At Oakmark, we buy stocks at substantial discounts to our estimates of their intrinsic value, taking the perspective of being the sole owner of a private business. We estimate these intrinsic values by forecasting future cash flows and discounting them to today. Currently, our view is that the S&P 500 trades at a 2020 GAAP P/E ratio1 of around 23–24x, which, converting earnings to cash flow, means the typical company could generate 4%–5% of its current market cap in 2020 cash. Mathematically, most of the total value of a growing company may come from the aggregate cash it will potentially generate in the years 2023–2050 and beyond.
If 2020 cash flows for the entire market dropped all the way to zero, the aggregate value of the market should only fall by 4%–5%. Therefore, we believe the proper question to ask when analyzing the coronavirus (or any emerging macro risk) is “How much will this affect the long-term cash flows of businesses?” I doubt very much that the owner of a thriving family business would accept a dramatically reduced offer for her entire company today versus two months ago simply because of virus fears.
While we can’t answer that long-term cash flow question with certainty, we can look back at prior “epidemic” fears to see the impact they had over time. SARS, bird flu, Ebola, and the West Nile virus are all examples of exogenous medical emergencies that the market faced the past two decades. In all cases, world economies adjusted to the threats without seeing significant impacts to long-term cash flows. In all four of those cases, the S&P 500 index exceeded its pre-outbreak high within two months of the initial concerns.
But it’s not just epidemics...it’s always something. In Bill Nygren’s third-quarter market commentary of 2016, when he discussed the Oakmark Fund’s 25th anniversary, he cited a litany of frightening events that occurred over that preceding quarter century (including the aforementioned epidemics, Desert Storm, 9/11, the global financial crisis, Brexit, etc.).
As with those other nerve-wracking crises (each uniquely different), no one knows how this particular issue will develop. There isn’t enough data today to reach specific conclusions. But you should know that at Oakmark, our framework for dealing with exogenous risks like this is to attempt to determine the impact on business value rather than extrapolate near-term costs in perpetuity.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
The S&P 500® Index is a widely recognized measure of U.S. stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large cap segment of the US equities market.
The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the US equity market. All returns reflect reinvested dividends and capital gains distributions. This index is unmanaged and investors cannot invest directly in this index.
The price to earnings ratio (“P/E”) compares a company’s current share price to its per-share earnings. It may also be known as the “price multiple” or “earnings multiple”, and gives a general indication of how expensive or cheap a stock is. Investors should not base investment decisions on any single attribute or characteristic data point.
GAAP (Generally accepted accounting principles) refers to a common set of accepted accounting principles, standards, and procedures that companies and their accountants must follow when they compile their financial statements.
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