Bill Nygren 4Q15 Market Commentary: There is no such thing as over-diversificationVW Staff
Oakmark Funds’ Bill Nygren market commentary for the fourth quarter ended December 31, 2015.
“Don’t keep all your eggs in one basket.” -Old Italian Proverb
“Put all your eggs in one basket and watch that basket.” -Mark Twain
Active managers had a disappointing 2015. Following 2014, when 90% of actively managed mutual funds underperformed the S&P 500, there was little improvement in 2015. The majority of mutual funds lost money this past year despite a small gain in the S&P. Most stocks declined, and that created a tough environment for active managers to make money. Unfortunately, the list of declining funds included most of the Oakmark Funds.
Bill Nygren – Investors moves from mutual funds to index funds
The poor mutual fund industry results led to an acceleration of investors redeeming shares from their actively managed funds and reinvesting in index funds. In my March commentary, I wrote that the inevitability of index funds outperforming the average actively managed fund didn’t imply that identifying superior funds was destined to fail. In fact, we concluded that the long-term rewards from active management can be as high as they have ever been.
Disappointments during the year also included some high profile funds suffering substantial setbacks due to a lack of succession planning, poor tax management or excessive concentration in top holdings. Many mutual fund industry observers highlighted those issues, threw their hands up in frustration and hopped on the indexing bandwagon.
When we launched the Oakmark Select Fund in 1996, I wrote a paper outlining our belief that a more concentrated fund of our best stock selections was likely to produce better long-term returns, albeit with higher short-term volatility, than our more diversified funds. To conclude that paper, I selected a quote that Warren Buffett had used in his 1991 annual report to the shareholders of Berkshire Hathaway:
“John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F.C. Scott, on August 15, 1934, that says it all: ‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.’”
Is the more than 80-year-old quote from Keynes and nearly 25-year-old quote from Buffett, two of the greatest investors of all time, still valid today? In 2016, we will celebrate the 20th anniversary of Oakmark Select and the 10th of Oakmark Global Select. As one of the early advocates for concentrated investing in mutual funds, we at Oakmark thought this would be a good opportunity to revisit the case for concentration.
Bill Nygren – There is no such thing as over-diversification
Academic theory states there is no such thing as over-diversification. If all stocks are always priced appropriately—meaning there is no way to increase return without increasing risk—then diversification is a free good. The more stocks you add to your portfolio, the less risky the portfolio is. According to that theory, it makes sense that investors should own lots of stocks. Effectively, your eggs should be spread across as many baskets as you can find. And that is why most mutual fund portfolios own well over 100 stocks. The problem with this line of thinking is that if stock selection doesn’t add value, then active management doesn’t add value either, and low-cost index funds become a superior choice.
But what if stocks aren’t always appropriately priced? What if, because investors occasionally are confused or overcome by emotions, some stocks get mispriced and offer a different risk-return tradeoff than other stocks? Then diversification theory gets stood on its head. Then some stocks are superior to others. Then there is a difference between one’s favorite stocks and all the other stocks. Then diversifying away from those favorite stocks reduces expected return. Instead of more diversification always being better, it becomes a trade-off of risk versus return: Holding more stocks in a portfolio lowers risk, but at the cost of also lowering expected return. You still wouldn’t want all your eggs in just one basket, but you’d recognize there is a cost for using too many baskets.
At Oakmark, we believe that the academic view on stocks is largely, but not completely, correct: We think that most of the time, most stocks are priced about right—but not always, and never each and every stock. We believe that misunderstood and “out of favor” stocks exist and that by using a disciplined approach to finding them and having the patience to hold them long-term, we can reap the excess rewards those stocks offer.
If you don’t think that is possible, I encourage you to look at the performance graphs showing how a $10,000 investment has fared in each of our Funds. Then compare that performance to the relevant benchmark index shown on each graph. All Oakmark Funds use the same long-term value philosophy. But these Funds were started at different times, and they invest in different geographies and varied asset classes. The graphs show actual returns to shareholders, meaning they already deduct all expenses.
Because we believe our stock selection adds value, we own fewer stocks than most other mutual funds. Our diversified funds (Oakmark, Oakmark International, Oakmark Global, Oakmark Equity and Income, and Oakmark International Small Cap) generally own 40-60 stocks each. Typical mutual funds own two to three times that many. We believe adding more stocks to our portfolios would decrease their expected returns and only slightly reduce their volatility.
When I started in the investment business, in the days before Morningstar made information on mutual funds so easily accessible, many fund investors picked just one fund and invested most of their assets in that one fund. Today, most mutual fund investors build portfolios of mutual funds. When we started Oakmark Select, I used to bring a prop when I spoke to investors. It answered a simple question: What would the portfolio look like for an individual who put $10,000 into the top-rated fund in each of Morningstar’s nine style boxes? And I didn’t mean just a listing of nine funds. I wanted to show the portfolio of all the stocks held through ownership of the nine funds. So I printed out that portfolio, listing each stock and showing how much of the $90,000 was invested in it. For those of you too young to remember, computer printers back then didn’t use regular paper; they used a continuous roll of paper with perforations for page breaks rather than separate pages. In any event, that printout showed a portfolio with over 1,000 stocks, and it was more than 30 feet long. Over-diversifying is not a good recipe for beating the market!
I don’t think the mutual fund industry has changed to reflect how most investors now use funds. Because investors are diversifying their assets across multiple funds, their ability to outperform the market is lessened if each fund holds over 100 securities. That’s why our diversified funds generally hold only 40–60 stocks, and our two Select funds generally own only 20 stocks. That magnifies the importance, both good and bad, of our stock selection. It also makes our Select funds great complements to holdings that are primarily indexed or to an investor’s portfolio of funds. Because the Select funds have higher volatility, they are not as appropriate for “one-stop shopping” as our other funds are.
Bill Nygren – Investing approach at Oakmark
Nearly 20 years ago, in the first quarterly report I wrote introducing the Oakmark Select Fund, I said, “By concentrating in my favorite stocks, I hope to increase the probability of achieving our outperformance goal. The downside is that the short-term results will show more ups and downs.” We’ve delivered on both goals. Our shareholders have definitely endured bigger ups and downs, but in return, they have enjoyed results that exceeded the Oakmark Fund in 14 of 19 calendar years and achieved significantly greater cumulative returns.
In that same report I also said, “We currently plan that at most times the Oakmark Select Fund will own 20 or fewer stocks, with about half of its assets in its five largest positions.” Almost 20 years later, we still aim to own about 20 stocks. But we have made one change. Graphs of portfolio volatility at the time of the Fund’s inception showed that most of the benefit of diversification was obtained by owning just 7-10 independent securities, implying weightings of 10-15% each. Now, because stocks have become more correlated with each other and somewhat more volatile, today’s graphs show that 10-15 securities are needed to get the same reduction in portfolio volatility. Based on that, we believe somewhat smaller position sizes are prudent, so we now generally limit our largest positions to 7-10% of assets. The result is that our top five positions account for about 35% of assets instead of 50%.
In 2006, when David Herro and I started the Oakmark Global Select Fund, we wrote the following in our introductory shareholder letter. I’ll quote at length because it still accurately explains how we manage the Fund today:
“As with all Oakmark Funds, we believe that we can add value via our stock selection and therefore believe that we can magnify that value via concentration. We expect the portfolio to generally contain about 20 stocks, and we expect that, over time, about half will be U.S.-based businesses and half will be based outside the U.S. When we find it easier to identify cheap stocks in the U.S, we will invest more heavily there, and we will shift to more international stocks when we believe non-U.S. opportunities are more abundant…. We are not going to be benchmark sensitive and we will not attempt to minimize tracking error—the amount our performance differs from index performance. To us, that just isn’t a useful measure of risk. We will attempt to select securities that provide undervaluation, growing values, and managements that work to maximize business value. We believe those features lessen what we define as risk—which is the chance of losing money. Our goal will be to maximize the long-term, after-tax growth of shareholder capital. And as with all other Oakmark Funds, ‘shareholder capital’ includes our own.”
The Oakmark Global Select Fund has outperformed the average of Oakmark and Oakmark International in six of the nine ensuing calendar years and has also achieved a higher cumulative return. When stock selection is good, concentration makes it better.
We know it is painful to lose money. The past two years, during which most of our Funds have underperformed their respective indexes, have been difficult, and the first week of 2016 wasn’t any better. But if you again look at the performance graphs I referenced earlier, you’ll see that all of our Funds have endured periods, sometimes for several years, when they have either lost money or lost ground relative to their benchmarks. Though these times are frustrating for our shareholders—and, remember, that includes all of the portfolio managers—these periods of weak performance have been opportunities for additional investment rather than reasons to give up on our investment philosophy.
We are invested side-by-side with you, we share your frustration with recent results and we appreciate your patience. We believe that our Funds are positioned to continue delivering on their dual long-term goals of growing investor capital and performing better than index funds. You might be interested to know that every portfolio manager of every Oakmark Fund purchased more shares in the past twelve months. Actions speak louder than words.
William C. Nygren, CFA