“Investing is forgoing consumption now in order to have the ability to consume more at a later date.” Warren Buffett, Berkshire Hathaway 2011 Annual Report to Shareholders
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.
2012 is off to a great start for stock market investors. The S&P 500 was up 13% for the quarter. In just one quarter the S&P 500 returned more than a seven-year U.S. government bond would have returned over its entire lifetime.
In our letters last year, we said that we believed stocks were priced to offer better returns than bonds. We urged investors to restore balance to their portfolios. Bonds had outperformed stocks by so much that unless investors rebalanced their allocations, bonds became a higher percentage of their portfolios. To bring portfolios back to asset allocation targets, most investors needed to sell bonds in order to purchase equities.
But throughout the year, bonds kept going up while stocks moved sideways, and investors kept selling their stocks to buy more bonds. Finally, in the past quarter, bonds declined while equities rose, reversing most of last year’s divergence (though interestingly, industry data continues to show redemptions in equity mutual funds and inflows in bond and hybrid funds). Now some investors are asking if we think it is too late to invest in stocks. We don’t think so.
We’ve previously written that corporate balance sheets are now unusually strong and that an unusually small percentage of corporate earnings are being paid out in dividends. We believe that excess liquidity and excess cash flow will lead to more dividend increases, more share repurchases and more acquisitions. Some of you have asked how soon we think that might happen. The answer is that it is already happening.
Since most of our companies are on a December fiscal year and report full-year results during the March quarter, this is a good time to look at what happened during 2011. I’ll use the Oakmark Fund portfolio of 56 companies for this analysis. (For those of you who are more interested in the Oakmark Select Fund, the conclusions would be similar for that portfolio.)
For starters, 42 of our holdings, about 75%, increased their dividend last year. For those that paid a dividend in 2010, the median increase for 2011 was more than 11%. Not too shabby for what is being termed a no-growth economy. And remember that even before the dividend increases, stocks were yielding more than bonds.
In 2011, 47 of our 56 companies, 84% of our holdings, reduced their outstanding shares. One of my favorite managers, John Malone of Liberty Interactive and Discovery Communications, likes to remind investors that business value per share is a ratio: the company’s total value is the numerator and the number of shares is the denominator. As Malone says, sometimes it is easier to grow that ratio by shrinking.
For our companies that reduced their outstanding shares, the median share reduction was just over 3% in 2011. Although that might not sound like much, if a business grows its earnings by 4% while shrinking its shares by 3%, EPS will grow at a 7% rate. That is a point that I believe is missed by many who argue that earnings growth will be disappointing.
Our biggest share repurchasers retired a lot more than 3% of their shares. Northrop Grumman (NOC) reduced its shares by 13%, DirecTV (DTV) by 14%, and our largest repurchaser, Kohl’s (KSS), reduced its share base by 18%. For these companies, the share repurchase was almost as meaningful as a large acquisition. But unlike an acquisition, they didn’t have to pay a control premium, didn’t face integration hurdles, and won’t be surprised after they get to know the businesses. They each acquired the business they already know best.
Though we are often skeptical of the economics of large acquisitions, small add-on acquisitions often boost business value. In 2011, 40 of our 56 companies, just over 70%, were net acquirers of businesses (meaning the cost of their acquisitions exceeded any proceeds from divestitures). In most of these cases, the acquirer was able to pay what looked like a high multiple of current earnings, but that multiple will soon decrease substantially due to improved economies of scale. When a management believes that it is acquiring a business at a larger discount to value than its own stock sells at, we are happy to see our capital spent on acquisitions.
A year ago, we wrote about corporate balance sheets having less net debt (debt minus cash) than at any time in the past 20 years. Despite such a strong starting point, last year 27 of our 56 companies ended the year with even less net debt. With interest rates so low, strengthening the balance sheet produces very little incremental earnings. Cash that earns 1% after tax would have to be valued at 100x earnings to fully reflect its value. With the stock market trading at just over 13x expected earnings, it seems that cash today is an unusually hidden asset.
Finally, most of our companies haven’t been putting all of their eggs in just one basket. Twelve of our companies, just over 20% of our holdings, used their cash flow to achieve all four goals: they increased the dividend, reduced the share count, made an acquisition and still ended the year with a stronger balance sheet. Thirty-seven of them, about two-thirds, accomplished three of the four goals.
We expect these uses of cash will continue to drive value growth for our companies in 2012 and beyond. Consensus forecasts for S&P dividends in 2012 amount to only 28% of expected 2012 earnings, and that assumes a 9% increase in S&P dividends from 2011. That leaves 72% of earnings to fund incremental growth. Some of these earnings will be needed to support organic growth, but barring a strong economy, companies will still have plenty of capital for continued share repurchases and acquisitions. With acquisitions adding to the earnings numerator and repurchases reducing the denominator, EPS growth could be surprisingly strong even if the economy isn’t.
As investors compare stocks and bonds, we believe the choice is clear. Bonds are near historically low yields, yet stocks remain priced slightly below their long-term average P/E multiple. Stocks currently yield more than intermediate-term bonds and are expected to continue to increase their dividends. Stocks also provide some hedge against higher inflation. When inflation increases, corporate earnings growth typically accelerates. Bonds are fully exposed since neither their principal nor their interest increases to offset inflation. When one thinks about which investment is likely to achieve Buffett’s goal of allowing an investor to consume more in the future, we think equities remain the easy choice.
William C. Nygren, CFA