Destripando el Oakmark Global

1. Reducing base interest rates
2. Lowering loan growth
3. Increasing credit costs

Interest rates

We believe the coronavirus will impact interim cash flows as governments take austerity measures and expect the lower base rates to persist for FY 2020 and for the first half of FY 2021. Our base case scenario is that rates remain lower for the next two years with an eventual return to pre-coronavirus normalcy in 2022. As a result of lower interest rates for potentially the next two years, we have brought down fair values by a few percentage points. In a lower for longer scenario, where these recently lowered rates persist for the next five years, our intrinsic value estimates would be reduced by mid-single digits. European banks have been operating in an environment with negative interest rates for some time now.

Actions taken by our banks have produced positive returns as a result of adeptly reducing costs, investing in digital and repositioning their asset mix toward superior quality. For example, we’ve invested with CEO Antonio Horta-Osorio since his days at Banco Santander. We initiated a position in Lloyds, the U.K. leader in consumer banking, in December 2011 after his arrival because of Horta-Osorio’s strong operational and capital allocation track record. Under his leadership, Lloyds has improved their net interest margin to 3%, twice the level of the average European bank. If interest rates were to remain flat from the recently reduced levels over the next five years, our interim profitability and capital generation assumptions would need to be reduced and we estimate that this could be a 2-9% headwind to our projected fair values. Keep in mind that assumes no offsetting measures taken by management, including cost reduction measures, growing fee-based businesses and a rationalization of marginal competitors, a scenario we see as unlikely. Asset quality

We do not see a big asset quality issue at the European banks. Given tighter underwriting standards, uncertainty surrounding Brexit and slow European growth heading into this disruption, we do not have residential or commercial real estate bubbles that need correcting, unlike heading into the global financial crisis. Governments across Europe are being very proactive in supporting small- and medium-sized enterprises and industries that are more exposed to the coronavirus, such as airlines and hotels.

Going forward, we do assume increases in non-performing loans (NPLs) and bankruptcies of corporate clients of the European banks. Overall, we are modeling an increase in NPLs of 20% in FY2020 and 10% in FY2021 but we note that increases are on a very low base (i.e., RBS’s NPL is at only 1.2%). Because we believe our bank holdings have strong loan books and good exposure to mortgages (which will be supported by governments), we do not believe these short-term adjustments will be material to our valuations.

 

Figure 2: Credit cost scenario analysis

Importantly, we believe European banks remain better positioned now than during the global financial crisis in the context of materially higher liquidity buffers and higher capital.

Liquidity
 The European Central Bank (ECB) is taking steps to ensure liquidity. The ECB reintroduced LTRO, a cheap loan scheme that was first used in 2011, with the aim to eliminate potential Euro liquidity strains. In the first LTRO auction this week, €109 billion was taken up by 110 banks. We believe this will be an effective back-stop for banks as funding conditions worsen. We are monitoring three month Libor – OIS spreads. While they have widened in the past week, they remain well off the global financial crisis highs.
Figure 3: 3 Month USD LIBOR –OIS Spread

 

While regulations and rules stiffened over the last decade, central banks in Europe and the United Kingdom are now reducing these counter cyclical buffers to help support the economy. The Bank of England (BOE) recently announced reduced capital requirements for both RBS and Lloyds, leaving them both way over-capitalized.

Given the spread of the virus within Italy, it appears Intesa will be the most impacted by this as it stands now. However, Intesa has the highest buffer to its required capital at ~460 bps, positioning the company to handle potential spikes in credit costs.

As is often the case, share prices of our banks have fallen by approximately 35% over the last month. We believe a value gap is widening. When this occurs, you can expect us to purchase the names with the most upside to intrinsic value, essentially de-risking our portfolio.

When the uncertainty starts to wane in time, we believe the European financials can provide strong total returns for our shareholders. Thank you for your continued confidence and patience.

Halfway through the quarter, the stock market seemed poised to continue its strong 2019 performance, though at a somewhat muted rate of increase. The S&P 500 was up 3% and the Oakmark Fund hit a new all-time high NAV on February 12, even though growth stocks still dominated over value. We had little portfolio turnover as most of our holdings were selling at prices between our established buy and sell targets. Then, the bottom fell out. From February 20 through March 23, the S&P 500 declined 34%, the fastest drop of that magnitude in history.
At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.
The expected downturn in GDP, which many thought was overdue, will not occur because of excesses in the economy, but because of a voluntary shutdown to avoid a worst-case death toll from the coronavirus pandemic, COVID-19. A new vocabulary quickly emerged, including terms like “flatten the curve,” “social distancing” and “shelter in place.” Epidemiologists became TV stars, tourism stopped on a dime, schools were closed, workers were told to stay home, the oil market collapsed, corporate bond spreads exploded and investors grew more worried about the banking system than they had been since 2008. Our Funds performed poorly in both absolute and relative terms as the companies we thought were cheapest before the decline tended to be those that were viewed as benefitting the most from a continued strong economy.
We were unusually active in the second half of the quarter. We believe that extreme market volatility allowed us to increase the fundamental attractiveness of our portfolio. We were able to buy stocks in companies we believed offered greater undervaluation, higher quality or stronger balance sheets (and, in some cases, offered all three) than the companies we were selling. When markets make such extreme moves, desperate investors who need cash have to sell, and those with cash are able to buy— in contrast to normal conditions when trades tend to occur because investors have different time horizons or opinions on a stock’s long-term value. In the past quarter, we often purchased from desperate sellers, using assets from our cash reserves or from selling off some of our holdings that had performed relatively well. To highlight the opportunities available: typically, we at Oakmark buy stocks priced at less than 60% of our estimate of business value and sell them when their price exceeds 90% of that value. During the past few weeks, we were selling stocks priced at 60% or more of our estimate of business value and buying companies priced at less than 40%. To us, these are incredibly compelling opportunities.
Amidst this turmoil, the financial media has been full of speculation as to whether or not the stock market bottom has been reached. We don’t believe anyone knows and we know that we don’t know either. Earlier this month, we wrote a note reminding Oakmark shareholders that we don’t consider market timing to be a skill of ours, so instead we consistently encourage portfolio rebalancing. Today, that likely means selling assets that have performed well, like Treasury bonds, and using the proceeds to buy assets that have underperformed, like stocks. That restores the portfolio balance that existed prior to the stock market’s downturn. In our personal accounts, most of the Oakmark portfolio managers bought more of the Oakmark Funds to rebalance our own investments.
As we look to the new quarter, we anticipate that our trading activity will remain at an elevated level as we continue to adjust to changing stock prices and capture the tax losses created by the downturn. We will also look even more closely at the management teams running our companies. We only invest in those companies that we believe are being managed to maximize long-term business value per share. We will evaluate what our companies accomplish during this downturn and revise our management quality ratings accordingly.
When we look back to 2008, some companies completed strategic acquisitions that were only possible because of the financial crisis: Wells Fargo purchased Wachovia, Liberty Media bought Sirius XM, Comcast bought NBC Universal and Berkshire Hathaway bought Burlington Northern. In hindsight, each of these added significantly to the acquirer’s per share value. Other companies, such as Netflix, took advantage of their own depressed share price to reduce the number of shares outstanding, increasing each remaining share’s percentage ownership. From late 2007 through 2010, Netflix repurchased 27% of its outstanding shares at an average price of $6 per share. Netflix today is priced at $372 per share, more than 60 times the repurchase price. We have no doubt that many of our companies will be looking for the value-enhancing opportunities created by this economic downturn.
On a final note, I want to express my thanks to the Harris Associates IT team. We’ve never been a work-from-home firm, believing that the corporate culture we so jealously guard would be eroded without the shared experience of being in the office together. Despite that, to protect our employees and our investors, we went to a work-from-home mandate a week before the city of Chicago did. It was no small task to make sure that all of our 200 employees could seamlessly communicate with each other, that our many data feeds were fully accessible and that we could execute the increased trading volume that we expected in a high volatility environment. It went off without a hitch.
Halfway through the quarter, the stock market seemed poised to continue its strong 2019 performance, though at a somewhat muted rate of increase. The S&P 500 was up 3% and the Oakmark Fund hit a new all-time high NAV on February 12, even though growth stocks still dominated over value. We had little portfolio turnover as most of our holdings were selling at prices between our established buy and sell targets. Then, the bottom fell out. From February 20 through March 23, the S&P 500 declined 34%, the fastest drop of that magnitude in history.
At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.
The expected downturn in GDP, which many thought was overdue, will not occur because of excesses in the economy, but because of a voluntary shutdown to avoid a worst-case death toll from the coronavirus pandemic, COVID-19. A new vocabulary quickly emerged, including terms like “flatten the curve,” “social distancing” and “shelter in place.” Epidemiologists became TV stars, tourism stopped on a dime, schools were closed, workers were told to stay home, the oil market collapsed, corporate bond spreads exploded and investors grew more worried about the banking system than they had been since 2008. Our Funds performed poorly in both absolute and relative terms as the companies we thought were cheapest before the decline tended to be those that were viewed as benefitting the most from a continued strong economy.
We were unusually active in the second half of the quarter. We believe that extreme market volatility allowed us to increase the fundamental attractiveness of our portfolio. We were able to buy stocks in companies we believed offered greater undervaluation, higher quality or stronger balance sheets (and, in some cases, offered all three) than the companies we were selling. When markets make such extreme moves, desperate investors who need cash have to sell, and those with cash are able to buy— in contrast to normal conditions when trades tend to occur because investors have different time horizons or opinions on a stock’s long-term value. In the past quarter, we often purchased from desperate sellers, using assets from our cash reserves or from selling off some of our holdings that had performed relatively well. To highlight the opportunities available: typically, we at Oakmark buy stocks priced at less than 60% of our estimate of business value and sell them when their price exceeds 90% of that value. During the past few weeks, we were selling stocks priced at 60% or more of our estimate of business value and buying companies priced at less than 40%. To us, these are incredibly compelling opportunities.
Amidst this turmoil, the financial media has been full of speculation as to whether or not the stock market bottom has been reached. We don’t believe anyone knows and we know that we don’t know either. Earlier this month, we wrote a note reminding Oakmark shareholders that we don’t consider market timing to be a skill of ours, so instead we consistently encourage portfolio rebalancing. Today, that likely means selling assets that have performed well, like Treasury bonds, and using the proceeds to buy assets that have underperformed, like stocks. That restores the portfolio balance that existed prior to the stock market’s downturn. In our personal accounts, most of the Oakmark portfolio managers bought more of the Oakmark Funds to rebalance our own investments.
As we look to the new quarter, we anticipate that our trading activity will remain at an elevated level as we continue to adjust to changing stock prices and capture the tax losses created by the downturn. We will also look even more closely at the management teams running our companies. We only invest in those companies that we believe are being managed to maximize long-term business value per share. We will evaluate what our companies accomplish during this downturn and revise our management quality ratings accordingly.
When we look back to 2008, some companies completed strategic acquisitions that were only possible because of the financial crisis: Wells Fargo purchased Wachovia, Liberty Media bought Sirius XM, Comcast bought NBC Universal and Berkshire Hathaway bought Burlington Northern. In hindsight, each of these added significantly to the acquirer’s per share value. Other companies, such as Netflix, took advantage of their own depressed share price to reduce the number of shares outstanding, increasing each remaining share’s percentage ownership. From late 2007 through 2010, Netflix repurchased 27% of its outstanding shares at an average price of $6 per share. Netflix today is priced at $372 per share, more than 60 times the repurchase price. We have no doubt that many of our companies will be looking for the value-enhancing opportunities created by this economic downturn.
On a final note, I want to express my thanks to the Harris Associates IT team. We’ve never been a work-from-home firm, believing that the corporate culture we so jealously guard would be eroded without the shared experience of being in the office together. Despite that, to protect our employees and our investors, we went to a work-from-home mandate a week before the city of Chicago did. It was no small task to make sure that all of our 200 employees could seamlessly communicate with each other, that our many data feeds were fully accessible and that we could execute the increased trading volume that we expected in a high volatility environment. It went off without a hitch.
Our analyst group has remained connected via daily group chats and weekly Zoom happy hours. With virtual meetings, we have maintained our tradition of sharing great lunchtime conversations as a team. It isn’t perfect, so don’t expect us to ever be one of those firms that works primarily from home. But given what I’ve heard from friends at other investment firms, we’ve been able to maintain our usual routines better than most. And to all my colleagues at Harris Associates, if nothing else positive comes from this, working from home has made me extremely grateful for the wonderful bunch of people I typically get to see every day. I miss you all and look forward to the day we can be back in the office together.
We are hopeful that three months from now, when you read our second-quarter commentary, the Cubs will be playing baseball, we will be eating inside of restaurants and we will all be rescheduling the trips we’ve had to cancel. If that has happened, we believe the economy will likely recover quickly as will the stock market. But if it takes longer to return to normal, know that we have weighted our portfolios toward companies that we believe can survive a longer downturn and that we fully expect can emerge stronger on the other side.