The price of the S&P 500 index is nearly 2.5 times what it was during its March 2009 nadir. That’s good news, but it has made finding reasonably priced growth stocks harder than it has been in years.

Even so, Bill Nygren and Kevin Grant, who have co-managed the 22-year-old Oakmark Fund for more than 13 years, say they are still managing to find stocks they categorize as “cheap.”

Their criteria for these “cheap” stocks combines elements of value and growth disciplines. Nygren and Grant focus on high-quality stocks with strong cash flow and growing earnings.

The companies they are looking for must be selling at a 60% to 70% discount to their estimated intrinsic value (what a rational private buyer would pay for the entire business). The stocks they want are also often out of favor for a variety of reasons. The companies may have had a disappointing earnings report or investors may be underestimating a strong business for artificial reasons.

Nygren and Grant will typically hold on until their stocks reach 90% to 95% of the intrinsic value estimate, even if they take several years to get there.

That has left the pair with a portfolio of only 50 to 60 stocks, mostly larger companies, although mid-cap names sometimes make a cameo appearance in the fund.

Grant concedes that in this environment, when many stocks’ prices are rising, it gets harder to find those that are undervalued. That said, “We’re still seeing a strong flow of investments that fit our criteria and support the kinds of returns we seek for clients,” he says.

Because Nygren and Grant tend to look for value in unexpected places, their portfolio gives short shrift to prevailing market trends and eschews the index. That means at times the two have suffered lagging returns over short periods. But the long-term performance has outshone that of other funds; the Oakmark Fund has landed in the top 14% of Morningstar’s large blend category over 10 years and in the top 2% over five years.

Nygren and Grant took over Oakmark with this new “go against the grain” style in March 2000. They assembled a portfolio with a hefty dose of stable growth consumer stocks and shunned the then-hot technology sector. In the months and years that followed, pricey tech stocks plunged, while the more reasonably valued Oakmark portfolio enjoyed a softer landing and recovered more quickly.

No Signs Of A Bubble
In 2013, we are now in the middle of another long bull market, and some investors see another market bubble forming similar to the one that burst after the Oakmark co-managers took over their fund. Nygren, 54, isn’t in that camp. He says today’s market isn’t anywhere near the heady territory of early 2000, when the price of the S&P 500 stood at 28 times earnings.

Today, stocks are selling at 15 to 16 times estimated 2013 earnings, which is about their historical average. For a number of reasons, he says, “a fair market multiple today should be above the historical average.”

Chief among those reasons is the enormous amount of excess cash on corporate balance sheets, which Nygren believes still isn’t reflected in current stock prices. Without evidence of strong economic growth, companies have been holding back on expansion and allowing that cash to accumulate. Once the economy picks up steam, they will be poised to deploy that money to fuel growth through internal expansion or acquisitions.

Investors are already experiencing the benefits of excess cash as companies buy back shares, a trend that looks to Nygren likely to continue. By reducing the number of shares outstanding, such buybacks increase earnings per share (benefiting shareholders).

Companies have also been raising or initiating dividends, and are well positioned to continue doing so in the future. In 2012, the payout ratio (dividends divided by net income) for the S&P 500 index was 30%, nearly 20 percentage points lower than its historical average.

The ample cash also gives companies currency for mergers and acquisitions. Earlier in the year, two companies in the Oakmark Fund, Heinz and Dell, saw a jump in share price after they received above-market-value offers for their stock from suitors.

Stocks are also relatively attractive, he says, because of how unattractive bonds are. “Bonds are a dangerous asset class right now,” he says. “Too many investors are looking at recent history and are blindly assuming that the strong returns can continue. But lending money to the government for a 3% interest rate is a long-term decision. Inflation was around 5% not that long ago. If inflation goes back up to that level, bond investors earning a 3% coupon will lose ground every year, for many years.”

While an increase in interest rates could draw money out of the stock market and into bonds, the market appears to be a long way off from such a scenario. He says it would take a 6% rate on long-term government bonds to make the equities market look less rosy.

At the same time, he cautions, some of the highest-yielding sectors of the market have become over-mined by bond investors looking for income from the stock market.

“The areas to worry about now are the parts of the stock market that look like bonds,” he says. “The safer the business model and the more a company pays in dividends, the more likely it is that fixed-income investors looking for alternatives have run prices up to expensive levels.” He cites utilities as one example of a sector where yield-hungry investors have inflated stock prices. Usually, the price-earnings ratios for the sector are below that of the S&P 500 index because of utility companies’ poor growth prospects. Now, they’re about even.

Finding Value
Outside of a few high-yielding danger zones, Nygren and Grant continue to find growth stocks with attractive price tags in diverse sectors such as financials, technology and energy.

One of Oakmark’s more recent purchases is Forest Pharmaceuticals. Generally, Nygren and Grant are negative on pharmaceuticals. They believe many stocks in this sector have performed unusually well because they pay high dividends, but Nygren believes the sector has become overpriced. Forest is a notable exception. A midsize pharmaceutical company, it differs from its larger peers on several fronts.

One is that it sells at almost 40 times trailing earnings at a time when most stocks in the group are priced at less than half that. And while the company has had an active share-buyback program, the stock doesn’t pay a dividend.

Despite Forest’s high price-earnings multiple, Nygren and Grant believe the stock does not reflect the company’s future earning potential and that it is selling well below the company’s intrinsic value. Unlike most large pharmaceutical companies, which are facing “patent cliffs” when the patents on their blockbuster drugs expire, Forest is in the unusual position of having seven new drugs to launch. So even though earnings are low now, the picture could be very different in a couple of years. The company could also conceivably be the target of a future takeover by a larger pharmaceutical company, which would lower Forest’s expenses dramatically.

“We don’t buy a stock because we believe a company looks like a good acquisition candidate,” says Nygren. “But we do look for undervalued, misunderstood businesses with the potential for higher earnings in the future. The approach happens to be similar to the one that private equity firms take.”

Halliburton, which joined the portfolio late last year, is one of the world’s largest providers of products and services to the energy industry. By the time the Oakmark managers added the stock, its price had fallen substantially from its 2011 high because investors were concerned about a short-term spike in materials costs and lower natural gas prices, which have decreased demand for Halliburton’s pumping services.

“Halliburton is well-positioned to ramp up its business when natural gas prices increase,” says Grant. “While we wait for that to happen, the company is experiencing growth overseas, and it’s already a strong free-cash-flow producer with a strong balance sheet.”

Oakmark’s larger holdings include Bank of America. Despite a 32% leap in the bank’s stock price in the last quarter of 2012, Grant says the stock is still selling at a significant discount to book value. Usually, he says, high-quality banks sell in the range of two times book. He anticipates that the bank’s earnings per share will grow significantly over the next few years as the economy picks up steam.

American International Group, another one of Oakmark’s holdings in the financial sector, is best known by most people for the $180 billion government bailout it received at the height of the financial crisis. Since then, the insurer has paid back that money and strengthened its financial position. “What we have now with AIG is a good quality life and property and casualty insurance company whose stock is priced at well below book value,” says Grant. He believes that the company will add more value for shareholders by starting a share repurchase program by year’s end.

The Oakmark Fund’s technology holdings include Apple, which the fund began buying in 2009. Grant says the company’s massive store of cash makes the stock a “compelling value” even after its long run-up. “Apple dominates every level of the value chain, from service, to support, to its retail presence. The company makes compelling, sticky products. The issue now is whether they can keep innovating, and the wild card is what else they’re working on.”