This month’s 20 Questions interviewee is the Oakmark Funds’ Bill Nygren (Trades, Portfolio). We gave our subscribers the opportunity to ask questions about his investment strategy and philosophy, the criteria he looks for in a company to add it to the portfolio, and advice for new investors.
Overview of Nygren’s portfolio
Nygren has been managing the Oakmark Select Fund since 1996 and Oakmark Fund since 2000. He currently holds 58 positions in his portfolio, which has a total value around $16.81 billion and a 5% quarter over quarter turnover.
The majority of his positions are in the financial services sector, which makes up 32.1% of his overall portfolio. The second most heavily weighted sector is technology, which is 20.1% of his portfolio and the third is industrials at 13.1%.
Average annual returns
The Select Fund’s average annual returns over the past 10 years as of April 30 was 8.67%, compared to the S&P 500, which returned 8.32%. Over the past five years, it returned 15.10%, compared to the S&P’s 14.33%. Over three years, it returned 18.83%, compared to S&P’s 16.73%. Since inception, the Select Fund’s total return was 13.49%, compared to the S&P’s 8.02%.
Oakmark Fund’s average annual returns over the past 10 years as of April 30 was 9.41%, compared to the S&P’s 8.32%. Over five years, both the S&P and the Fund’s annual return rate were 14.33% and in three years, Oakmark’s annual returns were 17.97% and the S&P’s was 16.73%. Since Inception, Oakmark Fund’s returns were 13.14%, compared to the S&P’s 9.59%.
1. Are there any companies you have always wanted to invest in, either in the U.S. or abroad, but didn’t because they didn’t fit all of your criteria? Have you ever made any exceptions to companies that did not fit all your criteria, but you saw potential in them and decided to invest anyway?
No. We defined our criteria at Oakmark such that companies that don’t fit our criteria are stocks that we would not want to invest in. So for every stock we invest in, we believe it is selling at a discount to value, its value will grow with time, and that management is working in its shareholders’ interest.
Of course not every stock we own ranks in the best decile on each of those measures, so we have to make some compromises. And we have a line in the sand we won’t cross for each criterion:
-We won’t buy a stock that isn’t priced meaningfully below our estimate of current business value.
-We won’t buy a stock unless we expect the combination of dividend yield and per-share value growth to at least match what we expect for the S&P 500.
-And we won’t invest with a management team that we believe is willing to sacrifice per-share value growth in order to more rapidly grow the size of the business. (For example, make an acquisition using stock that is more undervalued than the company being purchased.)
It is only when all three are met that we can be confident holding the stock for a long time – for Oakmark that usually means five to seven years. And it is that long time horizon that I believe gives Oakmark its greatest competitive advantage.
2. When meeting with a management team for the first time at a company you may not know as well as others, what are you asking them? Do you have a favorite question you like to ask management teams?
Before we meet with a management team we will do extensive preparation. That includes not only reading available information about the company but also reviewing presentations management has made. When we get a CEO to spend time with us, the last thing we want to do is waste that time on questions that we could have found answered in readily available material.
The most important thing we want to learn from CEOs is what their long term goals are and how they will measure their own success. We want to hear answers that tie to the success we have owning the stock. For example, we would much rather hear about goals for improving return on invested capital that we believe would drive the business value and stock price higher than to hear about opportunities to get bigger via acquisition.
We also want to hear their thoughts on capital allocation. When you expect to own a stock for five to seven years, how free cash gets invested will be a big determinant of the success or failure of that investment. We want managements to invest capital in whatever way maximizes long-term per-share value. Depending on the circumstances that could be through building new plants, it could be that the company is uniquely situated to achieve synergies from acquisitions, or the highest return opportunity might be share repurchase.
Finally, we want to make sure that if the company has an opportunity to sell to a buyer who will pay full value for the company, management would happily sell the company.
Effectively, what we hope to find is that they would act the same way we would if we knew their business as well as they do.
3. In the Oakmark and Oakmark Select Funds today, besides John Malone, who is your favorite manager or management team and why? Is it fair to assume your favorite manager is John Malone (former chairman of Tele-Communications, Inc., currently chairman of Liberty Media)?
When we evaluate managers, we are looking at strategic vision, operational skill, and financial skill. Rarely does one manager rank highly in all categories. Our funds have profited greatly from John Malone’s stewardship of the companies he has managed and many of their spin-offs. I believe John is top notch in all categories.
My second favorite is not nearly as easy to identify. All of our managers excel in at least one of the above areas, and most in two of the three. One CEO that I don’t think has gotten the credit he deserves is Tom Lynch at TE Connectivity (TEL, Financial). Under Tom’s leadership TEL has dramatically improved margins, sold off non-core businesses at good prices and used proceeds to repurchase undervalued stock. He has also opportunistically shifted capital allocation between strategic acquisitions where TEL was an advantaged buyer, and share repurchases. While some economically sensitive companies are just now getting back to the peak levels they earned in 2007 (when TEL was spun-off from Tyco), TEL has almost doubled EPS while improving its business mix and still paying out a reasonable dividend.
4. I really like the math behind stock buybacks and how one's percentage stake in a company improves dramatically over time as buybacks manifest. I was wondering, is this phenomenon offset by stock options?
The two items, repurchases and stock options, aren’t related but do work in offsetting directions. When options granted to management are exercised, the share count increases. The value of the company goes up only by the exercise price of the option, which by definition will be less than the share price at time of exercise (or else the option would be allowed to expire). That value leakage is why it is important to consider option issuance as an expense, just like any other form of employee compensation.
Repurchases work the other direction. The value of the company decreases by the amount spent buying back the stock, and the share base decreases by the number of shares purchased. As long as the price paid for repurchased shares is less than intrinsic value, intrinsic value per share will increase.
Many companies have what we would consider a misguided repurchase strategy, namely to repurchase exactly the same number of shares that are issued via options, regardless of the relationship of the stock price to intrinsic value. To us, option issuance is irrelevant to a proper share repurchase strategy. When the stock is selling at a discount to intrinsic value and repurchase is more additive to per-share value than are competing uses for that capital (such as building a new plant or making an acquisition), shares should be repurchased. When that is the case, growth by reducing the denominator is preferable to increasing the numerator. When the stock is fully valued or when growth opportunities add more value than repurchase does, increasing the numerator is preferable to decreasing the denominator.
5. Can you share your top criteria used to judge/categorize whether a company is considered high quality?
The ability to consistently earn a high return on invested capital. But that isn’t as simple as it sounds. You can’t just screen for high ROIC and have a list of good investment opportunities. You need to understand what enduring competitive advantage exists that will allow the company to continue earning high returns. And you need to buy the stock at the right price. We certainly aren’t alone in admiring companies that have enjoyed sustained high returns, and typically we find those stocks to be priced well above the level we would be willing to pay.
Many of our investments are companies where we believe they will begin to demonstrate high returns, but for various reasons that ability is not yet obvious from current financial statements. If we can identify those opportunities before they are obvious it is more probable that we can get a price to our liking.
6. How much of a 10K should an investor read?
I’m tempted to be uncharacteristically brief and say simply, “all of it,” but I don’t want to come off sounding like a smart aleck.
Many investors try to simplify decision making by focusing on only one metric – such as a P/E ratio – and therefore might only read the income statement. Ignoring the balance sheet will miss important clues such as how inventory levels have changed, or whether or not customers are paying their bills on time. The cash flow statement will expose important differences between income recognition and conversion of that income into cash. I think all three financial statements are important, as are all the notes to those statements.
In addition to the financial statements and notes, the business description often discloses details that aren’t readily available elsewhere about the company’s competitive position. The management discussion of the results from the past two years also gives an indication of what metrics they believe are most important for tracking their progress.
Many years ago I attended an analyst lunch for Tele-Communications, Inc. John Malone, its CEO, was chastised by one analyst for not having alerted the analyst community to how attractive its Liberty spinoff was going to be. I’ll never forget John’s answer; “Next time you get a 600-page document from us; I suggest you read it.” There are no shortcuts.
7. In 1977, Warren Buffett (Trades, Portfolio) wrote a brilliant piece in Fortune magazine called “How Inflation Swindles the Equity Investor”. In the piece, he reveals his insight of looking at equities as bonds with variable coupons and estimating the intrinsic value based on this insight. Do you use a similar method to estimate intrinsic value? Could you walk us through how you estimate intrinsic value?
I definitely agree that over the past 50 years there is nobody who has written about investing as well as Buffett has.
We would definitely agree that what Buffett described - basically a discounted cash flow analysis - is the right way to value a company. But that approach is very time consuming, and more importantly, small mistakes in growth rate estimates can have a very large impact on the value. It is rarely intuitive whether a company can grow sales at 3% or 5%, yet that can be the difference between attractively priced and fully valued.
Our approach is to forecast the next two years, not just the income statement, but all three statements, so that we are properly accounting for cash generation or cash needs. Then we use a five-year growth rate for years three through seven to calculate an appropriate target multiple for two years from now. We will check that target multiple against both stock market prices and acquisition multiples for similar companies. We do our multiple analyses on an enterprise level, and then compute the implied value for the equity by deducting financial obligations, and adding back cash and other non-earning assets. We adjust all our estimates for risk, essentially reducing the value for riskier businesses or more levered balance sheets. All else equal, our goal is to be invested in the stocks that are priced at the largest discount to our estimate of value.
8. Besides larger AUM, how does success impact your investment decisions?
I don’t think success on its own changes our investment decisions. Its only impact is to increase our already high conviction that long-term value investing continues to be an effective investment philosophy.
If, however, you changed the word “success” to the word “experience” I’d say it makes us much better investors. Each opportunity we have to watch an attractive-looking investment reach its conclusion – either rising to our sell target, or getting sold because we decide our analysis was wrong – expands our knowledge base. The more examples we have experience with, the more likely we are to recognize patterns of data that are similar to past successes or failures. As the old Mark Twain quote says, “History doesn’t repeat itself, but it does rhyme.” With experience, we can recognize a higher percentage of those rhymes.
9. If you only managed $100 million, had no restraints on how you were allowed to invest and your investors didn’t have to worry about capital gains distributions, how would your portfolio differ?
The presumption of the question seems to be that because our funds are large, we probably can’t invest them optimally. Certainly there are times when small cap stocks appear to be priced generally more attractive than large cap stocks, and if now were such a time it wouldn’t be possible for us to fully capitalize on that opportunity. However, we don’t believe today is such a time. In general, we believe that small and mid-cap stocks are priced at an undeserved premium to large caps. So, I don’t think our size hurts us much at all.
A more important difference if we had only $100 million under management is that we would not be able to afford as large and as talented a group of research analysts working to find new investment opportunities for our funds. I am certain that if our asset size was dramatically smaller, we would not have discovered the quantity of attractive stocks that we are now invested in. Most mutual fund observers tend to focus solely on how size restricts flexibility rather than also considering that it allows for stronger research teams and also usually results in lower expense ratios.
As for how we’d differ if we were tax-free, it would be minor. In order to reduce the leakage to taxes we will occasionally extend a holding period to reach long-term tax status (one year from purchase), but using a value approach typically produces long-term holding periods anyway. And unlike some funds that focus on tax minimization (as opposed to maximizing after-tax returns), when long-term holdings hit our sell targets, we sell them. We believe our returns will be higher by paying the tax and investing in another undervalued stock, than by holding a fairly valued stock simply to defer the tax payment.
Read Part II of the interview here.