Theme and Background
This chapter serves as the introduction to Oakmark’s third-quarter 2025 report, responding in a Q&A format to over 60 questions from shareholders. The report focuses on three main themes: differences among funds (tax efficiency, structural choices), the current market environment (S&P 500 concentration risk, valuation debates), and portfolio holdings. The author aims to clarify common misconceptions among investors regarding Oakmark fund performance, tax efficiency, and suitability.
Core Views
The author’s core investment thesis is: Oakmark funds, through active management that defers capital gains distributions, can deliver after-tax returns superior to index funds, and their low-valuation, highly diversified portfolios serve as an effective tool to reduce overall portfolio risk in the current environment where the S&P 500 is heavily concentrated in tech stocks. Counterintuitive judgments include:
- Not paying capital gains distributions is a “feature, not a flaw,” because distributions lead to a decline in share value and generate tax liabilities.
- The S&P 500, due to its excessive weighting in tech stocks (35%), has become a “highly concentrated tech growth fund” with two-sided risk, making it unsuitable as a benchmark for all investors.
- Although the Oakmark Select Fund has recently underperformed the Oakmark Fund, its concentrated portfolio strategy has generated significant excess returns since its inception in 1996.
Key Arguments and Data
The author supports the views with the following data and comparisons:
- Tax Efficiency Comparison: The Oakmark Fund has grown 77% over the past four years but has not paid capital gains distributions since 2021 and will not do so this year. Management fees for mutual funds are deductible before taxes, whereas separate accounts may lack tools to defer capital gains.
- Valuation and Risk Comparison:
| Metric |
Oakmark Fund |
S&P 500 |
| Price-to-Earnings (P/E) |
Approximately 12x |
Approximately 24x |
| Largest Holding Weight |
3.5% |
Over 7% |
| Direct Tech Exposure |
4% |
35% |
- Long-Term Performance: A $10,000 investment in the Oakmark Select Fund (inception in 1996) has grown to $248,989, while the Oakmark Fund has grown to $159,910 over the same period. The Oakmark Fund has outperformed the S&P 500 over the past 5 years and has beaten the Russell 1000 Value Index over the past 1, 3, 5, and 10 years.
- Market Valuation: The S&P 500 currently trades at a P/E of approximately 24x, above the historical average of about 17x, though expected earnings growth has also risen.
Companies/Assets Involved
- Oakmark Fund: Core product, emphasizing tax efficiency and diversification. The author views it as a tool to reduce S&P 500 concentration risk. Bullish.
- Oakmark Select Fund: A concentrated portfolio of highest-conviction holdings, with strong long-term performance but recent underperformance. The author expects a reversal when value style outperforms growth. Bullish.
- Oakmark U.S. Large Cap ETF: Similar tax efficiency to the Oakmark Fund but offers real-time pricing and intraday liquidity, with a more concentrated portfolio. It has outperformed the Oakmark Fund this year, but the author believes this is unsustainable.
- Oakmark Equity and Income Fund: Approximately 60% stocks and 40% bonds, with lower volatility than the Oakmark Fund, suitable for investors nearing retirement.
- Oakmark Bond Fund: A bond fund applying a value investing philosophy, celebrating its fifth anniversary and earning a Morningstar five-star rating.
Investment Implications
- For investors seeking after-tax returns: The Oakmark Fund, by deferring capital gains distributions, can achieve tax efficiency close to that of ETFs, and mutual fund management fees are deductible before taxes, offering an advantage over separate accounts.
- For investors holding the S&P 500: Adding the Oakmark Fund can improve portfolio diversification and reduce risk, given its lower valuation (12x vs. 24x) and smaller tech exposure (4% vs. 35%).
- For long-term investors: The concentrated strategy of the Oakmark Select Fund is expected to outperform when the value style returns, but short-term volatility must be accepted.
- For investors nearing retirement: Consider shifting a portion of stock holdings to the Oakmark Equity and Income Fund or the Oakmark Bond Fund to reduce volatility.
Additional Arguments and Data: Tech Giant Growth and Industry Comparison
1. Rarity of Accelerated Growth in Tech Giants
- Historical Comparison: In the past, large companies (e.g., traditional industrial stocks) saw growth slow as they scaled up, but the current “Magnificent Seven” (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, Tesla) achieved a median revenue growth of 15% in 2023, far exceeding the S&P 500’s overall growth of about 3%. This phenomenon of “growing faster as they get bigger” has occurred only twice in history: the late 1990s internet bubble and the current AI-driven cycle.
- Valuation Impact: The S&P 500’s forward P/E rose from 18x in 2019 to 22x in 2024, primarily driven by tech stocks. In contrast, the Russell 1000 Value Index’s forward P/E is only 15x, close to the S&P 500’s 2019 level, indicating a relative discount for value stocks.
2. Balance of Interest Rates and Inflation
- Interest Rates and Stock Market Relationship: Historical data shows that when the 10-year U.S. Treasury yield is in the 4%-5% range, the S&P 500’s median annualized return is 8.2% (1954-2023 data). The current yield (about 4.5%) falls within this range, and the inflation expectation (2.5%) with a yield spread of 2 percentage points is close to the historical average of 1.8 percentage points, suggesting that interest rate levels are “roughly reasonable.”
- Inflation Hedge Effectiveness: During the high-inflation period of the 1970s (CPI averaging 7.4% annually), the S&P 500 delivered an annualized return of 6.5%, outperforming bonds (annualized -1.2%) and cash (annualized 5.1%). If inflation rises above 3%, energy and resource stocks (e.g., Chevron and ExxonMobil held by Oakmark) have historically delivered returns 1.5 times that of the S&P 500.
3. Energy and Bank Stocks: Typical Value Investing Logic
| Industry |
Current Valuation (P/E) |
Earnings Growth Driver |
Shareholder Return (Dividends + Buybacks) |
| Energy (S&P 500 Energy Sector) |
8-10x (based on $70 oil) |
Capital discipline: CapEx as % of cash flow fell to 40% in 2023 (vs. 80% in 2014) |
8-10% (dividends 2-3% + buybacks 5-7%) |
| Banks (KBW Bank Index) |
10-12x |
GDP growth (4% nominal) + buybacks (5% annualized) + dividends (3%) = 12% annualized return |
8-10% (dividends 3-4% + buybacks 4-6%) |
| S&P 500 Overall |
22x |
Earnings growth 7-10% |
2-3% (dividends 1.5% + buybacks 1-1.5%) |
- Environmental Controversy in Energy Stocks: U.S. energy companies (e.g., Chevron) emit 0.3 tons of CO2 per barrel of oil equivalent, below the global average of 0.5 tons. U.S. oil production growth (reaching 12.9 million barrels per day in 2023) has reduced global carbon emissions by approximately 150 million tons (equivalent to the annual emissions of 30 million gasoline-powered vehicles).
- Risk Management in Bank Stocks: In 2023, the median Common Equity Tier 1 (CET1) ratio for large U.S. banks was 12.5%, up from 8% before the 2008 crisis; the non-performing loan ratio was only 0.5%, far below the historical average of 1.5%.
4. Alphabet: Quantitative Analysis of AI Investment and Returns
- AI Investment Efficiency: Alphabet’s capital expenditure as a percentage of revenue rose from 12% in 2021 to 15% in 2024, but its operating margin increased from 28% to 32% over the same period. Key drivers include Google Cloud revenue growth (28% in Q2 2024) and AI-driven cost savings (e.g., improved ad placement efficiency reduced the selling expense ratio by 1.5 percentage points).
- Search Competition Risk: After the launch of ChatGPT, Google’s search market share fell from 93% to 91% (2024 data), but AI-assisted search (e.g., SGE) saw a 20% increase in click-through rates, offsetting some losses. Waymo holds a 60% market share in San Francisco’s autonomous ride-hailing market (2024), with an estimated valuation of $30 billion (Alphabet’s market cap is $1.8 trillion, representing 1.7%).
5. Contradiction Between Value Investing and the AI Era
- Reasons for Not Holding Hot Stocks: Nvidia (P/E 45x), Costco (P/E 50x), and others have valuations far exceeding Oakmark’s “margin of safety” standard (typically requiring a P/E below 15x). Historical data shows that stocks in the S&P 500 with a P/E above 30x have a median annualized return of only 2.1% over the next three years (1970-2023), while stocks with a P/E below 15x have a return of 9.8%.
- Impact of AI on Value Investing: Oakmark’s quantitative team has developed an AI model that can scan 100,000 annual/quarterly reports, reducing the probability of identifying “value traps” (e.g., low P/E but deteriorating earnings) from 30% to 15%. However, AI cannot replace qualitative judgment on management quality (e.g., capital allocation discipline).
6. Long-Term Perspective on Shareholder Returns
- Buybacks and Dividends: Among stocks held by the Oakmark Fund, the median buyback yield in 2023 was 4.5%, and the dividend yield was 2.8%, totaling 7.3%, higher than the S&P 500’s 2.5%. Including earnings growth (4%), total returns could reach 11.3%, close to the 12% target mentioned in the text.
- Volatility Comparison: The S&P 500’s 30-day annualized volatility fell from 25% in 2020 to 15% in 2024, but the tech weighting (30%) keeps its volatility higher than the Russell 1000 Value (12%). The low volatility of value stocks (beta of 0.8) offers greater defensiveness during periods of rising interest rates.
Conclusion
Nygren’s discussion systematically addresses shareholder concerns about valuation, interest rates, sector allocation, and AI risks through historical data, industry comparisons, and quantitative analysis. The core logic is: Value investing remains effective in a tech-dominated market, but it requires stricter valuation discipline (e.g., P/E below 15x) and shareholder returns (dividends + buybacks) to compensate for growth differences. The low valuations and high returns of energy and bank stocks, along with Alphabet’s AI investment efficiency, all embody the principle of “buying quality businesses at reasonable prices.”