Bill Nygren (Trades, Portfolio) and his team are value investors. They buy companies that trade at a large discount to true business value. In evaluating opportunities the team is focused on:Ă‚
- A company's stock price compared to true business value.
- FCF or free cash flow.Ă‚
- Good capital allocation.
- High insider ownership.
In his most recent quarterly commentary, Nygren discussed Oakmark's strategy and how it relates to value investing. This was an interesting discussion of the state of value investing. Especially as value has lagged growth over the past 5- and 10 year marks.
Nygren kicked off by taking us through a history of the value investing philosophy (all emphasis is mine):
"Throughout Oakmark’s history, we’ve been on the lookout for situations where GAAP obscures economic value. Though value investing has always implied buying at a discount to value, the early descriptions of value relied more on assets than earnings. In 1934, Ben Graham and David Dodd wrote Security Analysis, which was quickly adopted as the Bible of value investing. In it, Graham explains his idea of only investing when he had a “margin of safety:” he only purchases a stock when it is priced at a large discount to a company’s intrinsic value. The concept remains a core principle of value investing today, even though the idea is almost 100 years old."
"Security Analysis" and "The Intelligent Investor" are classics. I'm guessing everyone knows either one or the other by now. Seth Klarman (Trades, Portfolio) of the Baupost Group and Bruce Berkowitz (Trades, Portfolio) of Fairholme Funds are investors that still stick very close to the original philosophy. Oakmark doesn't, and this letter talked about why they don't.
"Over the next 40 years, stock prices were generally quite tightly tied to their book values and patient investors could often find companies that were out of favor, trading below estimated liquidation value. It was an asset-heavy economy, which made it appropriate to value businesses based on their tangible assets. In fact, as recently as 1975, 83% of the stock market value of the average company was represented by its tangible book value."
I'd argue that even in that era, book value still required a fair amount of diligence to sort the good from the bad. But fundamentally it's true of course. Oil and railroad companies made up a large amount of the stock market.
"In an economy where value was derived from fixed assets, it was hard to maintain competitive advantage: If you earned unusually high returns, others would duplicate your fixed assets and your advantage disappeared. That made it difficult for companies temporarily trading at large premiums to book value to sustain their high stock prices. So, an effective investment approach was to buy the stocks priced at discounts to book value and then patiently wait for reversion to the mean."
Nygren seemed to imply that it has somehow become easier to maintain a competitive advantage now that intangible assets play a larger role. I don't think that's the case. Whether assets are tangible or intangible shouldn't make much of a difference to whether they constitute a competitive advantage. Capital can recreate most intangible assets just as well.
"But, as the economy has become more asset-light, intangible assets—such as brand names, customer lists, R&D spending and patents—have become more important. Today, the relative importance of tangible assets compared to intangibles has completely flip-flopped from what it was 40 years ago. Intangibles now account for over 80% of the average company’s market value. But much like Graham, GAAP doesn’t even attempt to value those assets."
Great point, meaning we should pay increasingly less attention to GAAP. You see this reflected by companies trying to argue for investors to rely on non-GAAP adjusted metrics. There are pros and cons to that. It gives management more opportunities to mess with earnings, but sometimes GAAP doesn't do any justice to real underlying earnings. Private equity companies and Berkshire Hathaway (BRK.A)(BRK.B) are great examples of companies where that's true.
"By the early 1980s, the Berkshire Hathaway investment portfolio, managed by Warren Buffett (Trades, Portfolio), looked nothing like the low price-to-book investments favored by his teacher Ben Graham. The portfolio included General Foods, RJ Reynolds, Time Inc. and Washington Post Co. When asked about the apparently high prices he paid for those companies relative to their book value, Buffett was fond of saying that their most valuable assets—their brand names—were not even on their balance sheets. The Buffett quote above, citing the decreasing importance of tangible assets in determining business value, sounds as timely today as it did when it appeared in Berkshire’s 1983 Annual Report. What Buffett figured out earlier than most value investors was that conservative accounting rules overlooked the value of intangible assets. In turn, book value didn’t fully reflect the economic value of businesses with strong brands."
I'm not sure if that's what Buffett overlooked. Buffett actually did better when he employed the Graham style in his partnership and achieved higher returns. But he adjusted when Berkshire achieved size, to enjoy the process better and for tax optimization reasons.
"For companies in the S&P 500 today, the correlation between stock price and tangible book value has become quite small, just 14%. This is a very big change from 25 years ago, when that correlation was 71%—or 5x stronger than it is now. Unlike 25 years ago, knowing the book value of a company today gives little clue as to its stock price. Investors who have relied primarily on a price-to-book mean reversion strategy have had disappointing performance for the past decade. Some even feel they “are due” for an extended positive run. That would indeed be the case if irrational exuberance were the reason that book value is currently disconnected from stock prices."
This is definitely true. Book value is mostly useful to get an idea of relative value of the market compared to recent history and it's still very useful in certain industries to quickly find potential disparities; think asset and capital heavy industries: banking, shipping, insurance and real estate.
"At Oakmark, we believe that the relative importance of intangible assets is more likely to continue than to reverse. As such, we think a portfolio of strictly low price-to-book stocks will continue to produce disappointing results."
Here I completely agree. Just relying on price-book seems like too naive of a strategy that is also well-publicized.
"Since Oakmark’s 1991 inception, we have sought out investments whose economic value was not easily seen in the simple GAAP metrics of net income and book value. Over that time, like Buffett, we’ve owned a lot of packaged food companies when we thought increased brand advertising was understating earnings."
There's some truth to the idea that advertising spend shows up as expenses now and only translates into earnings later. Online advertising puts things on their head again, however. Online advertising allows you to track conversions in real time. You can dial spending up and down instantly. There's no need to book a season of commercials in advance, not knowing what the ratings will be. Sure, we are still left with the issue that the customer lifetime value isn't reflected on the same time scale as the advertising expense, and that remains a good point.
"That has led Oakmark to invest in more companies generally owned by growth investors, such as Alphabet, Facebook, Gartner, Netflix and Regeneron. The thought process is no different than what led us to own food and cable stocks early in Oakmark’s life. Today, it simply applies to more companies."
Ultimately, this leads to Oakmark's conclusion that it should be investing in growth companies like Alphabet (GOOG, Financial)(GOOGL, Financial), Facebook (FB, Financial), Gartner (IT, Financial) and Regeneron (REGN, Financial).
I agree on Alphabet, and Facebook has been temporarily attractive after the political inquest commenced. On Netflix I disagree, and on the others I'm not familiar enough to judge.
But more and more frequently I encounter professional and individual investors who find a line of reasoning to justify investing in the winners of the last few years. Invariably they are growth stocks.
Maybe this is the perfect time to look really hard at deep, deep value investing: buying real assets at deep discounts to their intrinsic value. I'm convinced it still works really, really well. The hard part is finding the real asset deep value opportunities in this frothy market.
Disclosure: author owns no stocks mentioned.
