May 20, 2004, 8:31 a.m.
Mr. Market’s Moods

The stock market has been suffering, like the rest of us, from the terrible news out of Iraq, but it's also suffering from the good news out of the U.S. economy. This may be puzzling, but your mission as an investor is not to analyze the manic-depressive moods of Mr. Market — that handy personification of the investing crowd, as invented by the financial genius Benjamin Graham — but rather to exploit them.

If Mr. Market is so glum that he'll offer to sell fine companies for low prices, then take him up on the offer. Don't feel guilty!

Will Mr. Market become even more depressed in the months ahead? No one knows. If you think he will plead with you to take shares of excellent businesses off his hands at even lower prices, then wait. Be my guest. But understand that you are trying to predict the short-term behavior of an emotionally disturbed person.

“We don’t try to forecast the market,” writes William Nygren of Oakmark, a Chicago-based family of seven mutual funds with terrific records and $25 billion in assets, in a recent letter to shareholders. “We simply buy out-of-favor stocks that appear to be selling below growing business values.”

There are, in fact, two ways to invest in stocks. The first suits what Graham’s greatest student, Warren Buffett, calls, without disparagement, the know-nothing investor. This is the person who lacks the time and the inclination to buy and sell individual shares of businesses. Thanks to that brilliant democratizing invention, the mutual fund (and its cousin, the exchange-traded fund, or ETF), know-nothing investors can hire professionals to manage their portfolios or can simply participate in the market, or parts of it, by owning an entire index, such as the Standard & Poor’s 500, roughly the largest U.S. stocks.

The second way to invest suits what Buffett calls the know-something investor, who likes to spend time picking stocks. Such an investor should slowly and deliberately determine the wonderful businesses in which he wants to become a partner for the very long run.

Whichever kind of investor you are, you should not base your decisions to buy or sell funds or stocks based on what the market as a whole is doing — or what you think it may do in the weeks or months ahead.

For the know-nothing investor, the market doesn’t matter because the immediate financial future can’t be predicted, no matter what the pundits say.

Sure, we have a pretty good idea right now that short-term interest rates will rise, but that prospect is already built into the prices of stocks. The question is whether new information will come out that will affect that judgment, information that might indicate rates will rise even more, or less, or not at all. The new information, by definition, is unknowable. So why try to guess it? Are you really smarter than the considered opinions of millions of investors, rendered in cash in transactions every millisecond?

Instead, I urge K-N investors simply to put away a fixed amount each month or quarter or year into a stock-index portfolio, such as the ETF called Spiders (symbol: SPY), which trades on the American Stock Exchange and mimics the Standard & Poor's 500-stock index, or into a diversified mutual fund that tries to beat the averages, such as Muhlenkamp (MUHLX), a mid-cap value fund with a superb track record and low expenses that is a top selection of the No-Load Fund Investor newsletter.

When I say “fixed amount,” I mean it. The K-N investor should pay no attention to the vagaries of the market. When you hear people talk about the gloomy world situation or the falling dollar or the balance-of-payments deficit, just ignore the blather. If these things matter, you can be confident that loads of other investors are aware of their importance and have already taken the information into account (or discounted it) in stock prices. Plus, for every piece of bad news, there’s usually an offsetting piece of good news: Earnings are rising, inflation is still low, jobs are increasing, etc., etc. These facts, too, are likely to have been discounted.

As Nygren wrote in his letter to shareholders, “Usually a compelling argument can be made for higher or lower stock prices, higher or lower inflation, economic boom or recession.”

So don’t bother guessing about the short term. In the long term, the best gauge is history, and two centuries of stock market performance have produced average annual gains for the broad market of a little more than 10 percent, or about 7.5 percent a year after inflation; bonds, the alternative to stocks for most of us, have returned only one-third as much after inflation.

The K-S investor must begin with the same confession of ignorance as the K-N investor. Buffett, the chairman of Berkshire Hathaway Inc. (BRK/A), which last week closed at $85,500 a share (up from $7,000 in May 1990), once said that he and his partner, Charlie Munger, “never have an opinion on the market because it wouldn’t be very good, and it might interfere with opinions we have that are good.”

The opinions that count relate not to the market as a whole, but to individual businesses, and Buffett and Munger don’t want to confuse themselves.

This is Bill Nygren’s philosophy, too. “We have never shown an ability to add value through market timing or, for that matter, through use of any macro-level forecasts,” he writes. All he knows is how to find and assess good businesses.

What has Nygren been buying?

Raytheon Co. (RTN), the defense contractor whose stock “suffered a brutal decline from its 1999 high of $75” to $33.12 at the close last Friday and is now trading at “11 times our estimate of 2005 economic earnings.” Raytheon has had real problems, but while Nygren believes there has been a positive change at the top, Raytheon stock “suffers from a stale perception of the company’s management quality.” That’s just what smart investors like to see.

H&R Block Inc. (HRB), the giant tax preparer, which has lost a third of its value since February and trades at a price-to-earnings (P/E) ratio of 11, based on projections of profits for 2004. Block, which is also in the mortgage and stock-brokerage business, has increased its earnings in a Beautiful Line over the past decade and generates powerful cash flow with little need for capital spending. Value Line estimates that Block’s earnings will rise at an average rate of 16 percent annually for the next five years.

Limited Brands Inc. (LTD), a diversified retailer that trades at a current P/E ratio of 15. The stock is down by more than one-fourth from its high of 2000, and again many investors, according to Nygren and his colleagues, are misjudging the company. Its Victoria’s Secret and Bath & Body Works chains are booming. The two businesses represent two-thirds of the firm’s sales and 90 percent of its profits, but investors instead seem focused on smaller Limited chains, some of which are struggling. This is another company with impressive cash flow and a good balance sheet. There’s no long-term debt, and the dividend yield is 2.4 percent.

As for the Oakmark family itself: Oakmark Select I (OAKLX), a highly concentrated fund with only 20 holdings, is closed to new investors, but the flagship Oakmark I fund (OAKMX), which is similar but broader (with 55 holdings and ultra-low turnover of just 21 percent annually), remains open.

Oakmark I owns chunks of Fannie Mae (FNM), the mortgage funder, trading at a current P/E of 9 and a dividend yield of 3 percent; Yum Brands Inc. (YUM), owner of fast-food franchises Taco Bell, Pizza Hut, KFC, Long John Silver’s, and A&W; Home Depot (HD), the home-improvement retailer whose earnings, still rising at a 15 percent annual rate, have increased eight-fold over the past decade but whose stock trades at less than half its high of four years ago; and First Data Corp. (FDC), electronic payment services, at a P/E, based on expected earnings for this year, of 17.

Those are Oakmark’s two big domestic stock funds, but its best performers in recent years have been Oakmark Equity and Income I (OAKBX), about a quarter of whose portfolio is in bonds, and Oakmark Global I (OAKGX), which in 2003 returned 49 percent. The latter fund’s top holdings include London-based Diageo PLC (DEO), which owns such alcoholic beverage brands as Guinness beer and Johnnie Walker Scotch; Swiss-based food giant Nestle SA; Euronext NV, owner of financial exchanges; and Takeda Chemical Industries of Japan.

The beginning of wisdom is the understanding that the pursuit of these investments — wonderful businesses at sensible prices — is entirely separate from the futile and foolish contemplation of Mr. Market’s moods.

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. He is also a member of Intel Corp.'s policy advisory board. Of the stocks mentioned in this article, he owns Berkshire Hathaway and Home Depot. This article originally appeared in the Washington Post.

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