Oakmark's Bill Nygren Makes Bullish Case

In his second-quarter letter to fund shareholders, Nygren lays out his case in favor of "acceptable" long-term returns for the stock market. "The dividend yield on the S&P 500 today is just shy of 2%," he points out, adding, "Earnings are expected to grow at 5-6% per year. If price-to-earnings multiples stay constant, the long-term investor would earn 7-8% per year."

Of course, that argument rests on the assumption that the market isn't overpriced, as ultrabear Jeremy Grantham argues. But Nygren believes it isn't: "On consensus estimates, the S&P sells at about sixteen times 2005 earnings. We think that multiple is somewhere between fair and a tad on the low side, given the current yield on bonds. So, if the multiple stays the same, the market delivers annual returns of 7-8%. If the multiple rises to eighteen times, returns bump up to 9-10%. The multiple would have to fall below thirteen times for the S&P to return less than the seven-year Treasury bond. To us, that environment clearly favors equities over bonds."

What can go wrong in Nygren's scenario? He acknowledges a sharp rise in interest rates could be problematic, though he says stock prices probably reflect that possibility. He also says his projection of 5% earnings growth could be off base, but notes the historical average is more like 6% to 7%. Finally, the S&P 500's forward P/E of 16 could be too high. However, that's about where the median P/E multiple on forward earnings has averaged over the past 40 years, Nygren points out.

Nygren's funds have benefited nicely from the resurgence of value stocks in recent years. But in his recently released letter to shareholders, he argues that tougher times in the value patch could be around the corner. "We believe that all active managers will have difficulty adding the kind of value over the next five years that value managers were able to add in the past five years. It may be an especially difficult period for value managers who are not willing to buy better businesses." Merely average companies were undervalued five years ago, he says, but the valuation gap between those firms and higher-quality ones has been all but eliminated.

Given that view, it's no surprise Nygren's funds, especially the large-cap-dominated Oakmark portfolio, have increasingly taken on a blue-chip look. Indeed, he has scooped up the likes of  Home Depot ,  Anheuser Busch , and  Abbot Laboratories in recent years. His latest additions are no exceptions to the blue-chip theme.

In the second quarter, Nygren added  Citigroup to Oakmark Fund. Since the stock's 2000 peak, Nygren says the financial behemoth's earnings per share are up 50%. And because its dividends have risen sharply, the stock yields around 3%. Thanks to a steep rise in earnings and a 20% decline in share price from its all-time high, Citigroup trades at around 12 times earnings, according to Nygren. "We consider Citigroup to have an unmatched global franchise across an unmatched breadth of financial service products," he writes in his shareholder letter, adding, "We therefore believe the company is well-positioned to participate in worldwide economic growth and that its earnings will continue to increase at an above-average pace."

The story is similar for  Wal-Mart Stores , also a second-quarter addition to the Oakmark portfolio. The retail giant's earnings have increased 86% over the past five years, Nygren says, but the stock has slid 25%. Given Wal-Mart's huge cost advantages, he believes the company can continue growing its worldwide market share. "Priced at less than nineteen times estimated 2005 earnings, Wal-Mart's P/E is closer to average than it has been in many years. We believe this far above-average company deserves to trade at a bigger premium to the market," Nygren argues.

There was less activity at mid-cap-oriented Oakmark Select, aside from the addition of  Limited Brands , a purchase that we discussed last January. In the letter, Nygren said he was sticking with  Washington Mutual , the fund's top holding at 16% of assets. The company recently announced it would  post sharply lower earnings due to a steep falloff in its mortgage banking business, which caused the stock to tumble. "We are carefully monitoring Washington Mutual's results," Nygren says, "but we still believe the value of the retail banking franchise exceeds the current stock price. With a dividend yield of 4.5% we think the cost is small of waiting for a mortgage banking turnaround, further retail growth, or eventual acquisition of the company."