Gurus On Board: Ask Bill Nygren -- The Answers

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Aug 10, 2007
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Bill Nygren is the portfolio manager of the $5.8 billion Oakmark Fund (10–year average 7.26% ) and more concentrated $5.9 billion Oakmark Select Fund (10-year average 15.16%). Recently our readers got an opportunity to ask him questions, and today we got his answers back.

#1. Bill, I understand that you sell when the price of the stock reaches 90% of your estimate of its intrinsic value. Have there been any exceptions? On average, have you found this to be an optimal sell strategy?

Bill Nygren: Four exceptions:

We sell at less than 90% of value if we lose confidence in either the management or the ability of the business to grow. Effectively, those are sales of our mistakes.

We sell at less than 90% of value if the business needs to be owned by someone else to maximize value (generally meaning acquisition synergy) and there is no reason to believe such a change in ownership is imminent.

We will sell at less than 90% of value if non-owned stocks are available at less than 60% of value. The relative gap of 40-50% appreciation is what we are really trying to capture.

We will wait for a holding to go long term if it is selling at around 90%-110% of our value estimate. If it increases past that, we’ll accept the short term tax penalty to avoid the risk of holding a significantly overvalued security.

Importantly, there is no magic in using 90%. For us, it seems to be about the right percentage to allow us to be generally fully invested, create reasonable turnover, and not create false precision in our estimates.

#2. I presume that a buyer of a whole business is willing to pay a premium for control. How much is this premium, typically? Is this premium the reason you as a non-control owner sell at 90% rather than 100% of fair value?

Bill Nygren: When I started in the business, control premiums were quite high, because in many cases, businesses weren’t being run to maximize value for the shareholders. Buyers, therefore, were willing to pay a high premium for control because they were going to radically change how the business was being managed. Today, I believe most businesses are already being run to maximize their value and buyers don’t bring much to the table, other than a willingness to use more financial leverage, so premiums are smaller. I don’t have a guess at a typical control premium. In general, I believe it is highest when a corporate buyer has synergy opportunities.

#3. Bill, just two questions about Discounted Cash Flow Analysis. First, can Return on Equity help you come up with a longer term (5 to 10 years) earnings growth rate? And do you count Book Value and expense options in DCF? Thanks in advance.

Bill Nygren: In any DCF we believe that options expense is as real as any other compensation expense, and therefore needs to be recognized on the income statement. Clearly, if a company quit giving options to employees, they would have to increase cash compensation, if not options are simply a gift from the shareholders. I don’t think that is the case. So, in a DCF, we either reflect the share increase from options, or else decrease cash by their value.

I think return on assets (or equity) can be helpful in estimating growth, but one needs to be extremely careful to differentiate between average returns and likely marginal returns on new capital.

#4. Hi Bill, could you let us know if you use options to minimize the risk in the portfolio (eg married puts) and also to maximize your returns?

Bill Nygren: I have used options only infrequently and only in small size. We have occasionally sold calls and puts, when we judged implied volatility to be too high, on up to 10% of several existing holdings that were priced in between our buy and sell targets. In those cases we were comfortable buying more at lower prices or trimming the position at higher prices. In total, I’ve never had more than two percent of the fund committed to purchase or sale via options. Recently volatility has been too low to profitably use that strategy on any of our holdings.

In general, I don’t think options strategies have been worth the time we have spent on them.

#5. Hi Bill, Several years ago Washington Mutual (WM, Financial) was your most favorite stock. Can you tell us what you've learned from that association over the years, and how do you feel about the company and it's prospects right now? Thank you.

Bill Nygren: WM question answered later in this Q&A.

#6. What is your view on the current subprime mortgage situation. Are there any sectors or stocks you feel are especially cheap at the moment and why?

Bill Nygren: Across asset categories, worldwide, risk premiums got too small. There is nothing wrong with the idea of a subprime mortgage, but like “subprime corporate debt” otherwise known as junk bonds, the spread over low risk bonds needs to be meaningful to allow for above average default rates. A lot of subprime mortgages got written at interest rates that were too low to make them good investments. Those have come down in value. Further, investment bankers sliced and diced those bonds into many traunches of varying risk levels, creating some securities that were highly levered in addition to having too low a spread to begin with. The risky traunches have obviously been miserable performers. However, we believe the market has begun to price a more negative scenario than we believe is likely.

I think stocks in general are usually priced to yield higher returns than most other investment opportunities. I don’t see any reason to view today as that unusual time when you shouldn’t own stocks. We’ve seen small stocks outperform for about 7 years, and for 4 years we’ve seen commodity and cyclicals outperform stable growth, low quality outperform high quality, and International outperform US. Looking for values today, I would look away from those categories that have done well recently.

#7. I am wondering why you are preferring Fedex (FDX, Financial) to UPS (UPS, Financial)? Both are trading below historical valuation metrics, however from a business economic perspective UPS appears the stronger with higher EBIT margins ROIC. Is the FDX preference based on a lower valuation multiple which you believe compensates for the comparatively weaker economics? Thanks

Bill Nygren: UPS and FDX sold at about the same multiple when we opted to buy FDX. If one assumed future growth could be estimated by multiplying the earnings retention rate by the ROE, one would have concluded that UPS was the superior grower, and therefore, probably the superior value. We believe that FDX has a stronger brand name, and believe that they have made some infrastructure investments both in the US and in new markets that are not yet earning the returns they will eventually achieve. Therefore, our expectation is that FDX will grow more rapidly than is implied by their current ROE.

#8. Bill, are there any specific areas that you are finding value these days? Also, what is your favorite stock that you already own where you don't think the market has realized its discount?

Bill Nygren: Part 1 was answered in Q#6.

Our largest holding, WM, is the stock I believe has the largest undiscounted value. Most investors view WM as a mortgage banker. True, those results swing their earnings more than the rest of the company, However, if one values the mortgage business separate from the retail bank, one finds the overwhelming majority of the value is in the bank, and that segment appears to be enjoying above average growth.

#9. Bill. How would you define your investment style - classic value, or GARP (growth at a reasonable price)? In your analysis of Best Buy, you speak about its potential for further growth, so that implies GARP. Also, one of the characteristics you look for in a stock is "growing per share value" - again implies GARP. I'd like to know how you see yourself, rather than how others describe you?

Bill Nygren: Those are distinctions I’ve always had a hard time with. If two businesses sold at the same price, any rational value investor would prefer the business that was going to grow more rapidly. Likewise, if two businesses had the same expected growth rate, any rational growth investor would prefer the cheaper one. Only momentum investors would rather pay more than less. High P/E multiples make us queasy faster than most growth investors. The result is that we happily buy average businesses at cheap prices and great businesses at average prices. But we leave the incredible businesses at high prices to the growth guys. I guess our willingness to pay average prices for above-average businesses makes some people say we aren’t really value, we are GARP. I’m confident that our approach is rational, so I don’t worry much about what label people apply to us.

#10. Bill, what is your current view of Western Union ?

Bill Nygren: We own Western Union in Select and in Oakmark. We believe that the global money transfer business will continue to grow, and that as the leader, Western Union should continue to achieve above average growth. Most people who don’t like WU stock seem to be concerned with technology advancements that could allow WU (or any of its competitors) to be bypassed (using services like ATM machines or Pay Pal for example). Because most of WU’s customer base is unbanked, we don’t believe those services present a viable threat.

#11. I find that initially finding undervalued stocks is possibly the most critical part of value investing. Could you provide us with more information on the Harris search strategy? Also, after finding a list of stocks for further research do you speed up the research process based on how undervalued they seem at first glance?

Bill Nygren: I believe the most critical part of value investing is following a disciplined buy and sell process. If that is a given, then yes, finding new ideas is the next most important thing. We buy stocks that meet 3 hurdles: significant discount to business value, business value grows at least at an average rate, and management aligned with shareholders. By definition, stocks we don’t own fail on at least one of those measures. So we try to identify change that might make them qualify: for those that looked too expensive, we look for large stock price declines. That is no doubt our largest source of new ideas. We also look for businesses that have achieved large increases in value where the stocks have under reacted, but that doesn’t happen nearly as often. Second largest source is probably management change. For some companies, we believe their stock is attractively priced, but we don’t have confidence that management goals are aligned with ours. In those cases we are watching for the people to change. And yes, we prioritize our research work based on both the probability of meeting our criteria, and also the degree of undervaluation.

#12. Hi Bill, I'm wondering what's your opinion of BSC. I feel that they are cheaper than their competitors now, while having superior management to all of them minus GS. I feel the subprime issue is completely priced in right now. What's your take?

Bill Nygren: We don’t comment on stocks we don’t own. In general, I’ve believed that business value for most brokerage firms is a premium to book value, and their asset management arms ought to be valued at P/Es consistent with other public asset managers.

#13. Bill in an interview with Motley Fool a few years back you mentioned that you enjoyed the John Train books and Jack Schwager books because the short profiles of investor's helped you find an investing personality. You also mentioned that Warren Buffett is one of your hero's. What are the five most important books you have read? And if you were to expand your list to three most influential people in your life who would they be? Thanks for your insights over the years.

Bill Nygren: Relative to my development as an investor the most important people have been: 1) Parents. They taught me to be a value based consumer, and to have the confidence to rely on my own judgment even when the crowd came to a different conclusion. Both have been essential skills in the investment business. 2) Professor Stephen Hawk. Prof Hawk headed the Applied Securities Analysis Program at the University of Wisconsin , which is where I went to Business School . He was the first person to help direct my passion for investing into thinking about a career and an approach that could lead to superior results. 3) Peter Foreman. Peter was one of the founding partners of Harris Associates, and was the partner I worked directly for in my early years at this firm. When I joined Harris, I had pretty good quantitative analysis skills, but very weak qualitative skills. Peter taught me that statistical cheapness was a starting point, not an ending point. Equally important was gaining an understanding of management’s skills and goals.

Bill Nygren: A couple of books I’d mention – of course Graham’s Intelligent Investor is a classic you’d expect a value guy to recommend, I’d also suggest Fred Schwed’s Where are the Customers’ Yachts?, and Roger Lowenstein’s Buffett. Two off the wall selections – Michael Lewis’ Moneyball, not only entertaining (partly because I love baseball), but a reminder that valuation gaps exist in many areas of life, and Elements of Style by Strunk and White, a reminder that communicating one’s ideas is just as important as coming up with them.

#14. Bill, It is no secret Warren is looking for someone to fill his shoes...if he approaches you and asks you if your interested in being the CIO, will you accept or deny and why?

Bill Nygren: I have a great job, enjoy the people I work with, and feel I have been treated very fairly by my employer. The hurdle to get me to consider a career change would be enormous. Further, though I admire him greatly, I’ve never even met or spoken to Mr Buffett.

#15. Washington Mutual is your largest holdings. I've held it for 4 years with a cost basis of about $39. While the capital appreciation is slow, I am more than happy to hold on and collect the dividend, which as you know is increased almost every quarter and the yield is over 5% right now). The dividend helps me sleep at night. This whole time, I have found it to be undervalued and I am convinced staying the course will end in good rewards. And now, I think it is worth $50+ (I think the sub-prime, Alt-A concerns are overblown in WM). I think it is safe to say that it is undervalued and I think you agree on this. I suppose I don't have a particular question on this stock, but could you give some more insight as to why you like WM so much as to make it your largest holding. In particular, what metrics do you look at when trying to determine the intrinsic value of WM?

Bill Nygren: We continue to believe that investment losses on owned mortgages will not cause a large reduction in our WM business value estimate. Obviously, the market is discounting a more serious outlook. Time will tell. I'm not allowed to comment on recent additions or reductions in our portfolios. I don't believe WM's subprime exposure is enough to blow more than a quarter's worth of income. Obviously, if problems spread to prime mortgages, the hit could be much larger.

The most compelling reason we continue to own WM is the valuations that have been placed on retail banking deposits in recent acquisitions (the premium to tangible book value, divided by deposits). Those imply a value to WM that is far above the current price. Second, the management is invested side-by-side with us, including CEO Kerry Killenger, who has the majority of his personal wealth in WM stock. The 6.5% dividend yield, and a dividend that has been increased for something like 40 consecutive quarters is another positive. I believe it would take more than a one-time mortgage write-down to break that streak. Finally, we believe that over the years, WM has been prudent with their risk taking, and we believe that will continue.

#16. What has your biggest investment mistake been and what lessons can be learned from it?

Bill Nygren: How about missed opportunities. Has there been any stock (or stocks) you passed on in the past 5 years which in hindsight represent a missed opportunity? A stock that had everything you look for but for some reason you decided to take a pass on them? What lessons can be learned from it? Why did you pass on them at the time?

When I took the CFA exam in about 1982, there was an essay question asking us to use a bunch of financial ratios to back our argument as to whether Wal-Mart or Kmart was the more attractive stock. KM was cheaper relative to book, to earnings and had a much better yield. Of course, that was the one I picked. Over the next twenty years, KM went bankrupt and Wal-Mart returned many times its cost. That mistake taught me a lot about sustainable competitive advantage, and the importance of corporate cultures. That was the start for me of realizing that qualitative analysis was as important as quantitative analysis.

The number of missed opportunities is too long a list to even start on. I would say that last year, analyzing Select’s first ten years showed how important big winners have been to portfolio performance. I think sometimes value investors buy a stock to capture a valuation gap, but don’t adjust their valuation targets based on information that comes out after they purchase it. For stocks we owned like Cablevision, Dun & Bradstreet, and Moody’s, increases to per-share business value subsequent to our purchase were far more important to our return than was just the initial undervaluation.

#17. Bill, H&R Block has experienced a lot of turbulence in the past 5 years. As a long term shareholder, how do you rate the performance of its management? If Mark Ernst asked your opinion, would you recommend that it focuses on core tax business or would you still support a certain degree of diversification (bank, financial services, business services). What is your opinion of the OOMC deal? (price and chance of closure in Oct)

Bill Nygren: We believe HRB has a great tax prep business. We believe that business alone is worth a large premium to today’s stock price. We have never supported diversification into a financial super market. In fact in 2000, my co-manager on Select, Henry Berghoef, spoke at HRB’s shareholder meeting immediately following their Olde acquisition and was highly critical of that suboptimal use of capital. In hindsight, I guess Select shareholders should be grateful for that misstep as the stock decline in response to the acquisition allowed us to establish our position in HRB at well less than half today’s quote. We believe that back in 2000, our urging them to use tax prep cashflow to repurchase shares, instead of diversifying, has helped produce that outcome. That said, we’ve been disappointed at execution in the tax business, and also at how management got swept up in the subprime business – finally believing it was a core business when it was at peak earnings. The Option One sale, at a $300 million discount to a fair market based book value, probably is about a wash versus closing and liquidating it. I don’t think HRB should be in subprime, but I also don’t think they negotiated an irreplaceable deal. One way or another, I expect they will not be a subprime lender next year.

#18. You are running two multi billion funds. Do you feel limitations of investment ideas because of the funds’ size? What will you do differently if you run much smaller sum of money?

Bill Nygren: In some environments, size can be a real impediment. Back in 2000, in general, the smaller the cap, the more undervalued the company was. Though it was easy to find great midcap values, the microcap values were even better. Today, I don’t believe size is any impediment. After a long run for small and midcaps, that universe is really picked over. I believe most of the better values are in very large companies. If I only managed my own capital, I’d probably have it invested very similar to how Oakmark Select is invested.

I think a point that is often missed when investors worry about whether funds are “too big” is that as the organization grows to support asset growth, it becomes easier to attract talent. Today, we have a larger, higher quality research department than we have ever had.

#19. Who are the people that you learned the most from about value investing? Warren Buffett, Phil Fisher, or someone else? In which aspects does each of them changed the way you invest?

Bill Nygren: To me, value investing is a way of making sense of the world, not just investing. As I’ve said before, I think the first seeds were planted by my Mom from observing her grocery shop. She bought more when something was on sale and deferred purchases when the price was too high. As I started getting interested in stocks, writings of Graham and Buffett squared best with how I’d learned to behave as a consumer. After I started earning my income as an investor, people like Mike Steinhardt (his concept of variant perception – always understanding how your view of a business differs from what is already priced into the stock) and Bill Miller (value can include higher growth companies including tech stocks) helped refine my thinking.

#20. Bill, you stated that you occasionally read GuruFocus, have you incorporated any ideas you've found there in your fund?

Bill Nygren: I use GuruFocus as a convenient way to stay current with managers that I admire. It provides one-stop shopping for seeing what they have purchased, and what they have written about their holdings. Several of our buy ideas have come from monitoring buys by these managers. A recent purchase of ours, Sprint, was a stock we revisited multiple times after seeing other managers purchasing the shares. We weren’t as optimistic about the business value as they were, but as the price declined it met our valuation criteria. We probably could have found Sprint without that help, but it made it easier.

#21.Bill, you have very low portfolio turnover, of course that is good for shareholders. When do you sell a stock? Sell when it approaches the intrinsic value? Sell when you have a better idea? Or something else?

Bill Nygren: We buy a stock when:

it sells it a large discount to our value estimate,

we believe the value growth will be at least average, and

we believe management will act like owners.

We sell when we lose any of those three supports. Failures are when we lose confidence in management or the ability to grow. Successes are sold when the value gap has become deminimis, or other stocks have fallen such that they are far more attractive than those we hold.

#22. In your opinion, what are the characteristic traits to avoid, if you want to be a successful investor? Which traits should you be looking for?

Bill Nygren: To me, the most important traits are a combination of passion and discipline. Most everyone in this business is smart. That is necessary but not sufficient for success. Being able to stick to one’s investment philosophy through tough times is perhaps most important. We’ve all seen lots of smart people get whipsawed trying to surf the hot style. Last, I don’t think successful investors can turn it off. They are constantly thinking about businesses. For example, when they are in a store, they are seeing who is gaining and who is losing shelf space. It is definitely not an 8 to 5 job. Indeed, if it is thought of as a “job” that already makes success difficult. Successful investors have a passion for the challenge of investing, and to them, it is their way of life, not just a job.

#23. Warren Buffett talks a lot about “moat”, what is your take with “moat”?

Bill Nygren: I believe that as time passes, most businesses trend toward average returns. The high side exceptions are companies that have developed moats – some competitive advantage that is very costly or impossible to replicate. Of course, we like moats. Without some sort of moat, the valuation approach needs to be more asset based than earnings potential based.

The Oakmark Funds are distributed by Harris Associates Securities L.P. Member NASD. For more information about The Oakmark Funds, including a prospectus, please visit or call 1-800-OAKMARK. Please read the prospectus carefully before investing. An investor should consider a fund's investment objectives, risks, and charges and expenses carefully before investing. This and other information about the funds are contained in the fund's prospectus.

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