- Being worried about an all-time high hasn’t been a good reason to stay out of the market for the past 35 years
- Cost reductions tend to get passed through to customers unless companies have monopoly-like power. The more commodity-based a company is, the more that tax benefit gets passed through to customers as lower prices
- Looking at the past ten years, cumulative growth hasn’t been much more than 2% or 3%. At Harris, we don’t see the signs of excess in the economy that typically precede a recession
- The important thing is to look past the short term and anticipate what a business might be worth years from now
I’ve worked at Harris Associates for almost 9500 trading days. On 683 of those days, the market has reached an all-time high. It’s just not that unusual.
For example, two weeks after I started at Harris in 1983, the S&P 500®1 hit an all-time high of 166. Anyone who said then “I’m too smart to buy into the market near an all-time high – I’ll wait for it to fall 10%” – is still waiting. It never fell 10%. In fact, the price of the S&P 500® is up nearly 20-fold since then and over 40-fold if you include the reinvestment of dividends.
Yes, the market cycles up and down, but it has trended upward over time. Being worried about an all-time high hasn’t been a good reason to stay out of the market for the past 35 years and I don’t think it’s going to be a good reason to stay out of it in the coming years either.
S&P® 500 earnings forecasts are up only about 2% from last year – doesn’t this signal the end of a good economic period?
I think the effect of the 2017 tax cut on annual corporate earnings is something that hasn’t gotten nearly the attention it should. For a business, a tax cut is like any other cost reduction – whether that’s a raw material cost or labor cost. Cost reductions tend to get passed through to customers unless companies have monopoly-like power. The more commodity-based a company is, the more that tax benefit gets passed through to customers as lower prices. This doesn’t happen right away – it happens over time.
If you look at S&P 500® earnings growth from 2016 to August 2019, it averaged about 11.5% per year over that period. I think that the benefits to customers of that tax cost reduction have pretty much worked their way through the system. Now, growth is much lower – just 2% or so. I would expect that beginning in 2020 we will start to see a much more normal relationship between corporate earnings growth and GDP growth.
The recovery from 2008 can’t last forever – isn’t it time to concede a recession is right around the corner?
I think you have to measure an economy recovery not just in duration, but also in magnitude. If you look at the past ten years, cumulative growth hasn’t been much more than 2% or 3%. At Harris, we don’t see the signs of excess in the economy that typically precede a recession.
But let’s forget all that and say maybe a recession is around the corner. Obviously, we don’t know when a recession will happen – nobody knows. However, I think the lingering memory of how bad the 2008 recession was may be making investors much more fearful than they really should be.
Over the course of my career – with the exception of 2008 – by the time you actually know a recession has occurred, you’re on your way out of it. A typical recession has been a fraction of 1% decline in GDP in one quarter. During the next quarter, you wonder whether or not you’ll get another quarter of decline to fit the technical definition of a recession or not. In fact, a lot of the recessions haven’t even produce a decline in annual GDP. Instead, they were a fractional decline for a couple of quarters, followed by growth. When you put the whole year together, it produced a subpar growth year, but still a growth year.
I’m not predicting a recession and I’m not hoping for a recession. I just don’t think it’s something to be as afraid of as many investors seem to be today.
Q4 2018 was the first time Harris Associates’ strategies had a year when they were down more than the S&P 500® was down – doesn’t that mean Harris Associates portfolio managers are doing something different?
We aren’t doing anything different at all. I would argue instead that two sectors have changed – both of which are typically in value portfolios and can cushion the impact of market declines.
The first is so-called safety stocks – consumer non-durables, utilities. In my view, many of these stocks have been bid up by fixed-income investors who are happy to accept the low growth rate in such companies because they have high dividend yields. Because we believe companies like this are selling at a high market price relative to their value, they aren’t in our portfolios. As a result, our portfolios have had somewhat higher beta in declines more recently than they have had historically.
Secondly, I would point to the way financial stocks have behaved. Typically, financials have been viewed as a less risky area of the economy during a moderate recession. They sold at very low price-to-earnings (P/E)2 multiples, they had a relatively low growth forecast, and moderate recessions didn’t change that much. Today, I believe these stocks are affected by recency bias. That is, I believe many investors are concerned that financial stocks – especially banks – will behave like they did in the recession ten years ago.
However, it’s my view that banks have been much more volatile in the stock market than they have been in their earnings fundamentals. We don’t see any reason to believe why a moderate recession would create a negative outcome for long-term bank valuations. This is in part because of the amount of capital that banks have today and the revised lending standards they’ve been using over the past decade. That doesn’t stop investors from moving those stocks up and down in pretty big swings, even though the fundamental values are not changing that much.
Should I worry that Harris Associates seems to have a more expansive definition of “value” than its peers?
This is true – but I don’t think it’s a reason to worry.
Most of our peers rely pretty heavily on general accepted account principles (GAAP) P/E or GAAP price-to-book value, as opposed to non-GAAP figures. Harris Associates ventures outside of that area to look at companies where we think GAAP does a disservice to representing business value.
Some companies may not look cheap when you look at GAAP P/E or GAAP price-to-book. However, if you look at all of a company’s different components, you can uncover reasons to justify why it could be selling below market value or at a premium multiple. The important thing is to look past the short term and anticipate what a business might be worth years from now. We have optimism for the stock market, optimism for our value-based, active approach to investing, and a lot of patience when business fundamentals are going the way we expect them to.
2 The price-earnings ratio (P/E) or price-earnings multiple is the current market price of a company share divided by the earnings per share of the company.
Published in October 2019
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