Navigating market highs and (avoiding) value traps - U.S. equity market commentary 1Q24

Theme and Background

This chapter focuses on how Oakmark adheres to its long-term value investing framework against the backdrop of U.S. stock markets repeatedly hitting new highs. The report refutes the market consensus that "investing after new highs is dangerous" and delves into the identification and avoidance of value traps.

Core Views

• New Highs Are Not a Reason to Sell: Over the past 50 years, the S&P 500 has hit new highs in 26% of months. Selling after each new high would have avoided four major downturns but would have missed out on cumulative returns of over 200 times over 50 years. Oakmark does not engage in market timing.
• GARP Belongs to Value Investing, GAUP (Growth at Unreasonable Price) Is Momentum Investing: Buying quality companies at reasonable prices (GARP) is as much value investing as buying mediocre companies at low prices; buying growth while ignoring price (GAUP) is the opposite of value investing.
• Definition of a Value Trap: Companies whose value does not grow over time, particularly stocks with structural disadvantages and currently low P/E ratios. Oakmark requires analysts to forecast enterprise value seven years out; if the expected annualized value growth plus dividend yield does not match the market, the stock is not purchased.

Key Arguments and Data

• Historical Backtest: Over the past 50 years (600 months), the S&P 500 hit new highs in 156 months (26%). Selling after each new high would have avoided the 2000 dot-com bubble (-44%), the 2007 financial crisis (-38%), the 2020 pandemic (-19%), and the 2022 inflation and rate hike (-25%), but would have missed out on over 200 times the holding returns over 50 years.
• Current Portfolio Valuation: Since early 2023, the median P/E ratio of new holdings in the Oakmark Fund has been only 12 times the estimated 2024 earnings, roughly half the P/E ratio of the S&P 500.
• Value Trap Avoidance Mechanism: Analysts must forecast enterprise value seven years out; if actual value growth significantly lags behind the forecast, the stock undergoes additional scrutiny (including reverse review and analyst reassignment), making selling easier than holding.

Companies/Assets Involved

• Amazon (AMZN): Oakmark bought it in 2014 and sold it a year later when the stock price reached the valuation of its retail business (the value of AWS was uncertain at the time). After AWS's value became clear, Oakmark bought it again, believing the combined value of retail and AWS was discounted. The author believes the first sale was not a mistake, as the process discipline avoided more potential losses.
• Visa (V), Mastercard (MA), Apple (AAPL), TE Connectivity (TEL), Capital One Financial (COF): These are examples of "ten-bagger" stocks once held by Oakmark, bought at what was considered 50 cents on the dollar, but the magnitude and duration of growth exceeded expectations.
• T. Rowe Price Investment Management: Its CIO David Giroux believes GARP offers the highest long-term returns, cited in the report as a starting point for discussion.

Investment Insights

• Do Not Exit the Market Due to New Highs: Historical data shows that a strategy of timing sells at new highs severely damages long-term returns. Investors should stay invested and continuously shift positions toward the cheapest stocks.
• Beware of Low P/E Value Traps: A low P/E ratio does not equal value; it is necessary to assess whether enterprise value grows over time. Oakmark's seven-year value forecasting framework can serve as a reference for investors evaluating their holdings.
• Growth and Value Are Not Opposites: Buying quality growth stocks at reasonable prices (GARP) is a form of value investing; the key is whether the purchase price is sufficiently low relative to intrinsic value.