Commentary

2Q17 | Bill Nygren Market Commentary

June 30, 2017

Last month, Win Murray and I had the opportunity to be interviewed by John Heins of Value Investor Insight (VII). In addition to editing VII, which we find to be one of the most interesting value investor publications, John teaches investing at the University of Alabama. We enjoy reading VII because it provides in-depth looks into different value investors’ investment approaches, using individual stock examples that highlight their thought process. Below, we have excerpted a portion of our interview; the entire interview is available on our website

We’re assuming what you’re looking for – stocks trading at discounts to your estimate of value, management teams aligned with shareholders, and value that grows over time – hasn’t changed. True?

Bill Nygren: There hasn’t been any significant change. From the time we started Oakmark Fund more than 25 years ago those have been the criteria we’ve used to find companies in which to invest. We still believe they’re the three most important things on which to focus.

If you’re missing any of those, you start to struggle with the investment idea. If the name isn’t cheap, it doesn’t even qualify as a value investment. If the value isn’t growing, then you’ve got a clock that’s ticking against you. And if management isn’t focused on maximizing long-term per-share value, then no matter how good your analysis is of the business, the decisions being made can disrupt the rising path of value you’d otherwise see in the static business. It’s only when all three of those things are present – discount to the value, value that’s growing and management trying to maximize per-share value – that we have the confidence to make an investment.

Private-equity firms generally look for companies they believe investors will perceive differently five to seven years from now because of changes they can put in place. Investors today might be ignoring hidden assets or are overly focusing on a temporary problem, but a private-equity approach focuses on how business values could change over several years. That’s a very different way of thinking from most investors who are trying to outguess each other on next quarter’s or next year’s earnings. We try to apply a private-equity approach to public-equity investing.

You invest in some of the best-known and most-followed companies in the world. What can make them mispriced?

BN: The easiest thing for investors to do is to extrapolate historical trends. The opportunities we find usually arise when that extrapolation leads to something that is very different than what we think is likely. That could come from new management and believing future margins are going to be very different than in the past. It could come from non-earning assets we believe over time will display their value. It could come from an overreaction to what we think is a short-term negative for earnings.

Win Murray: Frequently we’re coming to companies that haven’t been run particularly well and because of that the investor perception is that the business itself is not very good. With Baxter International [BAX], for example, we saw a company with an operating margin of roughly half the 20% we thought was possible, with a new CEO, Jose Almeida, taking over at the beginning of last year after a very successful stint at Covidien, where we had been a shareholder. That type of situation is frequently interesting, combining a stale company perception with an executive who has a record of success. With our time horizon generally giving turnarounds time to work, you can find opportunity even in well-known companies.  [Note: Baxter shares, at $38.15 when Almeida became CEO, recently traded at $59.20.]

It’s more difficult than ever to distinguish between permanent and temporary issues facing companies and their industries. Describe how you deal with investments that aren’t working out as expected.

BN: When an analyst makes a recommendation, he or she is presenting a model for the business – how they expect the income statement and balance sheet to change over time and what that should mean for per-share business value – that stretches out for the next five to seven years. When we get to a point where the fundamental results have deviated significantly from that plan, say by a double-digit percentage level, that triggers a process where we completely revisit our assumptions to see if we'd have enough confidence to buy it today if it were a new investment.

Investors often struggle when a business hasn’t performed as expected. When do you challenge your thesis and ask yourself, was I wrong? Value investors take great pride in their patience, but for patience to be a good thing, your thesis has to be right. At some point you may have to recognize when new information presents enough of a challenge to your thesis that you should revisit whether or not this is an investment you would make today. That’s the process we go through when fundamentals are negatively deviating from our thesis. Likewise if they positively deviate, which is a much more pleasant situation.

How generally do you arrive at estimates of fair value?

WM: For most of our companies we estimate a normal cash-flow level – we use earnings before interest, taxes and amortization as a short cut – and then ascribe to that a multiple that makes sense in the framework of a discounted-cash-flow model and relative to valuations on all the other names we look at. We recognize the difficulty in precisely pegging what a company is worth two to three years from now, but if we’re making our best estimates in every case and arriving at those estimates in a disciplined and consistent manner, we should be surfacing the most-attractive relative ideas for each portfolio.

I’ll ask analysts, “If you had to bet your entire salary on whether or not the company will exceed or fall short of your cash-flow estimate, which way would you go?” If they’re able to answer that question in either direction, then they’re using the wrong number. We want them to be torn and not know if they’d bet the over or the under. Just because we’re value investors doesn’t mean that we want everything to be portrayed as conservatively as possible. When it comes to making portfolio-management decisions, it’s the absolute value of the error that is going to cause the investment mistake, not just being too high.

What do you think the market is missing about General Electric [GE]?

WM: We like to look for management catalysts in companies that we think have a stale perception in the marketplace, and this fits that profile precisely.

We have always admired GE’s businesses – we really like businesses where you sell a big piece of OEM equipment at a low margin and then collect a 40-year stream of high-margin service revenues that the customer is essentially locked into. GE has a lot of those businesses.

The problem we had with GE is that the culture of capital allocation developed under Jack Welch and continuing under Jeff Immelt was one that bought high-multiple businesses and sold low-multiple businesses in a way that destroyed shareholder value. They bought expensive healthcare, Amersham, when oil and gas was really cheap. Then they bought expensive oil and gas – Lufkin Industries, Vetco Gray, Dresser, and others – when healthcare was really cheap. They expanded financial services at the worst possible time. They sold NBC at the bottom of its ratings cycle at a very low multiple of cash flow. It was one thing after another that made us put a big discount on cash flows because of how they were being reinvested.

When Jeff Bornstein took over as GE’s Chief Financial Officer in mid-2013 you can draw a line when capital stewardship changed. They bought Alstom’s power-equipment business for a single-digit multiple of cash flows. They sold Synchrony Financial in a tax-efficient spinout and effectively used the proceeds to buy back shares. They sold the appliance business for a high multiple. They combined the oil and gas business with Baker Hughes at the bottom of an oil cycle in an asset-light way. They dismantled GE Capital swiftly and at a good multiple of book value. All very impressive and executed as a contrarian value investor would.

In another significant move, Bornstein drove a change in how GE’s top 6,000 or so executives are paid. The new incentive system put in place at the beginning of 2016 was a complete revamp of a 1950s-era plan that was almost union-shop in construction, based more on seniority and your bonus last year than how you actually performed. The new plan pays out based on a scorecard of factors under managers’ direct control and tracked in real time, and it’s far more possible to get paid a lot or a little than under the old system. That’s a big change we expect to have a very positive impact over time.

How well positioned do you consider GE’s key operating divisions?

WM: Aviation is a powerhouse that has been taking global market share and is currently rolling out its biggest product launch ever – the LEAP jet engine developed with France’s Safran – which is showing great uptake. The medical-equipment business is well positioned in its core ultrasound and imaging markets and has good growth potential in developing markets and with an expanded product line for the development of biologic drugs.

In power, while the broad segment may not grow quickly, there is significant upside for GE through cost synergies and cross-selling after the Alstom purchase. The last big piece is oil and gas. The Baker Hughes transaction filled holes in both companies’ portfolios with little overlap and now the merged company has access to GE’s balance sheet. Many national oil companies are resource-rich but cash poor and to develop their fields they would like to partner with an oil-field service company that can help finance the exploration and development. As the oil market recovers, the new Baker Hughes has the potential to gain share as a result.

Some analysts, citing a lower conversion of earnings into cash flow, have questioned GE’s earnings quality. Is that a concern?

WM: We don’t believe so. The company has been preparing for big product launches and has by design been less efficient with working capital in order to ensure smooth rollouts. We think that’s fully explainable by where they are in the launch cycles and that the cash flows they’re going to produce from those launches are well worth any short-term mismatch between GAAP earnings and cash flow.

Harley-Davidson [HOG] has been on value investors’ radar for some time now, without much benefit. What upside do you see from here?

WM: Before we purchased the company’s shares in Oakmark Select, we visited Milwaukee to meet with the CEO, Matt Levatich, who took over in May 2015. I was worried Matt would be too much of a caretaker CEO, kind of stewarding the strong brand along as it dealt with slow secular decline. We came away concluding that wasn’t at all the case.

Prior management had spent a decade trying to optimize capacity for demand and improving manufacturing efficiencies. That was all well and good, but the challenge now has been to correct for years of underinvestment in new products, marketing and geographic expansion. Today they’re investing more than 200 basis points of margin into marketing and new product development. They’re opening dealerships in markets like China, India and Vietnam. They’re marketing heavily to customers outside the traditional demographic of white males over the age of 35.

Is all that enough to compensate for traditional baby-boomer customers aging out of the market?

WM: Investors seem to be implicitly worried about the number of motorcycles current 50-to-70-year-olds will be buying in 10 to 15 years. Obviously that isn’t a high number. What’s more important is how many motorcycles 25-to-50-year-olds around the world will be buying in 10 to 15 years. We think that’s going to be a surprisingly high number.

According to industry data, current 25-to-50-year-olds are more likely to own a motorcycle than baby-boomers were when they were that age. According to Harley, people under the age of 35 are buying more Harleys per capita than the boomers did at the same age. Internationally, it’s not a question of demand for motorcycles – there are roughly eight million motorcycles in the U.S. out of 150 million worldwide – but the extent to which rising disposable incomes support the purchase of higher-end brands like Harley. We think the Harley brand is vibrant and healthy outside the U.S. as well as inside, and that it will benefit significantly as an aspirational brand. International now represents 36-37% of the company’s unit volumes.

How do you handicap the competition?

WM: The most buzz is around Indian, which is Polaris’s relaunched brand that has a lot of cachet among the type of rider that likes Harley. But Indian is a drop in the bucket relative to Harley, and its volumes are a long way from being large enough to incent Polaris to invest the large dollar amounts required to build significant additional Indian capacity. Our bigger worry would be competitors like Honda and Yamaha that do have the capacity.

This points to a key element of our thesis that will need constant scrutiny. We’re arguing that the company is navigating a customer-base transition, but that the strength of the core brand underneath will win the day with a long-enough time horizon. If the brand isn’t resonating with new customers as it has with old, that will clearly be an issue.

Are you finding it hard today to find sufficiently discounted share prices?

BN: It’s always hard. When prices get to a level where they look really cheap relative to history, it’s usually in the midst of a news environment that makes investors reluctant to commit long-term capital. I used to think it must have been easy to be an equity investor back in the 1950s when the dividend yield on the S&P 500 exceeded the yield on ten-year Treasuries. When we experienced that environment in just the past few years, it didn’t seem so easy.

I think it’s dangerous to draw lines in the sand after which you’ll just sit it out. Once you do, the temptation is to spend all your time trying to defend why now is not the time to be invested. I wrote a piece last year on the 25th anniversary of Oakmark Fund. At the time the fund had returned something like 20x investors’ initial capital, while the S&P was up 10x. But when you look at the list of things investors had to deal with over that time – wars, hurricanes, global financial crisis, oil-price collapse, just to name a few – it’s amazing the market returned 10-fold. It’s surprising to me how many of our peers, who share our long-term belief that equities are likely to continue to be the highest-return asset category, believe they can enhance that return by figuring out those occasional periods where the equity market is at higher risk.

You could look at the market today and say the trailing P/E is 15-20% above historical averages, which could be enough to give one pause. On the other hand, dividend yields as a percentage of corporate bond yields are higher than normal. The economic growth outlook right now is positive. Retained earnings are higher than average and are being put to use to delever balance sheets, increase dividends and repurchase shares. There are always reasons to be bearish and there are always reasons to be bullish. We’ve just never been comfortable in making judgements on overall market levels.

Postscript: Since the publication of this interview, GE has announced that CEO Jeff Immelt will retire on August 1st, to be replaced by John Flannery, currently CEO of GE Healthcare.  Jeff Bornstein will remain CFO and will also be promoted to the role of Vice Chairman. We believe these announcements are very positive. We’ve met with Flannery multiple times, and believe his cerebral return-focused leadership will serve the company well. GE remains a very attractive investment, in our view, and is well-positioned for substantial earnings and FCF growth. Flannery is being set up for success exactly opposite of the way Jack Welch left Immelt set up for failure.


William C. Nygren, CFA
Portfolio Manager
oakmx@oakmark.com
oaklx@oakmark.com
oakwx@oakmark.com

 

View other commentary and letters from Bill here.

 

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 securities mentioned above comprise the following percentages of the Oakmark Fund’s total net assets as of 06/30/17: Baxter International, Inc. 1.8%, Covidien Ltd. 0%, General Electric Co. 2.3%, NBCUniversal 0%, Alstom 0%, Synchrony Financial 0%, Baker Hughes, Inc. 0%, Safran SA 0%, Harley-Davidson, Inc. 1.1%, Polaris Industries 0%, Honda Motor Co., Ltd. 0% and Yamaha Motor Co., Ltd. 0%. 

The securities mentioned above comprise the following percentages of the Oakmark Select Fund’s total net assets as 06/30/17: Baxter International, Inc. 0%, Covidien Ltd. 0%, General Electric Co. 5.4%, NBCUniversal 0%, Alstom 0%, Synchrony Financial 0%, Baker Hughes, Inc. 0%, Safran SA 0%, Harley-Davidson, Inc. 4.0%, Polaris Industries 0%, Honda Motor Co., Ltd. 0% and Yamaha Motor Co., Ltd. 0%.

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