11 Questions With Oakmark's Bill Nygren and Win Murray

Reflecting on your current holdings, did the Oakmark Select Fund buy from a “shopping list” where you waited for your price/value point, or were you more opportunistic, following and buying from market mispricing?

Win Murray: Both parts of your question combine for the correct answer: We opportunistically try to take advantage of market mispricing across a “shopping list” of companies that we have already approved to be purchased by our portfolio managers.

Our research analysts, all generalists, are tasked with finding the best available investment opportunities. Once analysts have determined that a stock is attractive, they write a memo explaining the investment case and then distribute it (along with a model and other supporting exhibits) to the entire investment department. Another analyst is assigned to be the Devil’s Advocate; his/her job is to go through all of the numbers for accuracy and to surface risks that the originating analyst might not have considered. The investment idea is then discussed by our investment professionals. After a rigorous (and occasionally intense) Q&A session, three senior investment leaders vote as to whether the idea should be approved for purchase. Only at that point, after an idea has gone through this entire process and been approved, can portfolio managers buy the stock.

Our domestic “approved list” typically contains 100-150 securities, from which portfolios are constructed. Some of the stocks on the list are new, while others have been there for more than a decade. All are actively followed by a covering analyst (frequently the individual who originally brought the new idea, but not always), whose job it is to maintain accurate estimates of intrinsic value, so that portfolio managers can continually make optimal decisions.

Note that one excellent side effect of this process is that it effectively reduces “key man risk” at Oakmark, as all portfolio managers are selecting securities from this central, rigorously vetted list. We’ve had many portfolio managers at the firm since it was founded in the 1970s, and our adherence to this process has assured clients that no matter who the named portfolio managers are, the portfolios are following the same Oakmark investment philosophy.

In past interviews, you've talked about how you get excited about an opportunity when you're able to build a proprietary data set. Without giving away any of your secrets, can you give us some past, but somewhat recent, examples where you've been able to do that and how the data were collected or built? How have you employed technology to gain an edge in investing?

Bill Nygren: Our success has not been based on needing to be at the leading edge of new technology, but we are an extremely data-driven group. I think the most important way we’ve used data is to examine our own history of buying and selling stocks to identify behavioral biases and then adjust for them to help improve our outcomes.

There was a time when I think we kept a more useful database on M&A transactions than was otherwise available. I don’t think that is the case any longer, as data has become much more accessible and manipulation of that data is now easier and cheaper, so it is no longer an advantage.

Our advantages today are more often based on how we think about value as opposed to having proprietary data. Take, for example, our holding of LinkedIn (LNKD, Financial) last year. Most value managers avoided it because it had very low GAAP income and, therefore, a very high P/E. LinkedIn had a very successful and profitable Human Resources business, basically allowing companies that were hiring to bypass placement firms. But they were also investing those profits, which were immediately expensed, into tangential businesses trying to get users to increase the time they spent on LinkedIn. By making reasoned estimates of the margins in the HR business and applying valuation multiples solely to that income stream, we concluded that the stock price was substantially beneath our estimate of business value. Microsoft evidently agreed when they purchased LinkedIn at a price consistent with our estimates.

Many of our holdings have higher P/E ratios than the S&P 500, but for most of them, we believe the P/E ratio does a poor job of reflecting the total value of their various assets.

What is your most compelling investment right now?

Nygren: One way to answer the question would be to pick either Citigroup (C, Financial) or Alphabet (GOOG, Financial) 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?

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.

Every company seems fixated on improving margins. How do you determine whether a company is temporarily boosting margins by forgoing valuable investment? How do you figure out whether a company is investing enough in its business?

Murray: You are correct that margin expansion is a regular part of most companies’ operating plans. Some of this occurs naturally, as revenue growth scales across a business’s fixed cost base. Much of the time, however, the company has targeted a certain amount of expense reduction, incremental to operating leverage. This can come from cost of goods sold (by moving the manufacturing footprint to a lower cost region or by improving procurement to acquire raw materials more favorably), SG&A (the most common source of expense reduction, typically achieved by reducing corporate overhead, streamlining sales and marketing efforts, cutting research spending, or improving productivity per employee), or below the operating income line (by changing the capital structure to reduce interest expense or discovering a way to lower the company’s tax burden).

I mentioned before about the rigorous Q&A session that accompanies all new idea presentations. Frequently, half or more of the time spent discussing the investment idea is focused precisely on the issue of future margin forecasts and their feasibility. Your question hits upon one of the biggest parts of many investment theses, and we certainly don’t just take management’s projections at face value. It’s important that margin expansion goals are rooted in logic and reality, rather than being pipe dreams.

As analysts, we need to use common sense to determine whether a company’s margin expansion targets are realistic and if they come from logical sources of expense reduction. We do this by examining the company’s financial statements versus its peers, by assessing management’s historic track record of expense reduction (whether at the current company or in their prior roles elsewhere), and by talking with informed industry participants about the feasibility of such plans. We also examine the company’s proxy statement to see the metrics upon which management’s variable compensation targets are based, looking for the possibility that such metrics could create adverse, unintended consequences. We want management to have long-term incentives that align their interests with those of the business’s owners (its shareholders), so that proper investments are being made for the company’s future.

Do you think the market prices for Facebook (FB, Financial), Amazon (AMZN, Financial) and Alphabet (GOOG, Financial) are expensive? Or do you see them fairly valued for their quality and growth?

Nygren: We own Alphabet, so clearly we believe it is attractively valued. Our case for the company rests on the non-earning or, in some cases, money-losing investments owned by Alphabet that obscure both the earnings level and market price for the search business. A cursory look at Alphabet—$1,025 per share with $41 of consensus 2018 earnings, for a P/E of 25 times—could easily lead one to think that the market was applying an appropriately high multiple to a very good business. But consider that the company is projected to end next year with about $160 of net cash per share that is generating de minimis income. Subtracting that from the stock price gets $865 and reduces the P/E to 21 times. Then consider the other bets—autonomous driving and artificial intelligence to name a couple—that lose about $5 per share. Subtracting a $50 per share guess of the value of those bets from the share price and adding back their losses gets to an $815 price with $46 of earnings, or a P/E of 18 times. Then there is YouTube, which is growing extremely rapidly and is believed to contribute very little to current earnings, but if valued similarly to cable TV networks based on hours viewed, would be worth hundreds of dollars per share. Will streaming revenue per hour watched eventually converge with cable? We think so. Subtracting even a small fraction of the implied YouTube value leaves a search P/E that is well below the market average.

While we don’t go into depth about our valuation thoughts on companies we don’t own, we did recently own Amazon (AMZN, Financial) when the price-to-sales ratio was cheaper than for brick-and-mortar companies. Before you conclude that a stock is too expensive, I think it is important to check piece-by-piece values and other valuation metrics, such as price-to-sales or price-to-book, to make sure that the P/E ratio isn’t missing important elements of value.

Can you comment on GE (GE, Financial)? 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, Financial). 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.

This is far from the first investment mistake we’ve made at Oakmark. Our since-inception performance numbers (cited above) include scores of them. It’s difficult to accurately forecast the future, and we know that each of us is certain to make investment errors every year.

What’s important is handling the mistakes properly, once identified. Using GE as an example, when fundamentals looked as though they were moving in the wrong direction, one of our analysts wrote a full Devil’s Advocate memo on the company, which was distributed to the whole department and then discussed at our domestic investment meeting. The GE analyst and the Devil had to come to agreement about what numbers were acceptable to use in the model. In addition, portfolio managers met with management, including new CEO John Flannery, in Boston and again in New York.

It’s important not to anchor to the prior thesis and original assumptions, but instead to take a fresh look at the company at current prices. We believe that GE 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 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, Financial) and Apache (APA, Financial)? How do you estimate their intrinsic values? What are potential catalysts? I remember in one of the earlier quarterly letters, the team at Oakmark said it believes oil prices will rise to $70 to $80 per barrel over the next few years. What are the assumptions behind that price? 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.

The price of oil has only been under $70 for the past three years, so we are just now finally seeing a reduction in energy production, as the inventory of partially completed projects has been exhausted. On the demand side, there has been no change in the link between global growth and hydrocarbon consumption, with energy demand growing about half as fast as global GDP. Electrification of vehicles could slow that somewhat (though increased electricity production relies somewhat on natural gas), but at the penetration rates we believe are likely, this will take many years.

When we value energy companies based on what they would be worth when oil prices return to $70, Chesapeake (CHK, Financial), Apache (APA, Financial) and Anadarko (APC, Financial) 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. We have come to the conclusion that Netflix (NFLX) 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, and is expected to increase content spend by 25% in 2018 (in line with its 2017 revenue growth). Original series, such as “Stranger Things,” “Narcos,” and “Ozark” have proven that Netflix wasn’t just a two-hit wonder (“Orange is the New Black” and “House of Cards” were the original series from 2013 that put the streaming service on the map as an original content provider). Netflix plans to produce 80 feature-length films and 30 anime series in 2018. They’ve already supplanted the 30-year HBO/Comedy Central stand-up comedy duopoly, with comedians recognizing the superior model and signing on for specials. They’ve also signed exclusive deals with proven content creators, such as Shonda Rhimes (“Grey’s Anatomy”).

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 are your thoughts on Bitcoin?

Nygren: I don’t own any personally and it is not - and will not be - a holding in portfolios we manage. One of the reasons we have been successful at Oakmark is that we only buy securities when we have a well-developed opinion as to their intrinsic value, and we have no such opinion on Bitcoin. Further, we find the fascination with Bitcoin scary given how little relevance it has to anyone’s life. I think the only reason it is such a hot topic is because the price has been so incredibly volatile that monitoring it has become entertainment. The tremendous volatility certainly takes away from the concept that its primary purpose is as a store of value that is less risky than government-issued currency.

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 (Trades, Portfolio) 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.

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The table below shows performance as of 09/30/2017

Expense Ratio (as of 09/30/2016): 0.89%
Fund Inception: 08/05/1991

The table below shows performance as of 09/30/2017

Expense Ratio (as of 09/30/2016): 0.98%
Fund Inception: 11/01/1996

Past performance is no guarantee of future results. The performance data quoted represents past performance. Current performance may be lower or higher than the performance data quoted. Total return includes change in share prices and, in each case, includes reinvestment of dividends and capital gain distributions. The investment return and principal value vary so that an investor's shares, when redeemed, may be worth more or less than the original cost.

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.

Because the Oakmark Select Fund is non-diversified, the performance of each holding will have a greater impact on the Fund’s total return, and may make the Fund’s returns more volatile than a more diversified fund.

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.

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.

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, as of the date written and are subject to change without notice.

Before investing in any Oakmark Fund, you should carefully consider the Fund's investment objectives, risks, management fees and other expenses. This and other important information is contained in a Fund's prospectus and summary prospectus. Please read the prospectus and summary prospectus carefully before investing. For more information, please call 1-800-OAKMARK (625-6275). Harris Associates Securities L.P., Distributor.