The Oakmark manager discusses the lasting lessons of the financial crisis and how traditional value metrics aren't necessarily the best gauge of an inexpensive stock.
Our guest on this week's installment of The Long View is noted portfolio manager Bill Nygren. Nygren joined Chicago-based Harris Associates as an analyst in 1983 and later served as the firm's director of research. He has managed Oakmark Select OAKLX since 1996 and Oakmark Fund OAKMX since 2000 and has comanaged Oakmark Global Select OAKWX since 2006. In addition to these duties, Nygren serves as Harris' chief investment officer for U.S. equities. For his investing achievements, Morningstar recognized Nygren as its Domestic-Stock Manager of the Year in 2001, and his funds remain highly rated by Morningstar's manager research analysts. A frequent and insightful commentator on investing and markets, Nygren's shareholder letters are a must-read on the Street and beyond. In this far-ranging conversation, he discusses how his team's competitive edge has evolved, how traditional value metrics won't cut it in today's evolving economy, and the lasting lessons of the financial crisis.
How Stock-Picking Has Changed and What Defines Value
Portfolio and Holdings
About the Podcast: The Long View is a podcast from Morningstar. Each week, hosts Christine Benz and Jeff Ptak conduct an in-depth discussion with a thought leader from the world of investing or personal finance. The podcast is produced by George Castady and Scott Halver.
About the Hosts: Christine Benz and Jeff Ptak have been analysts and commentators on investments and the investment industry for many years. Christine is Morningstar's director of personal finance and senior columnist for Morningstar.com. Jeff is head of global manager research for Morningstar Research Services, overseeing Morningstar's team of 120 manager research analysts in the U.S. and overseas.
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Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance at Morningstar.
Jeffrey Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Benz: Our guest this week is Bill Nygren. Bill is a partner and portfolio manager at Harris Associates, the Chicago-based firm he joined as an analyst in 1983, later serving as the firm's director of research. Bill manages several funds under the Oakmark banner, including Oakmark Select, Oakmark, and Oakmark Global Select, which he's run since 1996, 2000, and 2006, respectively. In addition to these duties, Bill serves as Harris' chief investment officer for U.S. equities. For his investing achievements, Morningstar recognized Bill as its Domestic-Stock Manager of the Year in 2001, and his funds remain highly rated by Morningstar's manager research analysts. A frequent and insightful commentator on investing and markets, Bill's shareholder letters are a must-read on the Street and beyond. We're thrilled that he can join us here today.
Bill, welcome to The Long View.
Bill Nygren: Thank you, Christine. Nice to be here.
Benz: It's great to have you here. Let's start by talking about how the business has changed over your career. I think you got started in the business in the early 1980s. Looking back and reflecting on your many years of experience, do you subscribe to the view that stock-picking has become a tougher game since then?
Nygren: I don't think it's become tougher, but it's changed. If you go back a little bit farther than my history in the business, and probably back to, say, the 1960s, the easiest way for a typical investor to access the great returns that equity markets usually produce over the long term was their local stockbroker. That was a very expensive way to get involved in stocks, but it still beat the alternatives of other asset categories.
Then that was followed by mutual funds that were largely index-hugging mutual funds, where stock-picking wasn't a great element of what they did, but it was a much cheaper way to get an exposure to the market than was the local stockbroker. Then at that point in time, if you were a value manager, you could basically just buy stocks that were low P/E or low price-to-book and patiently wait for mean reversion, and that provided enough of a benefit versus a closet index fund to justify a full active management fee.
Then index funds came along, and with index funds, managers were suddenly forced to say, "Are you value or are you growth?" Then ETFs came along that could follow value or growth metrics. So, throughout my career and before, I think to be an effective active manager, you've always had to stay a step ahead of the more passive models, where today, just simply buying a bunch of low P/E stocks and patiently waiting for mean reversion hasn't been a very good strategy anymore.
Even if it were a good strategy, an investor can access that at almost no cost through an ETF. So, we have always been focused on trying to provide a definition of value that was, shall we say, difficult to replicate with a computer. So, at Harris Associates, an Oakmark fund owning names like Alphabet or Netflix 30 years ago, the cable TV companies inside of a value fund was something you wouldn't get if you were just finding a fund that bought low P/E or low price-to-book companies.
When I started in the business, we would get statistical screens done about monthly. They were expensive, and when they came into the office, analysts would all look at them constantly for the next couple days trying to find the newer names that had drifted to the less expensive area of the market.
Screens today do almost nothing for you because they're so easy. They're cheap. Almost anybody can run them, and because of that, their output isn't as useful. So, I think the premium that's paid today for more creative definitions of value is much more important. That's why a lot of our ideas today in the Oakmark funds are the companies that don't look cheap on a P/E or price-to-book basis. But when you get at a deeper level of analyzing the company, a stock that doesn't look cheap on the surface might be one of the cheapest names in the portfolio.
Benz: So, we want to spend more time talking about your specific approach to value and the strategy you employ at the funds that you run. Before we get on to that, there's been so much discussion in terms of how the marketplace has changed for equity investors. There's been so much discussion about what these dramatic flows into cap-weighted index products have meant for the business of picking stocks and whether that, in fact, has created inefficiencies. I'd like to get your take on that question. Do you believe that's true?
Nygren: Well, I'm not as big a skeptic on cap-weighted index funds as a lot of my value peers are. If you think about it, if the index fund is cap-weighted and includes all equities, then by definition, the active managers own the same thing the index fund does. It's just some of us own some of the names, somebody else owns the others ones, but all the stocks are owned by somebody, and the index fund own a different proportion than the active managers do.
I think where some of the inefficiencies could be today is the more popular indices that are not all-inclusive, say, the S&P 500, the 501 to 600 names that could have gone into the S&P might not have as much buying interest because they aren't included in the more popular indexes. So, we're large-cap investors, primarily, so most of the names we own are in the S&P 500 already, but we're a little bit extra excited if we find something that looks attractively priced that isn't in one of the indexes yet.
Ptak: So, when you think about the sources of your edge as an active investor, I mean, maybe we would break it down, and I think Michael Mauboussin has done this, he's talked about informational edge, analytical edge, behavioral edge, and technical edge. If we were to maybe think back a couple of decades and how much you would attribute to each one of those buckets versus today and how you think about edge and where you can add value, how would that have changed?
Nygren: Well, I think, again, if you go back almost 40 years, the statistical edge that you could get, and I'm not as familiar as I should be with Mike's work as to how he defines the different buckets, but the statistical edge, just simply buying stocks that were selling at low P/Es and waiting for mean reversion, that could have been enough to have justified your fee as an active manager and could have been your primary source of your edge.
I think more of the edge today is coming from trying to identify where the summary statistics are missing value. So, a company that you think the P/E does an injustice to maybe because there's a lot of growth spending that's going through the income statement, or as Warren Buffett said 30 years ago, the packaged goods companies, their most valuable asset wasn't even on the balance sheet, the brand names. Where you can find examples where gap accounting isn't giving fair credit to the assets of the business and the changes in those assets, I think that tends to be more important today.
Then also, the qualitative side. We spend a lot of time at Oakmark trying to get to know the management teams we're considering investing in. I think even though almost all the management teams today talk about managing for shareholder value, you hear that a lot of times from people who don't really know what that means or have a different definition than we do.
We spend a lot of time trying to understand, "Is the management team focused on maximizing long-term per share value? How do they think about putting capital into share repurchase when their stock is cheap? What are their personal economics or how closely tied are they to what we as outside investors benefit from?" So, I think those would be the areas that have become more important today as the straight statistical cheapness has become a less useful tool.
Benz: You talked a little bit about, and we've discussed it already, this idea of traditional value managers are maybe in a crisis of their own making, and how at Oakmark and Harris Associates you use a different interpretation of value where you're focused on intrinsic value. Can you talk about how your strategy is maybe a little bit of a high-wire act and that you’re forecasting cash flows far out into the future? Does it inherently impose a little more risk?
Nygren: Well, I think to argue that anybody's investment philosophy is not to some extent a high-wire act is probably a false argument. Sometimes you can get comforted by a cheapness statistic like low price-to-book value, and then retailers that are on their way out of business that look very cheap compared to book value still go bankrupt because they don't get the useful life out of the assets that the accountants depended on when they decided on what number book value should be.
So, I don't think there is necessarily more risk in straying from the low P/E, low price-to-book value metrics. I think it's just a natural step that as the economy has changed to more asset-light business models, that more and more of the assets are not things that you can touch and feel and say, "We'll have a seven-year life," so you depreciate it over that time. The way gap accounting works is if you can't touch or feel something, it's basically expensed immediately.
So, R&D expenditures are all going straight through the income statement. Customer acquisition costs all go straight through the income statement. That can really present an unfair presentation of what a company is accomplishing in a given year. So, I don't think it's any less disciplined the way we look at things--trying to identify business value, demand a significant discount to that, look for management teams that are aligned with the outside shareholders--than it is for picking a favorite metric and then doing all of your work based on that metric.
Ptak: It seems like in some of those situations where maybe gap could be more obscuring than illuminating, I guess, why would the mispricing persist in situations like those just given the amount of firepower that the institutional investing community is bringing to try and unearth situations like those? I mean, I think that in your letters you've described some of the types of adjustments that you might make or there's an expense that's running the P&L instead you'll capitalize and amortize and adjust earnings accordingly to get a better sense of what the earnings power of the business is. To me, easy for me to say, it seems like a couple of taps, keystrokes, where somebody could program that in and that opportunity ceases to be. So, what's been your observation for why these misunderstanding persist and there's an opportunity for you to exploit?
Nygren: I mean, I'd be really disappointed if you could replicate our research process with a couple of keystrokes. I think there is still so much capital that depends at least to some extent on the primary metrics that have historically been so useful.
Ptak: So, EPV.
Nygren: Yeah, price to earnings, price to free cash flow, price to book, that when names get outside of normal bounds on those metrics, you're taking that capital away from the potential buyer pool. We have consistently found that if we can identify those companies when the gap accounting is obscuring the true value and hold them during a time period where that value becomes apparent, that those tend to be successful investments.
It is a very research-intensive process, and I think there are just a lot of players, both individuals and in the institutional community, that are looking for shortcuts that can make the research process faster.
Benz: In the back of your mind when you think about a potential resurgence in value investing, maybe more traditional value investing, are you …
Nygren: It's usually a dream when I'm asleep.
Benz: Are you concerned that because your portfolio is less traditional in its view of value that it might not behave as a vanguard value index would? I mean, it wouldn't behave in that way. Are you concerned that it might lag in a resurgence of pure value stocks?
Nygren: Well, at Oakmark, we're buying the companies that we think are cheapest relative to their intrinsic business value. So, over long periods of time, we expect that to be the optimum portfolio. The fact that there are stocks out there that are selling at lower price to book than some of ours, I mean, maybe those names go through a resurgence. I don't see any reason why they have to, but there's also a lot of our portfolio that does look cheap on traditional metrics.
We have a lot invested in the financial sector, especially banks at single-digit P/Es and auto companies at low-single-digit P/Es, industrial companies way beneath the market. But we're able to supplement that with the names like Alphabet, and Netflix, and Regeneron that might not typically make their way in the value portfolios because R&D spending or customer acquisition costs are obscuring reported earnings.
Ptak: I wanted to talk about focused investing. You run Oakmark Select, and that, in some sense, is a bit of a dying breed. There seems there are fewer and fewer focused equity portfolios. We certainly aren't seeing very many of those launch, and they've also been dogged somewhat by perception issues. There was one very well-chronicled blowup that happened with a long-established value investor who ran focused money and one of their biggest holdings blew up. So, when you're having that conversation with investors, current or perspective, about why you think the wisdom of focused investing endures, what is that answer? What does that messaging sound like?
Nygren: I think it starts at a high level of very few people today for their investment portfolio will pick one mutual fund and put all of their assets into it. So, with investors doing a lot of the diversification work on their own or taking responsibility for diversifying on their own, there's room for a focused portfolio to be disappointing, as long as on the other side of that you've got one that's performing even better than you had expected it would.
I think one of the issues that makes it difficult for intermediaries to recommend focused funds is they tend to look at the returns of each individual fund that they have recommended for a fund portfolio as opposed to looking at the overall returns. I think also, for me, business perspective from the fund company's side, there's more risk in having a focused fund out there. The numbers can lag what your goals are for an extended period of time.
Oakmark Select Fund is an example. It's been around since 1996, has outperformed the Oakmark Fund by about 200 basis points a year over that, what is it now, 23 years. Over the past five and 10 years, it hasn't. It's hard to tell an investor who's been patient for five years that that may have not been a long enough time horizon to judge the investment approach fairly, but the reality is without any change in approach, something that works very well long term can have a five- or 10-year period like that where it's not adding value.
Ptak: You don’t buy the argument that some make that there aren't enough fat pitches to swing at as value investors anymore for focused investing to work.
Nygren: Well, as an aside, I'm probably one of the few portfolio managers who still has an email address that's out there that any shareholder can email if they want to ask a question. Some of the late-night emails get kind of interesting, I'm assuming people have had their bottle of wine or something, but I've been asked why at Oakmark we don't start a bottom-30 fund. The Oakmark Fund has 50 names in it. The Select Fund has 20. The reality is, for the past five years, the 30 names that we didn't think were good enough to make it into the Select Fund have actually outperformed the 20 that were our favorites.
It's frustrating. I can assure you it annoys me more than it annoys any single shareholder, but it's very hard to conclude you can add value as a stock-picker if over long periods of time your rank-ordering of ideas either is useless or even inverse. So, I think the problem is that most investors just don't have the time frame that's truly long enough to get as much benefit out of a focused approach as they would need to have.
Benz: We want to switch gears and talk a little bit about market valuation at large. You have argued that the market isn't unreasonably priced at current levels, and you pointed out that when 2008-09 dropped out of the cyclically adjusted P/E that the market might look even more reasonable. It's at, what, 31 today. So, not cheap. Let's walk through why you think the market isn't unreasonably valued at current levels?
Nygren: Well, we don't use the cyclically adjusted P/E. So, if I get in to a debate with somebody who bases their whole investment philosophy off of that, I'm going to lose, but we look at the market selling at 16 or 17 times expected earnings for 2019, a long-term history of selling somewhere in the midteens. I think my peer Bill Miller may have said it best when he said if you look at the past 50 years, it's true that the average is about 16 times earnings, but it's not a normal distribution.
There are a lot of times when inflation and interest rates were high and the P/E multiple was around 10, and there are a lot of times when the interest rates and inflation were low and the P/E has been around 20. So, S&P 500 at 16 or 17 times earnings versus 3% on a long-term bond, I think it's very easy to come down on the side of the S&P.
When you study profit margins, I know there are people that are worried that profit margins have been in this consistent upward trend, but a lot of that has come from changes in business, not being as asset-based as they used to be, having economies of scale so that marginal customers are more profitable in their business rather than less profitable, lower tax rates. So, we look at most of the margin improvement that we've seen over the past 10 to 20 years and look at it as being more permanent than it is temporary. So, 17 times earnings just doesn't seem like that high a price.
Ptak: So, what if rates rise? I'm sure that's a question that you routinely get maybe late at night from some of your shareholders. So, is that a razor's edge that the market is perched on in the event that rates were to rise and that shifts discount rates and has a number of other ramifications?
Nygren: Well, increasing discount rates are bad for any long-term assets. They would be worse for the assets that people have been most excited about over the past few years, and that's long-term bonds. Your payment is fixed there. There's no ability for higher inflation to come through in the way of higher earnings. Companies, at least if you give them a few years, can usually react to higher inflation, which presumably would be the cause for higher interest rates.
Instead of getting the net income growth or GDP growth that we have today of 3% to 4%, I would expect on a higher inflation and interest-rate environment that growth rate would go substantially higher. P/Es would come down, but I don't think you would lose nearly as much in equities as you would likely lose in bonds because equities have the ability to pass-through inflation.
Benz: You keep an eye on the intrinsic value of the portfolio relative to its current price. Can you talk about where that is today versus where it was, say, one to three years ago?
Nygren: I don't have a good metric for that, but I think in a similar vein, one of the interesting things to us of how stocks have behaved over the past two years or so is that it's been less monolithic. There's been more of a spread based on which companies are going up and which are going down. One way we look at values is if we rank order our whole approved list, the bottom quartile ideas versus the top quartile ideas, how different do they look in terms of valuation? We're seeing those differences about as large as they've been in the past six or seven years, which I think has been a reasonably good correlation with how attractive a value approach is likely to be.
When that line is rising, of the least attractive relative to the most attractive, when that line is rising, it's because momentum is working and the stocks that have been going up that looked overvalued keep going up. That's the environment we've been in the past couple of years. It's somewhat encouraging to me that we're getting up near-historic highs there.
I think one of the ways you see that is look at a couple of different sectors in the stock market today, banks and electric utilities. Most of my career, electric utilities have traded well underneath the S&P 500 multiple. Yet, today, they're at about 20 times earnings, certainly not because their growth expectations are higher, it's because frustrated fixed-income buyers see a slightly higher dividend yield there than they can get in an interest rate in the bond market, and I think for the small amount of incremental risk they're taking, because those business models are very stable, that it's a good step-up in yield. So, as a fixed-income substitute, that sector of the market has become as fully valued as we think the bond market is.
At the other extreme, the banks have rarely sold at less than half the S&P multiple where they're at today. They sell, a lot of them, around tangible book value, single-digit P/Es, yet, are much better businesses than they have been for the past decade or so--better lending standards, higher capital ratios, more of a competitive advantage from technology. That ratio of bank stocks to electric utilities to pay half as much on a multiple basis for banks as you would for an electric utility I think is an incredible value.
It's not like we think that loan growth is suddenly going to skyrocket to double-digit levels. A bank like Bank of America was just given approval to buy back 11% of their stock over the next year, and they're not digging into capital to do that. That's just the capital that they will be generating over the next year, and that's in addition to a dividend yield of about 3%, which is about all you're getting on electric utilities, anyway.
So, I think the opportunity for a long-term investor to create a portfolio today of dramatically undervalued names and to void some sectors that look pretty fully valued should create an opportunity to meaningfully outperform the rest of the stock market. We don't think the rest of the stock market is overvalued.
Ptak: So, I know one of the dimensions that you explore with your team is the bear case for each one of the names that you're either in or considering. So, since we're talking about financials, it sounds like the market is maybe misperceiving various aspects of the health of the financial-services industry, as well as the specific names that you're in. So, what does that bear case sound like for a name like Citi or BofA? I know there's a number of names that you're in and how have you gotten past that in gaining conviction in those names?
Nygren: I think there are a handful of bear cases that we hear about those companies. One, I think, is a recency bias. People say, "Look what happened to them 10 years ago on the last recession. Maybe it's time for the U.S. economy to go into another recession." Clearly, you didn't want to own banks in the last recession.
If you look back farther than that, banks generally haven't been an underperforming industry in modest recessions. If the recession we had 10 years ago is going to be a typical recession going forward, you're in trouble no matter what sectors you're invested in. We think of that as much more of a once-in-a-generation phenomenon rather than what you should expect in the next recession.
Another argument we hear is interest rates are going to be near zero for a long time. The way most of retail banking works is banks make a spread on your deposits by paying you either zero or at least significantly less than the Treasury bill, but in exchange for that, you get free use of a nice branch banking network. You get free checking accounts.
If rates are going to be zero-ish for the next decade, the banks will just have to change their pricing model. They provide a necessary service, and they'll just have to find a different way to make you pay for it rather than foregone interest income.
Then the last thing we hear is the risk of political overreach, that there is risk that politicians think they can get votes by attacking the banking industry, and they get credit for acting tough if they put regulations on the banks that really restrict what they can do. We hear people say, "This industry is at risk of getting regulated so heavily that they could become like electric utilities." That to us is clearly not a best-case outcome, but if they get priced in the stock market like electric utilities, and that would put them up to nearly twice the current stock prices. So, it's a risk in terms of not getting the optimal outcome, but in terms of the stocks are priced, I don't think it's necessarily a risk to losing capital.
Benz: Let's talk about the global dimension. You comanage Oakmark Global Select. We noted that the allocation to European and U.K. equities has risen as a percentage of the portfolio over time. You're bottom-up, of course, but does that signal that you do think more compelling opportunities are potentially overseas than in the U.S. today?
Nygren: We've got the ability in Global Select to go to maybe 40% in either U.S. or non-U.S. and up to 60% when we think the values are more attractive. If you look at the weightings that we've had, U.S. versus non-U.S., it tends to track as you would expect it would in a value-oriented firm. When the U.S. market has been substantially stronger than the European market, we tend to find more of our U.S. names getting near sell targets, and the names that are on the farm team, if you will, from outside the U.S. look a little more attractive to us than the ones that just missed getting in the portfolio from the United States. I think it's certainly fair to say that David [Herro] thinks at least as strongly of the international opportunities as the domestic team and myself think of the U.S. opportunities today.
Ptak: We're going to shift a bit and talk about circle of competence, so to speak, and learning new tricks in the spirit of continuous learning. I was just curious. A type of forecast you and your team had maybe concluded you're not capable of making just maybe through the years you've learned that it's really hard to pull a certain type of forecast in a certain area of the market or a certain type of company off, and then maybe the inverse of that where you've come to feel more comfortable forecasting certain types of outcomes in the future that perhaps maybe without the advent of technology you wouldn't have been as comfortable making in the past. How has that changed?
Nygren: First, in the area where we've gotten less comfortable because we don't think we've been very good at it, I would say would be in the areas where you think a stock is so cheap that you can tolerate a management team that you'd rather not be invested with. We've learned the lesson too many times about how much damage a management team can do that's not focused on what's best for the shareholders. So, rather than trying to make that a question of what price would we be interested in investing with management teams that are subpar, we've made those more off limits.
The area where we've grown more confident I would say would be in areas that are often called technology, but maybe like Alphabet or Netflix. They’re companies that are using technology in a more traditional industry, where they've developed the scale that you're quite comfortable forecasting out what the business might look like seven years from now.
When I started at Harris in the '80s, we had to consider most of the technology companies off limits because they hadn't developed a scale yet that had created a safety net. There's always the story of two high school kids in a garage potentially disrupting a leader in the computer industry. That's not going to happen today to a Netflix, an Alphabet, a Texas Instruments. Those companies have developed a scale that you don't have to worry about a newcomer completely disrupting them.
Ptak: Where does oil and gas go in your two hard piles, so to speak? I think Concho, I think Diamondback, EOG, Chesapeake, I think those are all holdings, and it's going to turn to a large degree on whether you get that commodity price forecast right. Is it not or are we mistaken on that assumption?
Nygren: Well, I think any commodity company is low on your list of how excited would I be to own this business other than price. One of the other reasons that the oil and gas sector has been difficult is, I think, they have been slow to adopt the move toward managing for the benefit of the shareholders, where you think of other companies that are willing to invest excess cash flow and share repurchase or sell off assets to strategic buyers if they think they get opportune prices for that.
The oil and gas industry has been more oriented to how do we become a bigger company, and because of that, a lot of the names in the space have been names that we've considered off limits. But there's a growing number of managements that are focused today on maximizing long-term per-share value and understand that in a lot of cases that means not drilling with every dollar that they get access to, and at certain price their stock becomes the most attractive investment opportunity. Anadarko Petroleum was a name that we owned in both Oakmark and Oakmark Select that was the best performer in the portfolio last quarter because of the acquisition offer they received from Occidental.
That was one of the few companies that over the past year had been taking excess cash flow and reducing their share base aggressively with it. We think Diamondback, Concho, Apache, EOG, we think all of them will be significantly cash flow positive with oil somewhere around current prices, and that they are oriented now toward thinking of their stock as a hurdle that has to be beaten in order to justify reinvesting in the business rather than investing through the stock market.
So, I think it's a changing industry. Then on the macro picture, nothing has broken the link between global GDP growth and consumption of fossil fuels that demand growth tends to be about half of global GDP growth. If that continues for a few more years, U.S. shale will no longer be the swing producer, which has been one of the problems for the industry over the past few years as when prices go up, U.S. shale produces so much that that alone drives price back down.
We think we will soon be at a point where U.S. shale won't be able to create enough supply to meet global demand, and that creates the potential for a golden age for the shale companies where they can earn significantly above-average ROEs because somebody with even higher cost than they have has to be able to earn an economic return in order to create enough supply to meet global demand.
So, I mean, no doubt about it: Oil has been a frustrating area for us because global growth has been slower than we've anticipated. It seems like each year the world bank starts the year saying, "We think global GDP will be up 4% this year," and somewhere between July and September that number has fallen to 1.5% or so, which more than doubles the length of time it takes to create a shortage again in the energy market.
It doesn't make sense to us that there would be a meeting of supply and demand long term at a price where the oil and gas companies can't earn an adequate return on their investment.
Benz: It's become a convention among fund managers to talk about a certain business being Amazon-proof in one way or another. Can you talk about companies that you own or that you might look at where you think Amazon's threat is maybe overrated and maybe also an example where it's underrated?
Nygren: I think one of the areas where there's concern about what Amazon could do to the industry would be Netflix. Amazon Prime subscribers are basically given a, call it Netflix-light-type product for free, or it's at least included in the $100 or so that they pay each year. We think that Netflix is so far ahead of Amazon in terms of original programming that it's very unlikely that that gap will ever be closed. Also, the number of subscribers that Netflix is high enough, so whatever they spend on original programming on a per-subscriber basis is less than Amazon or any of the other potential video competitors.
I think it makes sense that an Amazon product long term might be like the original Netflix or Blockbuster-type monthly rentals, where you're basically looking at older movies, older TV shows, and that Netflix would be where you would go for the current shows and original programming. So, I would say the threat is overrated there.
We've got a lot of respect for Amazon. I don't know a lot of areas you'd say it's underrated. Maybe banking? That's going to be another example of where the threat is overrated, an area that I think would be very difficult for Amazon to compete and provide a product that is better than what banks are currently offering.
One of the reasons that we don't own bricks-and-mortar retailers is because we think very few of them are Amazon-proof, and the consistent 20% to 25% growth in sales, in retail sales that Amazon has been able to achieve and, frankly, to us looks like they'll be able to continue achieving, makes it very hard to find the price on a bricks-and-mortar retailer that you would say it's finally cheap enough.
Ptak: We're going to talk about pricing power, given that a number of the names that you invest in or endow with various types of competitive advantages that often confers pricing power, but I just wonder your mindset as an investor in the low-inflation environment that we've had for really decades now. Has that made you a bit less insistent that you see that attribute in the firms that you're looking at and actually putting capital into, whereas maybe previously in decades prior you would be much more insistent on it out of fear of inflation and wanted to make sure that that pricing power was intact?
Nygren: Yeah. When you think what creates pricing power for a company, it's usually that that company offers something that its competitors aren't offering, and because of that, the consumers won't back away if the costs go up and those are passed through to them.
I think in our portfolio, Netflix would be one of the examples of strongest pricing power, where you see surveys of consumers that have Netflix along with several of the other monthly services, be it HBO or Spotify or SiriusXM, and they'll rank Netflix as the most important to them, even though it's the cheapest one today. That's an example where we think the company is investing through lower price in customer acquisitions, and it hurts their current earnings, but we think it's the right move for long-term value.
Most of our companies, we're not looking for significant price increases in the environment we're in today to justify the growth rates that we have. Our focus is more on the organic growth opportunities they have, what type of free cash flow they'll generate, how that might be deployed in a way to enhance per-share growth beyond what the company is growing.
Benz: When you think about the financial crisis and managing your portfolios during that time, in hindsight, what would you say was the biggest risk-management lesson that you learned and that you in turn incorporated into your process?
Nygren: I think before the financial crisis, we weren't doing as good a job reflecting financial risk in our banks and other financial companies as we were our industrial companies. We'd always done a good job with the industrials of thinking about the degree of undervaluation based on the entire enterprise value rather than on just the equity piece. So, we would take the equity market cap, plus the debt of the company, divide that by what we thought the entire business would be worth.
So, effectively, you can say, "How far off could I be on my guess of the business value before the stock price would have to fall?" As opposed to the way a lot of people do it is to say, "If I'm exactly right on my estimate, how much would the stock go up?" And that can lead you to companies that are more heavily levered.
I think a decade ago, we weren't doing as good a job reflecting how much capital a bank had, and differentiating enough to make sure we were avoiding companies that had excess debt unless they were so cheap that despite the debt that they were really more attractive.
I think when you look back at the financial crisis, it's interesting to me that the lessons some investors have taken away are so different than the lessons we think we learned, where you see some people say, "If I hadn't owned banks during the crisis, my numbers would have been so much better. How are you supposed to know what's inside a bank, so much of what they do in securitizing? It's just unclear what's really on their balance sheet. I just can't ever own them again."
We look at it, like I said, at a more nuanced view about not having reflected risk appropriately relative risk of one bank to another. I think if you look back at the financial crisis and said, "Banks, in general, have an asset side of their balance sheet that's primarily debt against real estate." What do you think would happen to banks if real estate prices fell by 20% or 30%? I think anybody who looked at that would have said, "You don't want to own banks in that environment."
I think one of the things that sometimes difficult in this business, even with the benefit of hindsight, is learning the right mistakes. You own stocks during a bear market and think the right lesson is I shouldn't own stocks. Maybe the right lesson is you should have been more patient, you should have been more diversified. You shouldn't have paid up as much on peak earnings. But even in hindsight sometimes, it's not obvious what the right lessons would have been.
Ptak: If we're to try to unpack your financials stake, and I don't think it's the most you've ever owned in financials when we go and we aggregate it up, but I think it's a 30-ish percent weight in some of the portfolios. They are different types of firms. I think you have diversified financial-services firms. You have the card firms. You have, I think, global custodians, brokerages and Schwab, right? There probably is an element of common factor risk. We've alluded to some of those elements previously. So, as a portfolio manager and a risk manager, how do get comfortable with sizing your exposure to a sector like that? Let's put aside the experiences that we might have had with that sector through the financial crisis. Just as a general matter, how do you get comfortable that you're not too big?
Nygren: Well, first off, when you look at a 30%-ish number, it's probably about right for both Oakmark and Oakmark Select. It's not a monolithic 30%. There are definitely companies that behave similarly to each other: Bank of America, Citi, Wells. Probably pretty close to a 1 correlation if one of them is up one day, the others are up. You look at an AIG, a very different business than a levered lender. State Street Bank and Bank of New York that we also own, much more of the fee-stream-type business than a net-interest-margin-like business, and then even within the banks. We have companies like Ally and Capital One that their deposit side, the liability side of their balance sheet, is much more Internet-like banking, where instead of giving you this big branch office structure to use, the company has passed through that interest rate. So, you can make a deposit at Capital One or at Ally and earn close to a Treasury bill rate of return.
Those stocks aren't going to be as exposed to a potential 50-basis-point decrease in interest rates as a Bank of America or a Citi will. So, even though 30% falls under the broad category of financials, they're all enough different from each other that I don't think there's a risk that if a bad event happened somewhere inside the financial-services sector that we could risk losing 30% of our portfolio.
Benz: Thinking in terms of the whole portfolio, when you think about managing the funds when they're in flow mode, where they're getting strong inflows of new dollars versus outflows, which they've been in for the past few years. Does that affect your approach to portfolio management at all in terms of even though you know you have a liquid large-cap portfolio? Are you doing anything different to adjust for meeting outflows? Should they maybe even hasten from where they've been recently?
Nygren: I don't think it really changes things in the portfolio. First off, I think anybody who's running an open end mutual fund that has daily liquidity has to keep some cash in reserves because tomorrow morning, there could be a big outflow that I have no way of anticipating today. So, we've typically held about 5% of the portfolio in cash both to handle unanticipated redemptions, but also to have an ability to be opportunistic and take advantage of forced selling.
So, whether we're in an inflow mode or an outflow mode, that chance of outflows is always there, so we're always keeping cash somewhere around 5%. We also are always trying to use either inflows or outflows to improve the portfolio at the margin. So, when you've got inflows, which is always a more fun environment, it's like, "I can come to work today and put capital to work in the names I think are most attractive in the portfolio."
The reverse is really the same thing, except it's a little harder psychologically. You're selling companies that you think are still undervalued, but they're not as undervalued as the rest of the portfolio. So, other than potentially messing with the manager's psyche, I don't think there's that much difference between being in a slow inflow or a slow outflow mode. I think either inflows or outflows can become problematic if they become very large relative to the size of the portfolio, and with Oakmark having been around now for, are we going on close to 30 years, I think the investors who are long-term thinkers have found us and because of that, we haven't faced the extreme inflows or outflows that some funds have had due to performance-chasing or running away from bad performance.
Benz: You mentioned the psychic dimension of this, of running a portfolio if it's an outflow mode. How do you manage that for yourself, as well as for the team contributing to the fund, to keeping everybody's spirits up, keeping them engaged with the job?
Nygren: I think one of the roles of someone who's been around as long as I have in this business is to share the stories that we've been through before, and to talk to the younger analysts about what it was like in the Internet bubble, when we were underperforming by a lot, when we had very large outflows, when some of our competitors were abandoning their discipline because they felt for business reasons they didn't have a choice. And the tremendous reward that followed when our stocks performed really well as the Internet bubble burst. Or back in 2008 when the world was worrying about would the economy every recover, and we had had a difficult 2007. We did not see the housing crisis coming and lost a lot of money, a lot of it in financial-services companies or in other ways, home-related companies.
As other people were trying to get rid of financial exposure or industrial exposure, cyclical exposure in their portfolios, we took the point of view of saying, "As a long-term value investor, we know the economy is going to get better. We don't know if it's going to start next quarter or even next year, but in a five- to seven-year time frame, the economy is, no doubt, going to be stronger." We just wanted to make sure we're investing in companies that had the ability to weather the downturn no matter how long that lasted.
Then in '08, '09, 2010, we saw tremendous returns for our funds because we hadn't abandoned the discipline. So, an analyst who has joined us less than a decade ago hasn't seen that yet. We need to share the stories with them of what the rewards are for sticking with your approach.
For me, one of my outlets is in shareholder communication, whether it's what I'm writing or an interview like this, to remind people the benefits of long-term investing. A quarter ago, after we had such a difficult fourth quarter, two quarters ago now, where there just seemed to be a disconnect between what stocks we're doing and what businesses we're doing. Our companies are basically reporting results in line with what we expected, but the market was way down. Our stocks were down more.
I wrote a quarterly report about what tremendous returns there have been for investors who are willing to take a 25-year time horizon, not about Oakmark, but about just staying in equities at a time when maybe you're having trouble sleeping at night because if you extrapolate that fourth quarter for too many more quarters, it's going to start to be a real significant problem.
You want to remind people that the worst 25-year period in the past 100 years was a 4-times return on their capital. Typically, a 25-year investor gets 12 times return or more. So, to me, being able to share that message with our younger analysts, with our shareholders and potential shareholders helps me keep it together when stocks are behaving differently than we anticipate they would.
Ptak: You used the word discipline before, and so discipline and prudence are some of the key things that you're assessing when it comes to capital allocation at the firms that you're looking to invest with or you put capital with. So, I was curious how that process differs between a firm that has maybe more distant or aspirational goals or perhaps has a certain optionality to the business I think of Alphabet with Waymo, right?
So, that could be a phenomenon in some years, and then there'll be cash flows associated with that, and then there are certain capital-allocation decisions that Alphabet management is going to have to make in a situation like that. First, as a more traditional maybe asset-heavy business that has more predictable cash flows, revenues, earnings, and how you would think about capital allocation, the prudence of it in that situation. Do you find that it differs markedly and you have different expectations for those management teams?
Nygren: I think one of the biggest differences you get between a value investor like Oakmark or growth investors is how far out you feel like you can look into the future before your crystal ball gets so cloudy that you can't see anything. One of the reasons we've picked a five- to seven-year investment time horizon is we think there are just too many examples where when you start forecasting longer than that, you get in trouble.
Twenty years ago, people would have said newspapers were one of the safest industries that existed, and it's because they were willing to forecast out over a very long-term time frame based on history without thinking about disruption risk. So, when we try to guess at what something like Waymo might be worth, we're not comfortable with some of the models we've seen Wall Street analysts use. They're more growth-oriented than we are, that might say, "We're in 2019 right now. By 2049, this is what we think could happen." You discount that back 30 years, and you get hundreds and hundreds of billions of dollars of value for Waymo.
We're more comfortable saying, "The way the industry is rank ordered today by people who try to estimate the technology that Waymo has or Cruise or any of the other autonomous players that Waymo always wins those competitions, and we've got market-based metrics to say what people are willing to pay for Cruise today. Whatever those numbers are, we think Waymo should be more than that, but we aren't willing to justify a purchase of Alphabet today based on a huge success for Waymo out decades from now. So, I think one of the reasons share repurchase is such an appealing use of capital to us is it's easier to see the immediate benefit.
One of my favorite corporate CEOs, John Malone from the old Tele-Communications Inc. now Liberty Media like Charter or all the other companies he's involved with, said that one of the problems in corporate America is management was all focused on trying to grow value by growing the numerator, and they forget that value growth can come just as easily from shrinking the denominator. A lot of times, I would say almost all the time, shrinking the denominator is more predictable.
You make an estimate of what the business is worth today, and if you go from 100 shares down to 90, you got an 11% increase in the per-share value. So, I think, obviously, a dividend is the easiest type of capital allocation to value. Share repurchase would be close. Debt repayment is easy to value. I think sometimes in asset-heavy businesses, investors take too much comfort in how easy it is to guess if a 30-year steel mill is going to have a good return on it or not. It may look good on a one- or two-year time frame, but trying to guess what that's going to be like 30 years in the future may not be nearly as good as what gap accounting makes it look like today.
Benz: Well, Bill, I'm afraid we're out of time. We have reams of questions still, but we'll have to leave it there. Thank you so much. You've been more than generous with your time today.
Nygren: Again, thanks so much for having me. This was fun.
Benz: Thanks for being here.
Ptak: Thank you. Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
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Ptak: And at Syouth1, which is, S-Y-O-U-T-H and the number 1.
Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.