Bill Nygren Market Commentary | 3Q13
September 30, 2013
During the quarter I had the opportunity to answer some questions from readers of GuruFocus. What follows is an excerpted version of that Q&A. Though lengthier than our usual reports, I thought our shareholders might find it useful insight into how we at Oakmark approach investing.
Q: How do you identify undervalued companies? How much time does it take you from detecting the opportunity until it is in your portfolio?
A: We compute our estimates of business value and look for companies selling at large discounts. When we value a stock, we first value the unlevered company, and then adjust for debt or cash to obtain a per-share value. Our favorite metric to base a valuation off of is the cash acquisition price of a similar company. In the absence of good comparable acquisitions we will consider as inputs acquisitions of businesses with similar characteristics from other industries, public market comparables, discounted cash flow models and so on. Our goal is to determine the maximum price an all cash buyer could pay to own the entire business and still earn an adequate return on their investment.
The time it takes can vary broadly. Sometimes an idea is so clear that within a week of starting work on it one concludes it should be purchased. Other times a stock can remain on our “research underway” list for years with no conclusion. I’ve found that our best ideas typically don’t linger very long in the “in process” stage. As Buffett says, it’s OK to decide a stock belongs in the “too tough pile.”
Q: What are some leading qualities of companies that finally attract you to make a purchase? Furthermore, when you analyze a company, what are some commonalities in the way you value them?
A: Most of our opportunities come from the very long term time horizon we use. When we model a company our analysts will do full financials two years out, then use an annual per-share value growth rate for the following five years, effectively giving us a 7 year forecast horizon. Most analysts use at most a two year horizon, and most stocks are traded based on even shorter horizons. A typical opportunity for us comes from negative news that we believe is cyclical that the market treats as if it is permanent. As an example, given weak economies today in most of Europe, current European car sales are beneath the level necessary to keep the car population flat. Many analysts are calculating business values based on static European sales, and conclude that auto businesses are appropriately valued. We don’t believe that Europe’s car population is going to go into secular decline. Therefore, we base our valuations off of sales much higher than are occurring today. As a result, we conclude that many global auto companies are cheap.
Q: What are some qualitative characteristics that you look for when buying shares in a company?
A: We look at many of the same characteristics other long term investors look at – competitive landscape, strength of brands, risk of disruption, and so on. But there are two questions that I think we pay more attention to than most investors do: Does forecasted growth require capital investment or will excess cash be generated? And how does management evaluate how to raise needed capital or invest excess capital? We want to invest with managements that measure themselves against per-share metrics, not just the total size of the enterprise they manage. Much of the research we read does not do a good job translating cash usage or generation into business value. Especially today, with near-zero interest rates, when a company is generating lots of cash and an analyst represents that in a model by simply growing the cash balance, then sets a value estimate based on a P/E, they are valuing that cash at pennies on the dollar.
Q: What makes your investment management different from that of others?
A: There are a couple of things in our firm structure that I believe differentiate us. First, we have career analysts that can achieve the same level of success as our portfolio managers. Many firms talk about how their superior research allows them to succeed, but then they economically encourage their best analysts to switch careers. Second, all we do at Oakmark (and Harris Associates, Oakmark’s advisor) is value investing. I think many firms are seduced by the attraction of offering both value and growth funds. That might help smooth the advisor’s earnings, but in the end, I believe that having two opposite approaches working together simply encourages style drift at the times when it is most important to maintain discipline.
Further, though we follow a very disciplined approach, we allow what we believe is an appropriate level of creativity in how value is defined for each company we analyze. For some companies book value is a good measure of value, for some sales, for others cash flow. Sometimes you need to look at discretionary cash flow before advertising or R&D to find hidden value. By not requiring that the same summary statistic (P/E for example) be used to define value for every company, I believe we meaningfully expand our selection universe.
Last, we are different from most fund managers in how we think about risk. To most managers, and most fund evaluation services, risk is defined either as volatility of returns or deviation from the S&P returns. We define risk as losing money. Though Oakmark returns in any given year may be somewhat more volatile than other funds, or may deviate significantly from the S&P return, I consider Oakmark to be a below-average risk fund. The statistic I cite is that if you look at every year when the S&P lost money, Oakmark lost less.
Q: Can you explain the rationale behind the large exposure to the financial services sector in your portfolio?
A: We think financials are very cheap. An interesting stat I saw recently showed that the price/book for financials was 20% lower than the price/book for utilities, despite currently earning the same ROE. Plus, we consider current financials earnings to still be depressed because of legacy home mortgage losses and legal expenses. One thing many investors fear is that new regulations will make financials much more like electric utilities. It appears to us that the market has more than priced in that risk already. Another fear many investors have is that in a slow growth economy with little lending demand, growth will be hard to come by for this industry. We aren’t certain that robust growth should be ruled out as a possibility, but if the economy only has tepid growth, we believe financials should be able to return almost all their income to shareholders in dividends and share repurchase.
Q: Many of the companies you own are heavy repurchasers of their own stock. Will there eventually be a shortage of available shares? At the current pace IBM (IBM) will effectively buy the entire company back in 20 years.
A: Clearly the individual who owns 1 share of IBM today, and holds it for 20 years, is not going to own 100% of IBM. Assuming the business value is static or increasing, using free cash flow to reduce the number of shares should result in an increase in the price of each remaining share. Though IBM in the past year purchased 5% of its stock with free cash flow, a rising share price should mean that the same amount of free cash in future years buys back a smaller number of shares. Effectively, if IBM buys 5% of its shares each year for the next 20 years it will not result in zero percent of its shares outstanding but rather 0.95 raised to the 20th power, or 36% of today’s share base. The individual who owns 1% of the shares today would see their ownership increase to just under 3%, not 100%.
Q: With your PMV/relative approach to valuation, what adjustments do you make to your process to protect your portfolio against the risk that all assets might be overvalued in the market place?
A: There are two ways we introduce into our process protection against all assets being overvalued. First, when we look at transactions for comparables, we are skeptical of acquisitions that were done entirely for stock. A little over a decade ago one could have looked at stock acquisitions of Internet companies and concluded that many Internet companies were cheap. Effectively, one company with a stock it knew was grossly overvalued would issue stock to buy another that wasn’t quite as overvalued. By focusing on multiples that were paid in transactions where the buyer parted with cash, we had a much less frothy view of values.
The second thing we do is to always use several models to support our valuation estimate. One of those models is a dividend discount model that bases fair value off of earning a reasonable return in excess of what can be earned in risk-free securities. If going private transactions were occurring at prices that looked too expensive relative to our dividend discount models, we would not use those comparables to value public companies. Also, to protect against our dividend discount model producing excessive valuations, we put a floor on our risk-free rate. Recently we believed the bond market was overvalued and didn’t want our equity valuations to be dependent on bonds remaining overvalued.
Q: How do you personally try to improve your investing methodology on an ongoing basis?
A: First, we spend a lot of time analyzing our mistakes both statistically and qualitatively. Discovering a pattern in mistakes has led us to some tweaks in our process. Additionally, I read a lot of the material put out by our competitors to make sure they haven’t thought of something that we should also be doing. Further, I am actively involved in the Applied Securities Analysis Program at the University of Wisconsin, and the value investing program at Columbia University. If there are changes in how investing is being taught in the best business schools, I want to be aware of it.
I think another way we improve is by keeping a good balance on our research team between experienced veterans and enthusiastic rookies. At Oakmark we have never had as strong a group of young analysts as we have today. And though the experience gained over a long career gives one the advantage of frequently believing, “I think I’ve seen this movie before”, the value of that experience would not be maximized without the energy that comes with great young analysts. They make me better, and I think I also make them better.
Q: What percentage of your portfolio do you intentionally keep in cash to take advantage of the occasional "event”-driven stock selling?
A: I like to have enough cash to initiate a full new position (about 2% of the portfolio for Oakmark) without having to first sell something we own. The rest of the cash we hold is to provide liquidity for potential redemptions so that we aren’t the forced seller someone else is taking advantage of.
Q: You obviously buy large quantities of stock to fill a position – do you buy in tranches, i.e. you have in mind a certain amount you’d like to invest and then buy a percentage and wait for the price to go down/up to purchase an additional tranche?
A: Strategically, for most new stocks in Oakmark I will target a 1% position size, which will get increased toward 2% as the stock gets cheaper, or as we gain further evidence that our forecasts are likely to be achieved. Tactically, how we purchase the orders I give our traders, is entirely up to them. I’m not a trader. Best case, if I took more control of the tactics, I’d be wasting a lot of my time. Worst case, I’d lessen the quality of executions we now get by leaving the decisions to the professionals. It puzzles me why so many fund managers aren’t willing to delegate trading tactics to their own professional traders.
Q: What do you do with distributions (dividends, etc.) – reinvest, mix in with your cash for future purchase or other?
A: We treat dividend payments the same as subscriptions to the Fund. Our first responsibility is to make sure we have a prudent level of cash – defensively that means enough to handle unanticipated redemptions without becoming a forced seller; offensively, enough to take advantage of a forced seller without first having to sell something we already own. The second responsibility is to make sure the portfolio weightings are consistent with how attractively priced we believe each stock is. When new capital is received, we redeploy it into the stocks that we deem most deserving of increased portfolio weightings.
Q: I used to think that I could select active managers, because I seemed to consistently realize 1% to 2% better results than the corresponding indexes for a very long stretch of time. But it turns out that I had systematically tended to favor low volatility funds over my investing history. Now I am wondering whether all I was doing was "harvesting the low volatility premium" as people would say nowadays, rather than exhibiting skill at selecting a manager. (My second favorite criterion is to read manager comments carefully and make a qualitative judgment about whether the manager seems to know what he is talking about.)
A: In theory, you’d expect lower risk to mean you have to accept lower return. If you were achieving modest outperformance with lower than average risk, you were doing a doubly good job. If someone tries to diminish that accomplishment by saying you just captured a low volatility premium, I think they are mistaken. You achieved an outcome academics say is impossible – higher returns with lower risk. It seems logical to me that your approach was successful because so many good managers achieve their results by first focusing on protecting their capital, and only then thinking about upside.
I also agree with you that reading manager commentary is an underutilized resource for manager selection. You get a very different perspective from reading a manager’s thoughts than you do by just analyzing historical performance. I believe that it is difficult to select good managers without understanding how they approach investing. Without that, you’ll never have the conviction to stay invested through the underperforming periods. That’s why we at Oakmark put so much time into writing quarterlies that attempt to explain our actions in a manner that sheds more light on our investment philosophy.
Q: Bill, your approach seems purely Grahamian rather than Buffett's variation on Graham's work. In light of the constant tax bite of selling when a stock reaches intrinsic value, are you ever tempted to follow Buffett and continue holding it so long as the business is operating well?
A: I think we analyze companies much more like Buffett than Graham. We assign a lot of value to intangible assets, such as brands or patents, as opposed to the focus on tangible assets that Graham utilized. But unlike Buffett, we do sell stocks when we believe they exceed 90% of value. You are right that the downside of our approach is that we don’t defer taxes as long as Buffett does. We believe that is more than offset by getting our sales proceeds (net of long term capital gains taxes) invested in stocks we believe are selling at 60% of value instead of 90%.
Q: Mr. Nygren, you have been quoted as saying you sell when a company is fairly valued rather than waiting for it to become over-valued because you would not buy a company that is merely fairly valued. Since "the growth guys" generally overpay, and since there is evidence that momentum can be profitably combined with value investing, do you think this counterargument has any merit?
A: To me, a basic part of being a value investor is that, all else equal, a higher price decreases a stock’s attractiveness and vice-versa. I think it is dangerous to attempt to marry a value approach with a price momentum approach. Momentum of analyst’s assessment of fundamentals, however, is something that can be incorporated. Our history has shown, and I believe other value firms have also experienced, that analyst sell targets tend to show an anchoring bias. By that I mean that the magnitude of the positive and negative adjustments to targets based on fundamental developments is less than would occur if the stock was being looked at with a clean slate. Before I buy stocks where our estimates of value have been in decline, or sell stocks where our value estimates have been rising, I will really push our analysts to make sure they have fully incorporated all recent news into their targets.
Q: You seem to think that the market is traded at a reasonable P/E ratio. Did you consider that earnings might be inflated by the historical high profit margins?
A: We have definitely considered that. Our opinion is that most of the increase in profit margins from historical averages is structural. Factors that, to us, suggest today’s higher margins are more than cyclical include: less profit from metal bending (low margin) more from intellectual property (high margin), less manufacturing more services, less US more International, and lower tax rates.
Q: Who is your all-time favorite investor and why?
A: I have tremendous admiration for the great value investors such as John Templeton and Warren Buffett. They followed a philosophy that makes sense to me, and their clarity of thought makes their written works very educational. But I’d have to say the investor I most admire is Michael Steinhardt. Michael was one of the first and most successful hedge fund managers. His track record of compounding investor capital at 25% per year over 28 years is amazing. I wrote about Steinhardt in a shareholder letter five years ago explaining how we at Oakmark have tried to incorporate some of his successful techniques (you can read that commentary here). His insistence on having a “variant perception” (understanding how his point of view differed from most investors) and his use of a clean slate when he felt out of synch are two ideas I find especially compelling.
Q: What is the biggest investment mistake you made while at Oakmark, what did you learn from it and how can other value investors apply this knowledge to their research and portfolio management process?
A: The most money we lost came from not anticipating the 2008 collapse in housing. We thought that housing was such a long duration asset, and the cost of housing was so dependent on interest rates, that low interest rates would allow house prices to stay stable at a higher level. I think it is natural when thinking of mistakes to first think about those investments that resulted in losses, but mistakes of omission can be even more costly to a portfolio than mistakes of commission. I don’t lose any sleep over watching a stock that we don’t own go way up from levels we didn’t think were attractive anyway. The most painful mistakes are when a stock meets our investment criteria but we don’t invest as much as we should have. So when I think of most costly mistakes, I think of buying Apple for less than $100 in January of 2009, a level from which it increased eightfold, but only getting half of a normal-sized position in Oakmark Fund, and not owning any in Oakmark Select. Those are the kind of mistakes that re-examination may help better prepare us for the next time.
Q: What are some good books to read for investing and portfolio allocation?
A: Anything written by Warren Buffett. I’ve also enjoyed the books that dedicate one chapter each to a group of successful managers – books like John Train’s Money Masters or Jack Schwager’s Wizards series. In those books, I especially find it useful to read about investors that use different approaches than we do. Though we focus on different variables, the similarity across successful investors of traits like discipline and passion is remarkable.
Q: Over the years that you have been in the business, upon reflection where do you think you have found the most "valuable" ideas?
A: Almost by definition, the stocks selling at the biggest discounts to value have to come from areas other investors aren’t looking, or where investors are so focused on short term negatives that they ignore long term opportunity. The stocks or sectors that leads one to are always changing, but the idea that the best opportunities are in places others are worried about or ignoring is almost fact rather than opinion. Among those cheap stocks, the best long-term performers have been those with managements that behaved like owners. When you own stocks for as long as we do, 5 years on average, the value additions that come from the unexpected opportunistic transactions management initiates can be very meaningful.
Q: What was the most valuable idea in your career and where was it found?
A: My best stock recommendation, by far, was Liberty Media. We bought it when it was first spun out from Telecommunications, Inc. in 1991. I found it because I regularly looked at spinoffs, believing that newly traded stocks had a higher probability of being misvalued than those with long trading histories. The stock was a hodge-podge of minority interest investments in cable TV systems and programming. It was levered, had no earnings, dividends or book value. There weren’t many screens that produced Liberty as a potentially cheap stock. But doing a tedious piece-by-piece valuation of each asset suggested that Liberty’s assets could be worth 3x the amount they were on the books for. The terms of its debt and preferred were so favorable that the liabilities appeared meaningfully overstated. Our guess of the per-share value was multiples of the value of the Telecommunications stock that needed to be exchanged to get the new Liberty shares. So few investors took advantage of this unusual exchange that we ended up owning much more of the company, 20%, than we had expected. Seven years later, when AT&T bought Telecommunications and Liberty, we had made something like 20x our original investment. I think it is much harder to find similar values today than it was 20 years ago because the asset-by-asset valuation methodology for companies that don’t make sense on typical metrics is now much more widely used.
Q: What would you say was the one book, teacher, job or whichever, that shaped your stock picking philosophy?
A: When I was in high school I read all the investment books our local public library branch had. That’s less heroic than it sounds because investing was not a popular topic in the 70s. The book that made the most sense to me was Ben Graham’s Intelligent Investor. I was raised by parents that were very value conscious consumers, so the idea that you could succeed by buying stocks like you bought groceries and clothing, made perfect sense to me. The teacher that I learned the most from was Professor Steve Hawk. Steve started the Applied Securities Analysis Program at the University of Wisconsin. That program has launched hundreds of successful investment industry careers. Steve taught with a blend of practical and academic experience that is sadly lacking at most schools today. He always told his students that there are lots of investment approaches that could be successful, but that it is up to each individual to find the approach that best suits him or her. Being a value focused consumer was so deeply ingrained in me that when I learned about value investing I knew I had found the approach I was most likely to succeed with.
Q: Do you think it is possible for an intelligent amateur investor to select an active fund manager who is more likely than not to outperform the average fund or benchmark in his category going forward? If so, how do you think the investor can do that?
A: I believe the answer is yes. If I were trying to identify such a manager I would look for the same things we look for in the management teams of companies we invest in: an individual track record of success, an organization that has a track record of creating successes, a rational disciplined investment philosophy, a strong team, and good economic alignment with the shareholders (large personal investment in the fund). That said, identifying successful managers is not nearly as difficult as it is to stay invested with those managers long enough to reap the fruits from their labors. Unfortunately, the average mutual fund investor has underperformed the average of the funds they invest in because of poorly timed entrances and exits. I think one is unlikely to achieve good (market beating) results unless fund purchases are limited to those where one believes in the people, process and philosophy, and where one has the strength of conviction to not panic and sell just because of disappointing short term performance. If the only reason for buying a fund is good recent performance, then there will be no conviction to stay the course when times get tough.
William C. Nygren, CFA