companies/Assets Involved
- Netflix (NFLX): Core case. Oakmark Fund holds 1.3% (as of September 30, 2017). Bullish, reasons: low pricing, scale moat, pricing power potential.
- Alphabet (GOOGL): Oakmark Select Fund holds 8.6%. Included in a value portfolio as a growth company, indicating that P/E does not fully reflect its value.
- Amazon (AMZN), Facebook (FB): Mentioned in Part 1 as companies whose R&D/marketing expenses depress current earnings, but not discussed in detail in this chapter. Holdings are 0%.
- Time Warner, AT&T, Sirius XM: Holdings are 0%, used only as comparison references.
Investment Insights
- Do not judge value solely by P/E: For companies with network effects, pricing power, or scale advantages, a current high P/E may be an active strategic choice (e.g., sacrificing profits for scale) rather than a bubble signal.
- Focus on the overlap between growth and value: Investors should examine whether a company has the characteristics of "buying growth at a reasonable price" rather than rigidly adhering to style labels. For example, if Netflix could significantly reduce its P/E by raising prices, it suggests its intrinsic value is undervalued.
- Beware of style drift bias: Fund managers often avoid cross-style stocks for fear of being questioned about style purity, but this may cause them to miss the best opportunities. Oakmark advises investors to actively question single metrics and accept the investment logic where growth and value intersect.