Bill Nygren’s letter to Oakmark investors for the fourth quarter ended December 31, 2016.
After the past quarter’s commentary highlighting Oakmark’s 25th anniversary, I was asked, “Why in the world did you have confidence 25 years ago that a small, Chicago-based, high-net-worth account manager could succeed in the mutual fund business, competing against many well-established, much larger firms?” I think the answer gives good insight into how we think, so I wanted to share it.
Perhaps we were somewhat naïve about the challenges we faced, and to the extent that played a role, I’m glad we didn’t realize what a difficult journey we were embarking on. But we weren’t a startup—Harris Associates had been successfully investing on behalf of its clients for 15 years. And being in the industry, we knew enough about the competition to identify five things we would strive to do better than existing funds.
Our Brand-Oakmark-Will Have Meaning
In the late 1980s, Morningstar became the dominant evaluation service for mutual funds. One of its great advances was to classify funds according to their investment style and universe. So instead of just comparing an equity fund to an index like the S&P 500, an investor could compare it to other funds that invested in the same size companies and that used the same investment approach. They created a box comprised of a nine-square grid that represented market capitalization (from small to large) and approaches (from value to growth), and they assigned each fund to a “style box.” Marketing departments for the big mutual fund companies saw the opportunity to offer funds in each style box, which resulted in a massive increase in the number of funds offered.
We never had an interest in filling all the style boxes. We knew we were good at one thing and one thing only—bottom-up value investing. So we thought it would be an advantage to our investors that when they heard the name “Oakmark,” they would immediately associate it with value investing. Unlike the larger firms, our brand name was going to mean something. Our goal was for Oakmark to make the short list when investors asked, “Who has a good value fund?” And it wouldn’t matter whether the question was about stocks or bonds, United States or international—Oakmark would be synonymous with bottom-up, long-term value investing.
Oakmark Communication Will Be Educational
Most mutual funds seemed to view shareholder communication as a necessary evil. As such, they allowed legal requirements to dictate how they communicated, writing reports twice a year that commented on the securities that most influenced recent performance. Based on our experience managing portfolios for individuals, we knew that the clients who had the best experience with us—and were our longest-tenured clients—were those who’d taken the time to learn how we thought about investing and why we expected our investment philosophy to work in the long run. During the inevitable periods of underperformance, those clients were the ones most likely to stay patient. The ones who focused only on short-term performance tended to come and go rather quickly.
With that in mind, we set out to use every opportunity to educate our current and potential shareholders about our investment philosophy and the team we had built. We wrote shareholder letters every quarter, rather than the required six-month interval. Instead of just writing about which stocks we bought and sold, we wrote about why we made those transactions. We made our portfolio managers available to the press, especially for stories about value investing. And we’d go on TV to explain how this strange creature, a value investor, could ignore day-to-day news and fads, instead investing with the expectation that we would keep our positions for about five years. Our goal was to have enough publicly available information that all of our shareholders and potential shareholders could know how we thought, rather than just knowing how we’d performed last quarter. By doing so, we cut down on the number of performance chasers in our Funds, which helped lower the costs created by in-and-out trading.
Oakmark Will Limit Diversification
The average mutual fund owns well over 100 securities. The logic of spreading one’s assets across such a large number of securities is consistent with academic teaching. Finance 101 students are taught that diversification is a “free good.” Since the market is assumed to be efficient, adding more securities does not lower the return of the portfolio but does lower the risk. The mutual fund industry followed that logic by constructing highly diversified portfolios that minimized the harm any one bad stock could cause. The problem with that reasoning is that its logical extension is that all investors are best served by passively owning a little bit of everything—or, in other words, index funds.
Diversification is only a free good if one cannot identify mispriced securities. Once the concept of mispricing is introduced, diversifying away from undervalued securities reduces a portfolio’s expected return. Instead of more diversification always being better, diversification becomes a trade-off: it lowers the risk but at the cost of also lowering expected return. As value investors, we at Oakmark believe we can identify securities that offer unusually favorable returns. We don’t want to dilute our best ideas any more than is required to be prudent. We want to strike a balance between the risk we are taking and the incremental return we expect our best ideas to achieve. So instead of over 100 stocks in our Funds, you’ll find our diversified Funds have less than half the industry average—around 50 holdings—and that our concentrated Funds have less than half that number—normally about 20. By limiting diversification, we increase the impact our favorite stocks have on our Funds.
Oakmark Managers Will Invest Personal Capital
At most mutual fund companies, the decision to launch a new fund is driven by the marketing department. Based on the types of funds investors are buying, fund companies race to produce new offerings that they believe will successfully attract assets. The problem with that approach is that giving investors what they want, when they want it rarely produces good investment returns.
At Oakmark, the process couldn’t have been more different. We started the Oakmark Fund because we wanted to invest our own capital in the same stocks we were purchasing for our clients. We thought that because we wanted to invest our own money that way, we should be able to convince others it was also appropriate for them. And that was the case with each of the seven Oakmark Funds. I’m still surprised by how many mutual fund managers choose to invest most of their personal capital in something other than the funds they manage.
Oakmark Will Strive to Maximize After-tax Returns
Most services that evaluate mutual funds do so based on pre-tax returns, so it is no surprise that most managers pay very little attention to taxes. The poor track record most funds had with taxes led to the launch of many so-called “tax sensitive” or “tax efficient” funds in the 1990s. The problem was those funds were so focused on minimizing taxes that they sacrificed returns to lower the tax bill.
At Oakmark, we focus instead on maximizing after-tax returns. That’s a very different goal than seeking to minimize taxes. If one thinks of pre-tax returns as a donut and the hole in the middle as taxes, we’re trying to maximize the size of the donut after the hole has been taken out. During the year, we take steps to lower our shareholders’ tax bills without decreasing their pre-tax returns. Because we hold almost all of our positions for more than a year, nearly all of our capital gains distributions qualify for long-term capital gains treatment, which cuts most investors’ taxes almost in half. If a holding appreciates to our estimated value in less than a year, we will often drag our feet on the sale, which allows the more favorable tax treatment to apply. Additionally, we actively tax trade our loss positions throughout the year, adding to those we believe are most attractive and trimming the least attractive. Then, after 30 days, when the wash sale clock has elapsed, we reverse those trades to capture the losses. For the long-term investor, this means their investment returns typically exceed their taxable returns. By deferring taxable gains, the power of compounding returns increases.
Where Oakmark is Today
After 25 years, we’ve changed very little. The Oakmark brand, as we had hoped, has become joined at the hip with value investing. Investors know that an Oakmark portfolio will be full of securities that are widely considered out-of-favor and that we believe are undervalued. We have received commendations for producing industry-leading shareholder communications. Our portfolios continue to be much more focused in our favorite securities than most in the industry. We continue to personally invest in our Funds, and our tax management boosts after-tax returns. In our president’s letter, once each year we voluntarily disclose the total investment of our employees and directors in our Funds. As stated in that letter this quarter, the portfolio managers and employees of Harris Associates, as well as the Funds’ Trustees, have personal investments of over $400 million in our Funds.
This was a combination of attributes we thought should appeal to potential investors. Given a total today of $70 billion of shareholder capital invested in our seven Funds, investors seem to agree. Our team thanks each and every one of you for the confidence you’ve expressed in us.
William C. Nygren, CFA
Portfolio Manager
