“Life starts all over again when it gets crisp in the fall.”— F. Scott Fitzgerald, The Great Gatsby
When the calendar flips from September to October, there generally is a palpable buzz in the upper Midwest. Whether it’s fall activities like apple picking, soup season, football, baseball playoffs or fun concoctions from coffee shops, “sweatshirt weather” seems to bring a bit of a reprieve from the humid summer. In addition to humidity, it was a tough go of things throughout the summer of 2022, whether your topic of choice was geopolitical, financial or Chicago sports. Any link you clicked or paper you opened seemed to point to more consternation among the populace, regardless of topic. Despite the headlines, there is hope for investors that the calendar turn will allow for a respite along the lines of cooling temperatures.
Investors have had a bit of a harrowing ride through the first three quarters of 2022. While the market notoriously dislikes uncertainty, this year has provided it in spades. Rising inflation, interest rate hikes, the ongoing war in Ukraine and the list goes on. The optimist would hope we are beginning to see the light at the end of the tunnel for some of these market overhangs. Perhaps answers to some or any of these overhangs in the final three months of the year would be a broad lift to the market. Such short-termism is never our focus at Harris Associates. In fact, we believe it is often that line of thinking that can lead to investing mistakes.
The volatile nature of this Jekyll-and-Hyde market has made that negative sentiment even more pronounced. Whether it was a strong July or a dour August and September, it seemed the market couldn’t find stable footing. Two notes highlight this point. First, the last seven sessions where the S&P 500 was positive in September were immediately followed by days where the market took all those gains back. Further still, within the quarter, the market was up 15% at one point only to finish down 5% by the final bell on September 30. That ~20% peak-to-trough move was the second-largest delta we have seen in the index’s history within that short of a timeframe.
The market has justified concerns, and that is why we have seen equities’ performance struggle thus far in 2022. We do not want to be ostriches with our heads in the sand when it comes to the factors that have driven market sentiment very negative—and understandably so. So, while we pay attention to any potential economic issues that could impact the earnings levels or quality of the businesses we own, we want to be able to maintain the long-term focus and discipline that have historically carried us.
With that backdrop, where does any sense of optimism come from? The short answer: The S&P 500 has fallen 20% or more six times (1962, 1974, 2001, 2002, 2008 and 2022). In four of those previous five periods, we have seen positive in the fourth quarter—so there’s an 80% chance it turns!
Curious as to the longer and more thought-out answer? It breaks down into two pieces for investors: firm history and valuation.
On the history side of the equation, the short answer is, “We have been through this before.” Not all bear markets are the same, nor are all the causes. But since 1976, Harris Associates has ridden out market downturns much to the success of our clients. The past is not always prologue, and there is no guarantee of future results. We believe, however, in our process and philosophy and that their repeatable nature will serve the patient and long-term investor well.
For example, take three notable recent market downturns: the dot-com bubble, the U.S. recession of late 2001 and the Great Financial Crisis. In all three instances, our disciplined style led to positive returns for our client base. When looking at the total period of pre- and post-crisis, we averaged excess returns of over 27% when compared to the S&P 500. Again, nothing is for certain. But in periods such as these, though, the market has a propensity to not be the most rational, oftentimes throwing the baby out with the bath water.
That’s where valuation comes in. Taking a 30,000-foot view, our opportunity set looks attractive. To a certain extent, that’s obvious, given the market’s downward spiral in 2022. While the S&P 500 is down 24% year-to-date through September 30, if you rewind to the end of 2020, the market has given back all the bountiful gains of 2021 and had a total return of approximately -2% for that 21-month period. It’s hard to imagine business values are flat over that two-year period.
Looking at the relevant statistics paints an important picture. Our Private Wealth Management composite portfolio comprises our team’s top holdings. The current P/E ratio is approximately 12.4x next year’s earnings compared to the S&P 500, which is 16.1x 2023 earnings. In addition, the most recently available return on equity figures, which measure a company’s profitability, is 23.2% for our composite as opposed to 19.5% for the S&P 500. This says our portfolio of companies is priced more attractively and are more profitable than the broad market. While the competitive landscape of our portfolio companies continues to evolve, we believe the numbers are encouraging when you take the long view.
On a stock-specific level, there are multiple examples. For instance, we find financials attractive at current valuation levels, especially the large deposit banks. Traditionally, these businesses can be valued at upwards of 2x their tangible book value, or the value of all the tangible assets on their balance sheets. Today, some deposit franchises we follow are being valued at only 70% of that level. This means that if these institutions simply sold all of their assets for market value, the stock should be 40% higher. This is simply too cheap, especially when interest rates are rising, which should be a net benefit to these institutions.
We find another good example of price and value dislocation in Alphabet, which is the parent company of Google, YouTube and other businesses. The headline P/E ratio is approximately 14x, which is about in line with the broad market. However, when you consider how they are investing in other pieces of their business, such as Waymo or Cloud, and factor in the cash they have on hand, the core Google and YouTube businesses are trading at 50% of the market P/E multiple. We believe this is simply too cheap for a business growing 16% overall, highlighted by 18% growth in core search and 39% in Cloud.
Concerns with the current outlook are not without merit, given the issues at hand. We could see earnings adjustments as companies reassess their outlook, continued belt-tightening due to inflation, overly-aggressive Fed rate hikes, or a host of other exogenous shocks. But looking at a down market with attractive valuations, it is these types of periods where we can be agile within portfolios, take advantage of price dislocations from business value, and allow the company health and balance sheet strength of our portfolio set the course to come out stronger on the other side.
A trying nine months should not dissuade investors with long-term mindsets from the ultimate goal of wealth creation. Checking account balances or the ticker daily can drive one mad, but “this too shall pass,” and, ultimately, we believe in sticking to our time-tested value philosophy.
As always, we thank you for entrusting us with your investment assets and continued support. Lastly, the best compliment we can receive is a referral from a satisfied client. We appreciate your referrals and handle them with the utmost of care.
Past performance is no guarantee of future results.
The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.
The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
Harris Associates L.P. does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.