With 2014 now more than half over, it seems like a good time to look ahead to next year.  The consensus S&P 500 (INDEXSP:.INX) earnings estimate for 2015, as computed by FactSet, is $133.  That results in a forward P/E ratio of just less than 15x. Relative to the index’s long-term historical average, which is in the mid-teens, the current valuation level suggests to us neither unusual opportunity nor risk.  Given that, why is there so much talk about the market being overvalued? I think three main reasons explain many investors’ negative outlook.

Bill Nygren - You bought What? Joins AMZN Bulls
Source: CNBC Video Screenshot

Bill Nygren: Missed the bull market

First, the market was much cheaper five years ago.  The S&P 500 bottomed in March 2009, and, including dividends, it has more than tripled since then.  Almost by definition, more investors were negative at the market bottom than at any other time.  The speed of this stock market recovery has made it especially difficult for those bears to admit their mistake and get invested again.  Instead of viewing March 2009 as an anomaly (we look back on it as a once-a-generation buying opportunity), they cite the unsustainable increase since then as a reason to remain on the sidelines.

A stock’s previous price rarely helps predict its future value.  The market is clearly not as cheap as it was five years ago, and it is highly unlikely to triple in the next five years.  Still, that fact is of little help to investors trying to decide whether or not they should own stocks now.  Future earnings expectations are much more important than historical prices for assessing where a company should be priced today.  And based on reasonably good earnings expectations, we don’t believe the case has been made for declaring the market overvalued.

Bill Nygren: Financials – never again

Second, many of the stocks that now have low P/Es on expected earnings are financials, and after their role in the crisis, many investors, including many value investors, have completely sworn off owning them.  The argument usually goes something like this: “I lost a lot of money on my financial stocks during the crisis.  The reason I lost money is that financial stocks have become very complicated and as a result are too difficult to value.  To avoid future losses I will avoid investing in this industry.”

We also lost money in financial stocks during the crisis, but have come to a very different conclusion as to why.  Financial companies had too much leverage, they let their underwriting standards decline, and most importantly, the real estate market crashed. Banks, as an example, collect deposits and lend them out, largely against real estate.  If you had asked any investor in 2007 how their bank stocks would fare if real estate prices fell by 30%, I doubt that even one of them would have said, “I think they’d be fine.” Our big mistake was that we didn’t see the real estate crash coming.  Today, financials are less levered, they have tighter underwriting standards, and most importantly, they do not seem likely to face another crash in real estate prices.

One of my co-managers for Oakmark Select, Tony Coniaris, posted an excellent piece on our website outlining our rationale for being so positive on financials.  Today, the sector most of the Oakmark Funds are invested the heaviest in is financials, and I think we are in good company.  As of year-end, Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) had invested over 40% of its public stock portfolio in financials, and, if you include its Bank of America Corp (NYSE:BAC) warrants, that percentage increases to the mid-40s.

Bill Nygren: Nothing else is cheap

The third reason investors cite for not owning stocks is that it has become hard to find stocks selling at low P/E ratios.  The median multiple on forward earnings estimates for the S&P 500 stocks today is 17x. (Low multiples on some mega-cap companies reduce the cap-weighted S&P 500 to 15x.) Though certainly higher than the 11x median in 2009, on its own, the level of 17x isn’t terribly problematic.  A bigger issue is the distribution.

Back in 2009, not only was the median P/E much lower, but the distribution around that median was very wide.  Of the 500 stocks in the S&P 500, 117 sold at less than two-thirds of the market multiple, and only 19 of those were financials.  That universe is very common hunting ground for value managers.  We all like to identify those companies we believe deserve to be priced like average businesses when we can buy them for less than two-thirds of the average multiple.  If we are right, when the gap closes, we can make a 50% profit. With so many cheap stocks to choose from in 2009, even value managers who didn’t want to buy financials could easily build a portfolio full of cheap stocks and wait for regression to the mean.

Today, however, the distribution of P/Es around the median has become very tight. Only 39 of the S&P 500 companies sell at less than two-thirds of the median multiple. And 15 of those 39 are financials. For the investor who uses that as their definition of “cheap” and who has sworn off financials, that leaves only 24 stocks to consider. Throw out the poorly managed and structurally disadvantaged companies, and there aren’t nearly enough stocks left to build a portfolio. Many investors who follow an approach somewhat like that have simply concluded that the market is too expensive and have raised cash hoping for a market decline. (Note: The dispersion in 2009 was somewhat high, but not an extreme anomaly. In 2004, five years before the bottom, the S&P 500 median multiple was 21x, and 95 stocks sold at or below 14x earnings, two-thirds of the median multiple.)

Though we too are always looking for average businesses at great prices, we believe the tight P/E distribution creates a different opportunity. When the market is pricing everything as if it were average, we’ll happily buy great businesses. To us, buying great businesses at average prices is just as much value investing as is buying average businesses at great prices. So we see opportunity today in the other half of the distribution—companies selling at a smaller premium than usual. Investors today aren’t asked to pay much extra to own businesses that we believe will enjoy long periods of above average growth. A company like Google Inc (NASDAQ:GOOG) (NASDAQ:GOOGL), which benefits from advertising moving online, or Visa Inc (NYSE:V) and Mastercard Inc (NYSE:MA), which benefit from plastic replacing cash, appear well positioned for an extended period of growth. Yet their stocks are priced as if investors will soon view them as only average businesses. We think that is exciting.

Bill Nygren: You bought what?

That brings me to our newest position, which will no doubt make some question our credentials as value investors: Amazon.com, Inc. (NASDAQ:AMZN).

Consensus forward earnings for Amazon are a little over a dollar. At the median forward P/E multiple, Amazon would be priced in the low $20s. So, even though the stock fell $124 from its January high of $408 to

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