| Commentary on The Oakmark and Oakmark Select Funds 3/31/2008 |  |
| “More than any time in history, mankind faces a crossroads. One path leads to total despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.” |
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I guess Woody Allen wouldn’t be an uplifting commencement speaker. But his view of the world, almost thirty years later, seems to be the dominant view in today’s commodity and credit markets. If prices in those markets reflect fundamentals, then we are facing a future of materials shortages and unprecedented bankruptcies. If one looks at Main Street instead of Wall Street, the picture, though far from perfect, looks much brighter. Businesses are profitable, unemployment is low and consumer spending remains at reasonable levels. Is it possible that market forecasts could be that far off the mark?
As large shareholders in JP Morgan, we took more than a passing interest in its agreement to purchase Bear Stearns. Bear opened its doors in 1923, survived the Great Depression and grew into one of the world’s leading securities firms. Like many other financial services firms, Bear had heavy exposure to home mortgages because those securities historically had very low default rates. Like many of its peers, Bear’s 2007 earnings were nearly erased by mortgage losses, and its stock price was cut in half, closing the year at $88. By Thursday, March 13, Bear stock had fallen to $57. Up to that point, you could have substituted quite a few financial company names for “Bear Stearns,” and the story would have hardly changed. On Friday, March 14, however, Bear’s story sharply diverged from the others. Rumors that Bear had a liquidity problem caused customers to search for safety and move their funds to other firms. The stock price was again cut in half to $30. In that one day, Bear’s liquidity problems sharply increased as it needed to sell assets to fund withdrawals. The downward spiral had gone too far to be reversed. On Sunday, JP Morgan agreed to rescue Bear Stearns for $2 per share. A run on the bank had virtually wiped out the stockholders. Did the short sellers profit from being quick to identify a fire raging out of control, or had they spotted a spark and thrown gasoline on it? The answer to that question will be an important one to those calling for more regulation. To the stockholders, whether or not Bear was insolvent on Thursday had become irrelevant. On Sunday it was. Fearful investors had forced the outcome. At least it was one of our companies, JP Morgan, that was positioned to take advantage of an amazing bargain (even at the revised price of $10 per share).
There is a tremendous amount of fear in today’s markets. Some portion is due to real economic events. The future for home prices is clearly not the straight upward march it used to be. With average home prices already down 10% from their peak and many homeowners having borrowed as much as their banks would allow, credit losses are certainly increasing. But are loss rates really going to be as high as the bond market is predicting? We normally like to use market prices as estimates for macro variables such as bond default rates, future inflation rates, or energy costs. We assume that those markets incorporate their specific experts’ best thinking and that our time would be more productively spent analyzing individual companies. However, the magnitude of gaps we now see between price and value across many markets has made it imprudent to simply use current market prices for our forecasts.
In his New York Times column last month, Ben Stein argued that today’s economy is not in such bad shape, but rather, “the new part is the hedge funds and the changing of Wall Street from a financing entity to a market manipulation entity.” In its cover story “Guess Who’s Behind the Commodities Boom,” Barron’s argued that the increase in most commodity prices had less to do with changes in supply and demand than it did with increased investment by institutions who now consider commodities an asset class deserving of a higher portfolio allocation. Barron’s states that most long positions are held by speculators and most shorts are held by suppliers. This implies that if commodity market participants were limited to producers and consumers, prices would almost certainly be much lower. A recent article in the Wall Street Journal examined the role short sellers play in stock price declines. In July of last year the short sale rules were changed to make it easier to sell short stocks that were already falling. The article quoted legendary fund manager Marty Whitman, who said “In my 58 years in the market it has never been easier to conduct bear raids.” As these articles suggest, there are numerous examples of large pools of new capital whose investment rationale is unrelated to estimates of intrinsic value. In the long run, the resulting higher price volatility should improve the opportunities for investors like us, but in the short run it requires more suspicion of the assumption that any given day's market price reflects long-term fundamental reality.
As shown by Bear Stearns, the market today is extracting a large toll from forced sellers. Though we always discourage short-term investing, we believe that such advice is especially important now. The gaps between price and value in a fearful market can become very large. If you have to sell stocks by a certain date, the risk is high that you might not get full intrinsic value for those shares. As always, we believe that equity investors, including those in mutual funds, should only invest capital that can remain invested for at least five years. We also don’t ever want an Oakmark fund to be a forced seller. That’s why we keep a percentage of each of our mutual fund’s assets in cash equivalents. Some argue that funds should invest every last dollar to prevent cash from being a drag, but we believe that by holding some cash we not only avoid the cost of forced selling, but we are positioned to benefit when other sellers become desperate.
The financial media is painting a picture that is similar to the Woody Allen quote at the beginning of this report: If the Fed acts aggressively then we are doomed to a future of hyper-inflation and a permanently declining dollar. If the Fed doesn’t act, then there is no bottom to the housing market and we are headed toward a depression. We hope they have the wisdom to choose correctly! As you might guess, our view is not so dire, and is in fact quite positive. We find it encouraging that the Fed is thinking outside the box and directly targeting the problem of financial market illiquidity. More importantly, we believe that the dividend yield of the S&P 500 now equaling the five-year Treasury yield is a significant sign of undervaluation. When the front page news is so negative, there is a high probability that the reality won’t be as bad as feared. In 1995, the financial author John Train wrote The Craft of Investing. Five years ago I cited a section from his book that described a typical market bottom. I think it is worth revisiting:
“At a major bottom, current business news is usually terrible and many authorities feel that things are likely to get even worse. There are several spectacular bankruptcies, of international importance. Unemployment is usually up. There is usually some grave unresolved national problem that is bothering everybody. The brokerage business itself is likely to be in the dumps, with many bankruptcies. Big “producers” of the up years have to cut back on their lifestyles. Wall Street’s own desperation reinforces the syndrome. When in a market collapse everything finally caves in during a few catastrophic days and weeks, there is an almost audible flushing effect. Stocks are hurled into the abyss, like the cargo of a sinking ship that the crew is desperately trying to save. Value means nothing.”
To me, the Bear Stearns collapse was “an almost audible flushing effect.” There is, of course, no guarantee that things won’t get worse, but this environment seems to closely parallel Train’s description of a bottom. Time to buy?
William C. Nygren, CFA
Portfolio Manager
oakmx@oakmark.com
oaklx@oakmark.com
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