Hot stocks to watch: Oakmark Fund’s Bill Nygren on his top value plays

Key Concepts

• Value Investing
• Share Repurchase
• S&P 500 Concentration Risk
• Earnings Multiples (P/E Ratio)
• Free Cash Flow
• Portfolio Risk Reduction
• Organic Growth vs. Per Share Growth

Market Overview and S&P 500 Risk

Bill Nygren argues that the S&P 500 is no longer an "average risk index" due to its heavy concentration in a few technology names. Nvidia, for example, constitutes approximately 8% of the index, and the top five holdings account for over 30%. The technology weighting is also over 30%, potentially exceeding 40% if fintech and communication technology companies were included. He compares the current risk profile of the S&P 500 to that of aggressive growth funds like Janus Twenty from the early days of his career. The S&P 500 trades at 23 times earnings, while the average stock trades at 17 times earnings.

Value Investing Strategy and Share Repurchase

Oakmark fund focuses on identifying companies trading at significantly lower multiples than the average stock. Almost half of Oakmark's holdings trade at less than 12 times earnings, which is less than half of the S&P 500's multiple. A key theme in their portfolio is companies with low organic growth but substantial free cash flow, which they use for share repurchase. This strategy allows them to achieve per-share growth rates comparable to more expensive, high-growth companies.

Portfolio Risk Reduction with Value Funds

Nygren suggests that investors heavily invested in the S&P 500 can reduce portfolio risk by adding a value fund. While he recommends Oakmark fund, he emphasizes that any value fund can serve this purpose. He notes that reduced-risk products are currently popular in the mutual fund industry, but the strategy of combining a value fund with the S&P 500 is not yet widely adopted.

Five Value Stock Picks

Nygren highlights five specific stock picks trading at attractive valuations:

1. Charter: Trading at approximately five times earnings, Charter is primarily an internet and mobile telephone business. The market may be undervaluing the potential for growth through share repurchase.
2. General Motors (GM): Despite facing tariff-related risks that have impacted earnings, GM is considered attractive at five times earnings. The company has a history of significant share buybacks, reducing its share base by over 20% in one year. Even in a down year, they are still buying back about 10% of the share base.
3. Corbridge
4. Global Payments
5. Ally Financial: These stocks are trading at seven times or less of next year's expected earnings.

These companies generate substantial free cash flow that is not needed for reinvestment in the business, enabling them to return capital to shareholders through buybacks and dividends. This leads to dividend and per-share growth rates comparable to companies trading at three times higher valuations.

General Motors (GM) Case Study

GM's earnings have been affected by tariff risks, delaying their expected earnings target of $10 per share by a year or two. However, Nygren believes the low valuation of five times earnings compensates for this risk. GM's aggressive share repurchase program, including a 20% reduction in shares outstanding in a single year, further enhances its appeal.

Notable Quote

• "These companies don't have great organic growth opportunities, but they're generating a lot of free cash flow that doesn't need to be reinvested in the business. Buybacks and they do buybacks and dividends. And because of that, their dividends and per share growth rates are actually in line with companies that are three times as expensive." - Bill Nygren, explaining the rationale behind investing in companies with low organic growth but strong free cash flow.

Technical Terms Explained

• Earnings Multiple (P/E Ratio): A valuation ratio that compares a company's share price to its earnings per share. A lower P/E ratio may indicate that a stock is undervalued.
• Share Repurchase (Buyback): A company's act of buying back its own shares from the open market, which can increase earnings per share and potentially boost the stock price.
• Organic Growth: Growth that comes from a company's existing operations, rather than from acquisitions or other external factors.
• Free Cash Flow: The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.

Synthesis/Conclusion

Bill Nygren advocates for a value investing approach, particularly in the current market environment where the S&P 500 is heavily concentrated and potentially overvalued. He emphasizes the importance of identifying companies with low valuations and strong free cash flow, which can be used for share repurchase and dividends, driving per-share growth. He recommends that investors consider adding a value fund to their portfolio to reduce overall risk and potentially enhance returns. His stock picks, including Charter and General Motors, exemplify this strategy.