Oakmark Funds – A Long Term Perspective
We believe that, over time, the price of a stock will reflect the true underlying value of the company.
True underlying value, also referred to as intrinsic value, can be determined in a variety of ways. At Oakmark, we use a number of these methods to determine a company’s value. One important way we estimate value is to evaluate a company’s proficiency at generating free cash flow over time. In our view, a company that generates free cash flow and re-deploys it in a way that maximizes shareholder returns is more valuable than a company who spends their cash flow in low-returning, value-destructive ways.
We think it is especially important to focus on a company’s long-term ability to generate free cash flow – three years or more – rather than the just the next 12 months. As the diagram below illustrates, the first three years of a company’s cash flow usually amount to only a small portion of its full forecasted value when using a standard cash flow valuation model.
Source: Harris Associates. Forecasted free cash flow was calculated for a typical company, defined as a company with a 20% return on equity, a discount rate of 8%, and a growing net income of 4% for 10 years and 1% into perpetuity.
Assumptions regarding expected growth rates and required returns – in addition to the quality of the business and its management team – are critical inputs to a cash flow analysis. However, precisely modeling the future cash flows of a company is not nearly as important to us as getting the direction and magnitude right.
At Oakmark, our investment teams spend considerable time estimating and debating the value of different businesses. In the end, we believe that carefully assessing a company’s ability to generate cash leads to better investment outcomes than speculating on short-term stock movements.
We are patient investors at Oakmark
Having a patient approach requires courage, especially during periods of underperformance. In a recent shareholder letter, portfolio manager Bill Nygren observed: “If one could avoid owning stocks in the negative years, one’s return would be even higher (and one’s risk would be lower) than if one used a buy-and-hold approach. With this in mind, many investors attempt to time their investments in stocks. But almost every study has concluded that trying to time the market is futile for most investors.” In other words, timing the market for short-term gain is extraordinarily difficult.
Since the value of a business usually changes slowly over time, we believe portfolio changes ought to occur slowly too, as short-term fluctuations in stock prices are often driven more by investor emotions than by business fundamentals. This patient approach is evident in our lower than average historic portfolio turnover.
1K.J. Martijn Cremers and Antti Petajisto, “How Active is Your Fund Manager? A New Measure that Predicts Performance,” published by Oxford University Press on behalf of The Society for Financial Studies, 2009, http://www.petajisto.net/research.html
Portfolio turnover for the 12-months ended September 30, 2014.
We believe there is enormous value in practicing a patient investment approach. As Warren Buffett reminded us during the 2008 recession:
“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Clearly, being patient can be rewarding.
Oakmark: Investing in value stocks
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
Oakmark, Oakmark Global and Oakmark International Funds: The Funds’ portfolio tends to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Funds’ net asset value than it would if the Fund invested in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Funds’ volatility.
Because the Oakmark Select Fund and Oakmark Global Select Fund are non-diversified, the performance of each holding will have a greater impact on the Funds’ total return, and may make the Funds’ returns more volatile than a more diversified fund.
Oakmark Select Fund: The stocks of medium-sized companies tend to be more volatile than those of large companies and have underperformed the stocks of small and large companies during some periods.
Oakmark Equity and Income Fund: The Fund invests in medium- and lower-quality debt securities that have higher yield potential but present greater investment and credit risk than higher-quality securities, which may result in greater share price volatility. An economic downturn could severely disrupt the market in medium- or lower-grade debt securities and adversely affect the value of outstanding bonds and the ability of the issuers to repay principal and interest.
Oakmark Global, Oakmark Global Select Fund, Oakmark International Fund and Oakmark International Small Cap Funds: Investing in foreign securities presents risks that in some ways may be greater than in U.S. investments. Those risks include: currency fluctuation; different regulation, accounting standards, trading practices and levels of available information; generally higher transaction costs; and political risks.
Oakmark International Small Cap Fund: The stocks of smaller companies often involve more risk than the stocks of larger companies. Stocks of small companies tend to be more volatile and have a smaller public market than stocks of larger companies. Small companies may have a shorter history of operations than larger companies, may not have as great an ability to raise additional capital and may have a less diversified product line, making them more susceptible to market pressure.
Before investing in any Oakmark Fund, you should carefully consider the Fund’s investment objectives, risks, management fees and other expenses. This and other important information is contained in a Fund’s prospectus and summary prospectus. Please read the prospectus and summary prospectus carefully before investing. For more information, please call 1-800-OAKMARK (625-6275).
