4Q17 | Bill Nygren Market Commentary
December 31, 2017
During the quarter, Win Murray and I had the pleasure of answering some reader-submitted questions for GuruFocus, which covered a range of topics, including value investing, Harris Associates’ investment philosophy and some of our current portfolio holdings.
Below is an excerpt of the Q&A. The full version can be found here.
What is your most compelling investment right now?
Bill Nygren: One way to answer the question would be to pick either Citigroup (C) or Alphabet (GOOG) because they are the largest holdings in Oakmark and Oakmark Select. I would highlight the price of Citigroup being barely above book value, or adjusting for the non-earning assets at Alphabet that leave a search business at less than a market multiple. But I don’t think that is the best answer to your question. Our individual stock selections underperform the market close to half the time, and our opinions change as facts and prices change. So a month after I write that answer, it might not accurately reflect our thinking.
I think the better answer is to go to the asset category and say stocks or a portfolio of stocks that appears attractively priced based on long-term expectations, such as the Oakmark Fund. As an asset class, stocks have a record of impressively outperforming other types of assets, and individuals who try to time ins and outs have a poor record. I believe individuals should develop an investment plan that is as heavy in equities as is allowed by their financial situations and risk tolerances. Then they should periodically rebalance their weighting in equities back to their target, meaning trimming after price increases and adding after declines.
This view, of course, assumes that before investing dollar one in equities that enough cash has been kept to meet near-term expected expenses, as well as enough to last through an extended emergency or job loss. It also assumes that any credit card debt has all been paid off because the after-tax cost of that debt is much higher than the return expected in stocks. Lastly, I can’t resist pointing out that buying staples on sale can be the best return of all, and cash will be needed for that, too. If toothpaste, for example, is on a two-for-one special, the return on that purchase is 100% after-tax in less than a year. No other investment can consistently match that!
What signals should we look for to warn us of an imminent market correction? What stocks do you recommend owning as a defensive position against a large correction?
Win Murray: Implicit in this question are two concepts: 1) the market is overvalued currently and 2) the market can (and should) be timed, with cash balances raised ahead of downdrafts.
Let’s address the second point first. If you had invested in the S&P 500 at the Oakmark Fund’s inception in 1991, reinvesting dividends and never selling, today you would have nearly 12 times your initial investment, despite some enormous intervening market declines, including the worst global financial crisis in a generation. If you had instead invested in the Oakmark Fund, following our disciplined investment approach, you would have 25 times your starting money. The long-term track record for investing in equities and the power of compounding are so attractive that we believe it’s not worth the risk to try to exit the market during the periods of time in which equity returns are less attractive.
As to the first point…There’s no question that the market looks expensive on absolute metrics, such as P/E versus its own history. However, the market can’t be valued in a vacuum. If stocks are worth their discounted cash flows (and they are), then the discount rate by definition is a big component in valuation. The current interest rate environment is as low as it’s been in our lifetimes, and thus the value of future cash flows discounted to today should be higher than it’s been in the past, producing higher warranted P/E ratios.
In addition, the P/E ratios themselves are somewhat misleading, as the cash on companies’ balance sheets isn’t producing the interest income it used to historically. Meanwhile, the large increase in R&D-heavy enterprises within the overall market leads to a mismatch between current expenses (R&D spending immediately reduces current income) and future earnings (as the revenues generated from current R&D expenses will be seen in the years to come).
Finally, if you did truly believe a correction was coming but you wanted to continue to own stocks (as we do), the most attractive securities would likely be the ones trading at the largest current discount to fair value. These are precisely the stocks that we endeavor to own in our portfolios in all market environments.
Can you comment on GE (GE)? Any thoughts on upside? Time frame? Mistakes they have made in the past? What would you like to see them do?
Murray: We were wrong in our initial assessment of General Electric (GE). We believed that its new CFO Jeff Bornstein would help change the company’s history of poor capital allocation, as evidenced by transactions he initiated, such as the GE Capital exit, the Alstom purchase, and the Synchrony spin. We also believed the company’s cost structure had not been run as efficiently as it could’ve been and that margins would expand over time.
As it turns out, GE’s culture of “growth, growth, growth,” with a focus on reported EPS, was inappropriately applied to the company’s Power division. GE Power built capacity and inventory for orders that never came and sold OEM equipment at poor contract terms, while booking GAAP profits through adjustments to prior-period long-term service agreement accounting. GE Power’s sustainable operating income turned out to be vastly lower than what had been reported. The stock has been a significant underperformer, and many executives (including the CEO, CFO, two Vice Chairmen, and the head of GE Power) no longer work for the company.
After taking a fresh look at GE, we continue to believe it has some outstanding businesses with long-lived service income, which should (when properly run) trade at least at parity with other high-quality industrials. We also believe that John Flannery is a very capable CEO who will ultimately run the company more effectively than it’s been run in decades. The turnaround won’t occur overnight, but the current price appears to be factoring in significant challenges, and we believe the stock remains attractive.
What is your take on Chesapeake Energy (CHK) and Apache (APA)? How do you estimate their intrinsic values? What are potential catalysts? Isn’t shale and “oil producing nations undercutting each other” increasing the supply, and electric vehicles dampening demand?
Nygren: For any company the Oakmark team looks at, we project out two years of financial statements, estimate a growth rate for the next five years and make thoughtful estimates as to how cash flow will be invested or, in higher growth situations, how capital needs will get funded, to arrive at a per share value estimate. Because we are looking out a total of seven years, our assumption is that the economy will be at “normal” levels, reflecting neither peaks nor valleys.
With commodity companies, the single most important variable to forecast is the price of the commodity. As with the economy, we want to use a price that reflects “normal” times. That means a price that is high enough to incentivize new production to meet new demand that comes from growing global GDP, yet not so high a price that a surplus is produced. Over the past decade, oil has ranged from a low of $28 per barrel to a high of $147. Our analysis suggests that for new exploration, a price of around $70 is needed to earn a 10% return on capital. That is also conveniently a fair amount under the average of the past decade, stated in current dollars.
When we value energy companies based on what they would be worth when oil prices return to $70, Chesapeake (CHK), Apache (APA) and Anadarko (APC) are among the most attractive. When we further consider which management teams have been the best stewards of capital, these companies really stand out.
I’m surprised to see Netflix (NFLX) in your portfolio. I understand your explanation in the quarterly letter about how the P/E will drop if they bump up the monthly rate by a few dollars (to $15 per month). But why do you think Amazon or Apple (AAPL) cannot capture this market? I don't see the moat in Netflix.
Murray: The competitive threat from competing video sources, whether they be traditional media or new entrants, is a constant debate point for us internally on Netflix (NFLX). We have come to the conclusion that Netflix does in fact have a strong moat.
The winners in media are the companies that show the content that consumers want to watch. Consumers want to watch the same shows that other consumers are watching, so a strong network effect is created once a distribution platform regularly produces such shows. The virtuous cycle in media is Strong content -> More subscribers -> Higher revenue -> More strong content.
Traditional cable networks are constrained as to how much they can rationally spend on content, as there are only a fixed number of primetime viewing hours to fill. Online competitors like Netflix, however, have no such constraints, nor do they have to spend a portion of their subscriber/ad revenues on fees to distributors. Therefore, they are able to spend more money on content creation, which will drive viewership, driving subscriber growth and ASP increases, driving more content spending.
Netflix already spends more on scripted content than any non-sports video provider, it is expected to increase content spend by 25% in 2018 (in line with its 2017 revenue growth), and plans to produce 80 feature-length films and 30 anime series in 2018.
It’s true that Amazon, Apple, Hulu, and the new Disney streaming service are all similarly advantaged in distribution versus traditional broadcast networks, but even if one of these services chooses to invest billions more in content creation than Netflix’s current budget, consumers have proven in the past that they will consume multiple “channels” of entertainment. We are optimistic that Netflix will continue to create content that consumers will demand, and that this will create economic value that leads to more in-demand content, proving to be a formidable moat.
What resources or advice can you give to somebody starting their own investment partnership? Could you touch on the legal setup? I want to model it after Warren Buffett in the ‘50s and ‘60s.
Nygren: If you are picking an investor to model your career after, there isn’t a better choice than Buffett. I think one of the many important things Buffett got right when he started his partnership, and it was unusual at the time, was the legal structure that gave him full discretion for stock selection. When unusually attractive opportunities present themselves, they are typically shrouded in controversy. Even when you believe you have clarity as to the value, it can be very difficult and time consuming to convince your investors that you are right. I would suggest not putting yourself in a position where you have to seek permission before making each investment.
Stepping back from the structure, I think one of the difficulties many underestimate when setting up a small partnership is the importance of the team you are surrounded by. One of our biggest competitive advantages at Oakmark is the depth of our team and the many years we have spent working with each other. Throughout our history, the investment leadership at our company has been working with each other for at least a decade. That was the case with the generation before me and it will be the case with the generation after. I take for granted that I can walk up or down the hall poking my head in any office and find a co-worker who is a long-term value investor whose opinion I respect enough that I want to bounce ideas off of them. Working together makes us all better investors. Anyone thinking of starting on their own needs to find a way to replace that network, and it isn’t easy.
William C. Nygren, CFA
View other commentary and letters from Bill here.
The securities mentioned above comprise the following percentages of the Oakmark Fund’s total net assets as of 12/31/17: Citigroup, Inc. 3.5%, Alphabet Inc., Class C 3.5%, General Electric Co. 1.8%, General Electric Capital Corporation 0%, Alstom SA 0%, Synchrony Financial 0%, Chesapeake Energy Corp. 0.4%, Apache Corp. 1.8%, Anadarko Petroleum Corp. 1.4%, Netflix, Inc. 1.5%, Amazon.com, Inc. 0%, Apple Inc. 2.6%, Hulu, LLC 0% and Walt Disney Co. 0%.
The securities mentioned above comprise the following percentages of the Oakmark Select Fund’s total net assets as 12/31/17: Citigroup, Inc. 6.0%, Alphabet Inc., Class C 9.0%, General Electric Co. 3.9%, General Electric Capital Corporation 0%, Alstom SA 0%, Synchrony Financial 0%, Chesapeake Energy Corp. 2.5%, Apache Corp. 4.0%, Anadarko Petroleum Corp. 0%, Netflix, Inc. 0%, Amazon.com, Inc. 0%, Apple Inc. 0%, Hulu, LLC 0% and Walt Disney Co. 0%.
Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Access the full list of holdings for the Oakmark Fund as of the most recent quarter-end.
Access the full list of holdings for the Oakmark Select Fund as of the most recent quarter-end.
The Price-Earnings Ratio (“P/E”) is the most common measure of the expensiveness of a stock.
The Price-to-Sales is a stock’s capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per share basis.
The Price to Book Ratio is a stock’s capitalization divided by its book value.
EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.
The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market. All returns reflect reinvested dividends and capital gains distributions. This index is unmanaged and investors cannot invest directly in this index.
This interview originally appeared in a December 7, 2017 GuruFocus article titled, “11 Questions With Oakmark’s Bill Nygren and Win Murray” by Holly LaFon.
The Oakmark Fund’s portfolio tends to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Fund’s volatility.
Oakmark Select Fund: The stocks of medium-sized companies tend to be more volatile than those of large companies and have underperformed the stocks of small and large companies during some periods.
Because the Oakmark Select Fund & Oakmark Global Select Funds are non-diversified, the performance of each holding will have a greater impact on the Funds’ total return, and may make the Funds’ returns more volatile than a more diversified fund.
Investing in foreign securities presents risks that in some ways may be greater than U.S. investments. Those risks include: currency fluctuation; different regulation, accounting standards, trading practices and levels of available information; generally higher transaction costs; and political risks.
The discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.
All information provided is as of 12/31/2017 unless otherwise specified.