Wall Street never changes, because human nature never changes.
-Jesse Livermore
Indexing is on a winning streak
Active managers had an unusually tough year in 2014. Only 10% of equity mutual funds outperformed the S&P 500. There was blame assigned to the usual suspects—fund expenses, trading costs, and cash that earned next to nothing. Additionally last year, stocks of global companies headquartered outside the U.S. (think Nestle, Diageo and Unilever), yet owned in many mutual funds, performed much worse than their U.S.-based peers in the S&P 500. Also, some of the largest companies, like Apple and Microsoft, performed very well. Many mutual funds base their position sizes on perceived attractiveness rather than on capitalization, as the S&P 500 does. So even if a mutual fund owned these stocks, as Oakmark did, they likely added more to the performance of the S&P 500 than to the mutual fund’s portfolio. All-in-all, the average equity mutual fund returned only 8% last year while the S&P 500 returned 14%. And unfortunately, the Oakmark Fund wasn’t in the 10% of funds that performed better than the market.
At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.
For most mutual funds, performance wasn’t disappointing just in 2014. As investors looked back at three-year performance, the average fund trailed the S&P 500 by seven percentage points, and over a five-year period, that gap increases to nine percentage points. Predictably, this has led many investors to question the rationale for active management, and they have increasingly shifted to index funds. So where does that leave Oakmark, whose Funds are not only active, but are quite concentrated compared to its peers?
For starters, we don’t see anything wrong with passive strategies, such as owning index funds. We expect the global economy to achieve good long-term performance, and therefore we expect equities to continue delivering higher long-term returns than most other asset categories. At the same time, we don’t see any reason that the investing environment we face today is materially different than what we’ve faced throughout our history, and our Funds’ historical returns speak for themselves.
Why that won’t change
How should we define success for active managers? A March article in The New York Times, titled “How Many Mutual Funds Routinely Rout the Market? Zero” defined success as having a top quartile return in each year since the market bottom in March 2009. 1 By that standard, each of the 2,862 mutual funds they studied failed. Though predictable annual outperformance would be the holy grail, is that really the hurdle for claiming an active manager has failed?
Academics believe that risk and return correlate nearly perfectly. In their world, the only way to earn a return greater than the market is to take more risk, and likewise, the consequence of taking less risk than the market is earning a lower return. Were that the case, the only logical conclusion would be to own an index fund and use cash or debt to adjust the risk level to personal preferences. Success in this world—or proving the academics wrong—would be achieving a long-term return higher than the market without taking increased risk—or achieving the market return while reducing risk. What matters is the cumulative long-term return and the risk taken to achieve it, not the ranking in successive annual performance scorecards.
If you summed up the holdings of all active investors (both individual and professional), you’d end up owning the entire market portfolio. So no matter how each investor structures his or her portfolio, the average of active investors will be market performance. This means that net performance, after expenses, has to be worse than the market. That’s just the unpleasant fact. No way around it—summing up all the results, as a class, active managers are destined to fail. That’s why Vanguard’s John Bogle preaches that most investors would be better off not trying to beat the market and instead should just purchase index funds.
Why Oakmark expects to keep winning
The only way investor A can succeed is to trade with investor B, who willingly takes the losing side. Think about that when you evaluate different managers—to succeed, they need to get investors to take the other side of their trades. When a manager says, “We buy growth at a reasonable price,” does that mean the investors they sell to are saying, “We buy growth at an unreasonable price”?
At the beginning of each Oakmark commentary is the following statement: “At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.”
Are we dependent on finding investors who want to own shrinking businesses managed to the detriment of their shareholders? Of course not. We are generally purchasing stock from investors who appear to have overreacted to negative news that we believe will have little impact on long-term business value. Or if the other investors do share our assessment, they aren’t prepared to wait for the stock price to reflect it. Purchasing from a fearful seller at a reduced price allows us the opportunity to earn a higher return and to also reduce our risk. To believe we have a chance to succeed, you must believe that other investors are impatient or emotional. I believe there is a tremendous amount of evidence that throughout history many—if not most—investors act emotionally or impatiently. In fact, I’d go so far as to say that’s just human nature. In effect, then, our investment approach capitalizes on other investors not being able to suppress human nature. That’s why I believe our historical success can be sustained.
As an aside, one might ask why I have such confidence in our long-term prospects when the Oakmark Fund has gained less than the S&P 500 in the past year. The biggest causes of our underperformance have been our heavy ownership of financials, especially banks, which have trailed the S&P 500, and our underweighting of healthcare stocks, many of which have exceeded our estimates of their intrinsic value. To anyone who has followed us, it should come as no surprise that we were early in selling a very strong sector and then used that capital to add to a less popular sector. That’s the same thing we’ve been doing for more than twenty years. And we know from experience, it often doesn’t start working immediately.
Why Oakmark concentrates
If you agree that stocks are likely to achieve good long-term returns and that a disciplined investor has the opportunity to outperform, then why concentrate? Again, the academics highlight diversification as a “free good” of which more is always better. That is the logical conclusion stemming from their belief that there is no way to select stocks, adjusting for risk, that will outperform the market. If stock selection can’t add value, then concentrating into a smaller number of holdings won’t increase expected return, but it will increase risk. And that’s bad. Even among active managers, you can see how the “more is better” view of diversification has influenced portfolio construction: the average equity mutual fund holds 121 stocks.
Shortly after I started managing Oakmark Select, I was on a panel of investors discussing portfolio concentration. The manager seated next to me spoke glowingly of his process, which produced a portfolio that was invested in hundreds of stocks, and proudly stated, “This ensures that no single mistake can meaningfully hurt the portfolio.” My response was not well-received: “If mistakes don’t matter, doesn’t that mean successes don’t matter either?” (I’ve since learned that—despite the moderator’s encouragement to speak up—investment panel decorum is to sit silently when others spout nonsense.) Active managers who widely diversify across hundreds of stocks have almost no chance of outperforming the market after deducting their fees and expenses. They are “closet indexing” with the goal of not underperforming by enough to get fired.
Our starting point is very different at Oakmark. We believe our disciplined long-term approach allows us to add value via stock selection. And since we believe that, we quickly get to the point that any benefit from reducing risk by adding more stocks to our portfolio is outweighed by the return lost from diluting our best ideas. We are trying to maximize our probability of outperforming by a meaningful amount. That’s a very different goal than closet indexers have. That’s why our Funds range from a low of 20 stocks to a high of about 60. Our most diversified portfolios have only half the positions of our average competitor.
Why over diversifying is a problem
Many well-intentioned mutual fund investors collect mutual funds for a hobby. They find an attractive fund and add it to their existing portfolio of funds. Eventually they own dozens of funds, each designed to have enough diversification to protect an investor who puts all their equity assets in that one fund. Adding together all the funds they own, these investors often end up with a portfolio that doesn’t look much different than the market, yet they are paying active management fees on the entire portfolio. The math suggests their likelihood of outperforming the market after fees becomes de minimis.
We realize that most Oakmark shareholders use our Funds for just part of their mutual fund portfolio. Since our investors are already taking steps to diversify their assets, we believe it is counterproductive if our portfolios are also heavily diversified. By concentrating our assets in our best ideas we are restoring our shareholders’ opportunity to outperform.
We have great respect for the index funds we compete with. And we don’t begrudge John Bogle’s evangelic zeal for these products. In fact, he’s probably right when he says that many investors won’t put in the effort to identify attractive funds, and of those that do, many won’t have the courage to stick with them when they encounter inevitable difficult times. So they really would be better off just buying index funds. But, for the disciplined investor who is willing to put in the effort—and who doesn’t panic when times are tough—there is still as much opportunity as there has ever been for active management to add value. Human nature doesn’t change.
As of 03/31/15 Nestle represented 1.5%, Diageo 1.4%, Unilever 1.3%, Apple 2.0% and Microsoft 1.5% of the Oakmark Fund’s portfolio of net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
As of 03/31/15 Nestle represented 0%, Diageo 0%, Unilever 0%, Apple 0% and Microsoft 0% of the Oakmark Select Fund’s portfolio of net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Click here to access the full list of holdings for The Oakmark Fund as of the most recent quarter-end.
Click here to access the full list of holdings for The Oakmark Select Fund as of the most recent quarter-end.
1”How Many Mutual Funds Routinely Rout the Market? Zero,” The New York Times http://nyti.ms/1ACOJEG, March 14, 2015
The Oakmark Fund’s 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 Fund’s 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 Fund’s volatility.
Oakmark Select Fund: Because the Fund is non-diversified, the performance of each holding will have a greater impact on the Fund’s total return, and may make the Fund’s 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.
The discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds’ investment adviser, at the time of this letter, and are subject to change without notice.
