The Oakmark Equity and Income Fund celebrated its 25th anniversary at the beginning of November. Over its history, the Fund has managed to slightly outpace the S&P 500, despite typically having a weighting of 60% equity and 40% fixed income securities. This balanced approach also helps reduce volatility as the Fund has only had four down years in its history. As noted in the anniversary retrospective those returns were generated during adverse market conditions, including the implosion of the technology bubble, the great financial crisis, a poor decade for value stocks and the Covid-19 sell-off. Fortunately, the Covid-19 sell-off has been short lived and the market is up strongly for 2020. In fact, the rebound has been so dramatic that some now wonder if the market is in a bubble.
Although no two markets are ever the same, recent events have reminded some observers of the technology bubble that led up to the 2000 crash. This year, 19 IPOs doubled on their first day of trading—triple the amount of any year since 2000 when 79 IPOs tripled on their first day of trading. Special-purpose acquisition companies (SPACs), which raise money for companies to invest at a later date, have raised over $80 billion in 2020, more than they raised over the entire previous decade. A novice Robinhood trader made nearly 13,000 trades in a six-month period this year1. Yet the number of stocks outperforming the S&P 500 is at its lowest point since 2000, according to the Leuthold Group. Small trader call buying has more than tripled over the past year and is now even higher than its previous peak in 2000. The Russell 1000 Growth Index is up 38.5% this year versus 2.8% for the Russell 1000 Value Index. The S&P 500 CAPE ratio, which is the cyclicality adjusted P/E based on 10 years of earnings, has reached its highest point ever, aside from the 2000 technology bubble.
After increasing over 700% prior to its inclusion in the S&P 500, Tesla was the largest company ever added and is the sixth-largest company currently in the index. In terms of revenue and earnings, however, Tesla ranks 73rd and 87th, respectively, within the S&P 500. Excluding the Chinese OEMs, Tesla’s fully diluted market cap is bigger than the 10 largest OEMs combined. It is estimated that the addition of Tesla alone will increase the S&P 500 P/E from 22.0x to 22.4x. The value of in-the-money stock compensation is estimated at around $135 billion, which would be the 53rd-largest company in the S&P 500.
These stats and stories are not meant to suggest we are in a bubble, but they highlight the striking similarities between today and 2000. One simple explanation for much of the market movement can be explained by extremely low interest rates. Growth stocks have a much higher percentage of their expected future cash flows weighted well into the future, which means that a decline in rates has an outsized effect on their net present value. As we have commented before, whether many growth stocks can grow at the forecasted rate or if the distant cash flows should be discounted at today’s very low interest rates is debatable. It is also worth noting that many of today’s large technology stocks, several of which are currently owned by various Oakmark funds, are dramatically more profitable, well entrenched and trading at much lower multiples in 2020 than similar companies did in 2000.
If we are heading toward a moment like the period following the bursting of the technology bubble, this is not necessarily a bad thing for the Equity and Income Fund. In fact, despite the S&P 500 declining each year from 2000-2002, the Fund enjoyed one of its strongest periods of absolute and relative performance then. That is because our portfolio was—and is—quite different than the index. The Fund currently holds 42 stocks. These stocks range in capitalization size from small to large and they trade at what we believe are significant discounts to the market. While Covid-19 has impacted the short-term fundamentals of some of our holdings, we do not believe it will permanently impact any of them and we expect that most of our holdings’ business fundamentals will improve markedly as vaccines are rolled out in 2021. Our analytical team has extensively researched these companies and believes they trade at significant discounts to their intrinsic values.
Given how long growth has outperformed value, it is easy to forget that, historically, leadership oscillates between the two styles. The dramatic outperformance of growth stocks this year has only helped to cement investors’ preference for higher growth stocks. While this trend has pressured our near-term performance, we do not believe it is permanent and we expect that this setup will only help to exacerbate the rotation whenever it does occur. In 2000, many respected value managers left or were forced out of the industry as their returns were so far behind the S&P 500, it appeared hopeless that they would ever catch up. Just a few years later, many of the remaining value managers were handily beating the index. We are patient investors, and time has taught us that if we do our analysis well, a meaningful percentage of our investments can close their valuation gaps and reward our shareholders with attractive returns.