Bill Nygren Market Commentary | 3Q19

September 30, 2019

During the quarter, Win Murray (U.S. director of research and Oakmark Select co-manager) and I had the privilege of answering questions submitted by readers of What follows is an excerpt that focuses on investment philosophy and process. The entire Q&A, including our thoughts on specific companies and industries, appears on the GuruFocus website. You can read Part I here and Part II here.

At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.

How do you control your emotions when dealing with a position at a loss, where you know that it is still undervalued?

Bill Nygren: First, you say “where you know that it is still undervalued.” I think it’s important to state that we never have enough certainty to say we know a stock is undervalued. We may believe it is undervalued, but it is extremely important to keep an open mind to new information that could prove the thesis incorrect. As a value investor, discipline and patience are prerequisites for success. However, taking them too far and becoming stubborn can be a fatal flaw. A great way to prevent becoming stubborn is to always search for non-confirming information.

I think the best way to keep emotions under control is to remain focused on business fundamentals rather than stock price. When we buy a stock, we establish a roadmap for how we expect the business fundamentals to progress. If the fundamentals are meeting our expectations but the stock has declined, we often use that as an opportunity to add to our position. On the other hand, if the fundamentals aren’t aligning with our expectations, we will usually consider our thesis broken and move on, regardless of how cheap the stock may look relative to our original expectations.

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.

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 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.

How do you value businesses? Are asset-based or earnings-based valuations more useful?

Murray: A business is worth the sum of its future cash flows, discounted to today. Mathematically, that’s the only truly accurate way to value a company. At Oakmark, we estimate a business’s pre-tax, pre-interest cash flows (assuming a normal margin), apply an estimated tax rate, capital required for growth, and a projected capital structure, then estimate an intermediate growth rate. These factors, combined with an appropriate discount rate, tell us what multiple of cash flows the business likely deserves.

You mention two other valuation metrics: earnings based and asset based. Both have utility as shortcuts to a discounted cash flow model, although cash flows ultimately determine value. If the company’s earnings are approximately equal to their after-tax cash flows, then an earnings-based valuation model will likely be an accurate tool for determining the business’s value. This is not uncommon in a lot of mature industries that aren’t too research and development or amortization heavy and, therefore, is pretty widely used by investors.

Asset-based valuations are especially useful in very cyclical industries during time periods when current cash flows are far lower (or higher) than a company’s “normal” long-term cash flows. Take, for example, a deep-water drilling company. The company owns dozens of deep-water drillships, each worth hundreds of millions of dollars. When oil was more than $100 a barrel, these ships were contracted at exceptionally high rates, producing amazing cash returns on the original asset prices. However, when the oil price collapsed, many of these ships were left idle, producing no cash flows at all (and, in fact, requiring maintenance cash flows to keep shipshape for the future). A reasonable valuation methodology here would be to determine the replacement value of these assets if someone were to try to build the same fleet (adjusted for deprecation) and use this as a basis for valuing the company long term. You have to be careful when doing this, though, because ultimately all that matters are the cash flows. If, for example, circumstances in the industry have changed such that it would be impossible to get a good long-term return on a newly built drillship, then an asset value model would overstate the company’s value.

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.

The securities mentioned comprise the following percentages of the Oakmark Fund’s total net assets as of 09/30/19:  Ally Financial 3.3%, Alphabet Cl C 3.8%, Apple 2.0%, AT&T 0%, Bank of America 3.3%, Berkshire Hathaway 0%, Capital One Financial 3.2%, CarMax 0%, Carters 0%, Citigroup 3.6%, FedEx 1.0%, Fiat Chrysler 2.2%, General Motors 2.2%, HBO 0%, Home Depot 0%, Netflix 2.7%, News Corp Cl A 0%, Sirius XM 0%, Spotify 0%, Tesla 0%, Tiffany 0% and Wells Fargo 2.2%.

The securities mentioned comprise the following percentages of the Oakmark Select Fund’s total net assets as of 09/30/19:  Ally Financial 7.8%, Alphabet Cl C 10.7%, Apple 0%, AT&T 0%, Bank of America 5.0%, Berkshire Hathaway 0%, Capital One Financial 4.7%, CarMax 0%, Carters 0%, Citigroup 7.3%, FedEx 0%, Fiat Chrysler 4.7%, General Motors 0%, HBO 0%, Home Depot 0%, Netflix 3.5%, News Corp Cl A 0%, Sirius XM 0%, Spotify 0%, Tesla 0%, Tiffany 0% and Wells Fargo 0%.

Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks. Current and future portfolio holdings are subject to risk. Portfolio holdings represent only securities held in the U.S. domiciled Oakmark Funds and may not be representative of any other portfolio managed by Harris Associates L.P.

The price to earnings ratio (“P/E”) compares a company’s current share price to its per-share earnings.  It may also be known as the “price multiple” or “earnings multiple”, and gives a general indication of how expensive or cheap a stock is.  Investors should not base investment decisions on any single attribute or characteristic data point.

The Price to Book Ratio is a stock’s capitalization divided by its book value.

Price-to-cash flow is defined as a stock’s capitalization divided by its cash flow for the latest fiscal year.

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.

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.

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 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, at the time of this letter, and are subject to change without notice.

All information provided is as of 09/30/2019 unless otherwise specified.