Bill Nygren (Trades, Portfolio), a renowned value investor, is manager of the Oakmark Fund, Oakmark Select Fund and Oakmark Global Select Fund, as well as chief investment officer for U.S. equities at Harris Associates, a Chicago-based firm with approximately $118 billion in assets. His Oakmark colleague, Win Murray, co-manages the Oakmark Select Fund with Nygren and serves as director of U.S. equity research at Harris Associates.
GuruFocus question: How do you analyze the management of companies?
Win Murray: Individual investors shouldn’t despair that they don’t have the opportunity to meet with management teams. Most of our analysis of company managements comes from doing a deep dive into their track records, in both operations (how they have grown sales and controlled costs historically) and capital allocation (how they have spent their discretionary cash flows and what their acquisition/divestiture scorecard looks like). If we see that a company issued relatively cheap stock to make a large, expensive acquisition, we can frequently close the book right there and move on.
We do try to meet with management teams before making investments. We have to be careful, though, because it’s easy to be impressed by a CEO. They tend to be charismatic, confident, well-spoken and with such deep knowledge of their companies that they can “wow” you with answers to any fact-based questions you may have.
This is why, when we meet with management teams, we try to ask questions that give us some sense for how the executives would think in different situations rather than discuss what’s happening with their business units or the marketplace today. Bad questions would be, “What are you currently seeing in your European end markets?” or “So what do you expect the government to do on tariffs?” Good questions would be, “What part of your current capital spending plan do you believe will lead to the highest returns, and why aren’t you spending twice as much on it?” or “What skill sets would you like to see added to your board of directors to help you best run the company?” We want to try to put executives into positions where we can see them thinking about different scenarios rather than giving the same standard answers.
It’s also always important to check the proxy statements to see how the executives are being paid. We don’t want to see people getting compensated for sales growth or profit growth. We look for metrics with “denominators,” like sales per share, earnings per share, return on invested capital, etc. We always want to make sure that the costs of growth are being properly captured.
Bill Nygren (Trades, Portfolio): We purchased News Corp. based on an asset-by-asset valuation model. We believe that its ad-supported real estate websites (both REA Group and Move.com) are its most valuable assets. But after owning the stock for several years, not seeing an increase in our estimate of per-share value and not observing management take steps, such as repurchasing stock with excess cash, we decided to sell the majority of our position last quarter. We believe the stock is statistically cheap relative to the value of its disparate businesses, but other stocks also look cheap where we have more confidence in the management and the growth trajectory of per-share value.
Question: What's a go-to resource for you for investment ideas and inspiration, beyond typical business publications and websites?
Nygren: Some investors suffer from a “not invented here” syndrome, which can cause them to look negatively at any idea that originated outside their own organization. One of the things I believe we do well at Oakmark is realizing we haven’t cornered the market on good investment thinking. We all read about what our competitors are doing with an eye toward using some of their best ideas.
I like reading books about successful investors, especially those who use a different style than we do. I admire Warren Buffett (Trades, Portfolio) and would say if you are going to read about only one investor, pick him. But rather than reading a seventh book about Buffett and maybe learning something new about his diet, read about great growth investors or commodity traders. The genesis of our work rigorously tracking how company fundamentals have deviated from our expectations came more from commodity traders than from other value investors.
We also read the quarterly reports from other funds that invest similarly to Oakmark. When a firm we respect takes a new position in a stock we don’t own, we like to research the idea and at least understand why we don’t agree with them. If we can’t find a reason to disagree, we are humble enough to admit that other investors can sometimes find good ideas before we do.
Question: In your metrics, do you take off-balance-sheet liabilities into account?
Murray: Yes, we make every effort to do so. Always think about valuing a company as if it’s your family’s business. Environmental liabilities, multi-employer pensions, potential legal judgments, lease obligations, etc., would be important to you as a business owner because in all cases they have the potential to intercept your cash flows, so they should be included when valuing an enterprise.
Nygren: Apple imports phones from China and the Chinese market for Apple products is important and growing, so a trade war with China definitely increases the volatility of the company’s short-term earnings. But this provides a good example of how Oakmark’s very long-term time horizon forces us to look past the ups and downs of news cycles and instead look at long-term fundamentals.
It seems that opinions about how long the trade war will last range from a few weeks on the short end to after the 2020 election on the long end. We own stocks based on what we believe investors should be willing to pay for them five to seven years from now, or about 2025. I haven’t heard anyone speculate that the trade war could last that long. Because of that, the only change in our valuation due to the trade war of companies doing business in China is a modest decrease in our estimate of cash generated in the next year or two. That generally lowers our estimate of value by at most a couple percentage points and doesn’t change our opinion on whether or not the stock is undervalued.
Nygren: We have tremendous respect for Berkshire’s CEO Warren Buffett (Trades, Portfolio), and he is one of my investing heroes. But that said, Oakmark’s very positive view toward Buffett is in no way a non-consensus opinion. Because of that near universal admiration, the company’s stock has never appeared to us to be cheaper than the other financial services or diversified companies that we’ve owned. Berkshire stock is a reminder that having a positive view toward a business or its managers is not sufficient to make a stock attractive. The company will be undervalued only if that positive view is not already incorporated in the stock price.
Question: Can you expand on the process that you follow to understand the “margin of safety” on your investments?
Murray: The difference between a stock’s current price and our estimate of the company’s intrinsic value per share is the margin of safety. We spend much of our analytical time attempting to determine an accurate estimate of intrinsic value.Once we’ve done that, it’s easy to see the margin of safety.
However, consider a scenario in which we believe Company A, with relatively little debt, is worth $100 per share, and we also believe Company B, with a lot of debt, is also worth $100 per share. Let’s also say that both companies were selling for $60 per share. Do they both have the same margin of safety? It would appear so at the equity level, but in total enterprise value terms, not at all!
Our estimates of intrinsic value are at the enterprise level, taking all net liabilities into account. If Company A has net debt equal to 15% of its market cap while Company B has net debt equal to 700% of its market cap, then the same $40 equity margin of safety on the stock prices is far less risky at Company A. A 10% error in our estimate of Company A’s intrinsic enterprise value ($115) would only mean an 11.5% decline in our estimate of per share equity value, whereas if our Company B value ($800) is 10% too high, it would mean our $100 target stock price would be high by 80%!
So please, always look at company valuations at the enterprise level to ensure that your margins of safety are as safe as they appear.
Question: What do you know about investing now, that you wish you knew when you started?
Murray: When I started in this industry at age 26 after business school (and a full seven years before I joined Oakmark), I was given a sector to analyze (basic materials) and was essentially told to pick stocks that would go up. The idea that Consolidated Papers, for instance, was “worth” twice the current quote to a strategic buyer was irrelevant if the coated paper cycle was turning down because analysts were judged purely on how their stocks performed over short periods of time, typically one year.
I was being trained not how to value businesses, but instead to try to understand what news flow would likely occur over the next few quarters and then figure out what other market participants were thinking to determine whether it was already priced in or not. This is a perfectly interesting job, but it’s most definitely not how to make money in this field over many decades. Pretty much every investor you’ve ever heard of with a 25-plus year track record has made their money the exact same way: buying companies at a big discount to what they’re worth (usually when they’re terribly out of favor) and holding them until the cash flows eventually drive the companies’ prices to fair value.
Luckily, I was taken under the wing of an old-school value investor who helped show me what investing really is. By the time I joined the Oakmark team, I was well versed in the philosophy. But as director of research, I still see countless candidates who believe that “investing” involves picking stocks that “work,” as opposed to buying companies at a big discount to the present value of their future cash flows.
I remember interviewing a very intelligent analyst candidate in late 2012. He worked at a well-known but struggling hedge fund and was in charge of analyzing the transportation sector for them. We were discussing FedEx, a $90 stock at the time, and an Oakmark holding. The analyst had done a lot of work to determine the company was probably worth $160 per share, yet his firm didn’t own it. I was surprised he saw that much upside yet held no position. He explained that trans-Pacific trade figures hadn’t shown any sign of turning and he couldn’t recommend any stock without a catalyst lest he subject himself to significant career risk at his shop. A year later, catalyst-free FedEx was $40 higher and a year after that it had doubled.
As a young investor, I never realized how much of the week-to-week stock market movements come from “investors” who are chasing psychology and news flow. It flies in the face of the efficient market theory, but so many “investment” firms have created incentives for their analysts based on 12-month stock performance that it’s believable to see occur. Luckily for us, I don’t see this industry model changing anytime soon, so market inefficiencies should continue to exist even in the largest cap companies.
Nygren: I think the most common tendency of young investment professionals is to rely almost entirely on quantitative skills and ignore qualitative positives or negatives of businesses and their managers. I was no exception. It is really just natural because fresh graduates have better quantitative skills than their bosses. And if you’ve got the biggest hammer, you want everything to look like a nail. But I can’t think of one investment we’ve made at Oakmark where we developed an advantage over other investors by “outmodeling” them.
With experience comes an appreciation for the qualitatives that are hard to incorporate in a model. Our most successful stocks typically include a differentiated point of view on the quality of management or the quality of the business. As a young analyst, I always started by looking for really cheap stocks, and after concluding they were indeed underpriced, I then tried to convince myself that neither the businesses nor managements were bad enough to offset the statistical cheapness. Having completed all the valuation work before even meeting the management, you can guess how strongly biased I was to conclude that they were at least acceptable!
Today, I encourage our analysts to reverse that process: Find businesses and managements they’d be excited to own and then do the work to see if the valuation is attractive. If it isn’t attractive now, monitor the stock price so you are prepared to act when it is more attractive. It is really amazing to see over the course of our holding period, typically five to seven years, how much value a great management can add that never was incorporated in our model, and conversely, how much value a bad management can destroy.
See the first part of this interview here.
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