The Oakmark fund manager on the limits of macro, why financials look cheap, indexing’s pitfalls, and more.
Our guest this week is Bill Nygren. Bill was one of our earliest guests on The Long View, appearing for the first time back in August 2019. Bill is a partner at Harris Associates, which he joined in 1983. There he serves as the firm’s chief investment officer for U.S. Equities and is also the longtime manager of several Oakmark funds, including the Oakmark Fund, the Oakmark Select Fund, as well as the Oakmark Global Select Fund. Bill received his bachelor’s in accounting from the University of Minnesota and his master’s in finance from the University of Wisconsin’s Applied Security Analysis Program. He is also a CFA charterholder.
“Bill Nygren: ‘A Stock That Doesn’t Look Cheap on the Surface Might Be One of the Cheapest,’” The Long View podcast, Morningstar.com, Aug. 7, 2019.
“Oakmark Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“Oakmark Select Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“Oakmark Global Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“Oakmark Global Select Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“Oakmark International Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“Oakmark International Small Cap Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“Oakmark Equity and Income Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“Oakmark Bond Fund: Second Calendar Quarter 2023,” by Bill Nygren, oakmark.com, June 30, 2023.
“5 Value Stocks With Oakmark’s Bill Nygren,” by Tom Lauricella, Morningstar.com, May 31, 2023.
“Why We Still Believe in Concentrated Investing,” by Bill Nygren, oakmark.com, Feb. 8, 2023.
“Differentiated Value Investing,” by Bill Nygren, oakmark.com, Jan. 6, 2022.
“The High Price of Low Volatility | U.S. Equity Market Commentary 2Q23,” by Bill Nygren, oakmark.com, June 30, 2023.
“Bill Nygren on CNBC’s ‘Closing Bell Overtime,’” oakmarkfunds.com, June 27, 2023.
(Please stay tuned for important disclosure information at the conclusion of this episode.)
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is Bill Nygren. Bill was one of our earliest guests on The Long View, appearing for the first time back in August 2019. Bill is a partner at Harris Associates, which he joined in 1983. There he serves as the firm’s chief investment officer for U.S. Equities and is also the longtime manager of several Oakmark funds, including the Oakmark Fund, the Oakmark Select Fund, as well as the Oakmark Global Select Fund. Bill received his bachelor’s in accounting from the University of Minnesota and his master’s in finance from the University of Wisconsin’s Applied Security Analysis Program. He is also a CFA charterholder.
Bill, welcome back to The Long View.
Bill Nygren: Thank you. It’s great to be here.
Ptak: You were interviewed about a year ago and the conversation turned to the economy. And you said, to paraphrase, that by the time you draw a conclusion about whether we’re in recession or seeing a spike in inflation, it’s too late. Can you explain why that is?
Nygren: Well, there are a couple of reasons. One, the market always anticipates. And I think as a rule of thumb, you think of the market looking at least six months ahead. So, just on that basis, you would expect that by the time you’re hearing on the news or reading in the paper that we’re in a recession, we’re in a bear market, inflation has gone crazy, by the time you’re hearing that in the media, it’s generally too late. I do a quarterly commentary piece on our Oakmark.com website. And I wrote about this about a year ago when everybody was panicked that all over the news media was we’d entered a bear market, the S&P was down 20%.
And we actually went back and looked on all three of these measures—bear market, high inflation, and recession—what would actually have happened if you invested in stocks after the market had fallen 20%? What would happen if you invested after two quarters of down GDP? What would happen if you invested after inflation had exceeded, I think, 7% was the number that we used? And on all three of those, the median performance that you would have achieved after the news was known was actually a little bit better than average. And I’m not really trying to argue that it’s statistically significant that it’s better than average, but it certainly wasn’t worse. And especially for individual investors who just hear that drumbeat of we’re in a bear market, you better be careful what you’re investing in, I think it’s really important for them to understand investing just doesn’t work that way. By the time the news is out, it’s too late.
The only time I can remember in my career where that wasn’t the case was the housing collapse in 2008, which was the precursor of the great financial crisis. We had looked at that time period and said the same thing. We’re reading this in the newspaper. Historically, we’d never seen a meaningful decline in residential home prices. It must be too late. And over my 40 years, that was the one time that you actually could have invested pretty well having already read it in the paper. But I guess that’s the exception that proves the rule because most of the time it doesn’t work like that.
Benz: Do you have any insight on why, and not to go too deep in the weeds on 2008, but why that wasn’t perceived better in the popular media about what was actually happening?
Nygren: Well, I think the popular media got it right; it’s the investment community that didn’t. And I think one of the big things we missed was the way the securitization market had multiple copies of each mortgage that was out. So, if you started trying to do an analysis of what percentage of mortgages might go bad and say, you said that number was 5% or 10%, what was being missed was that same mortgage might have been in synthetic pools so that five different investors lost money on that mortgage rather than one. So, the impact of the decline in housing prices was much greater in the investment markets than it was in the actual economy.
Benz: Oakmark Fund’s portfolio appears to be heavier in cyclical names than is normally the case. Some of this is your large stake in financials, but it’s also consumer cyclicals like Magna International. Do these names look as cheap as they have at other times that recession worries have taken hold? Or is it at least partly a function of defensive and tech looking expensive right now?
Nygren: It’s certainly partly the latter. Investors are paying up a lot for perceived high growth in technology and for what I would call safety in the low-volatility, high-dividend yield names. We tend to find those sectors expensive and don’t own much of that. So, it naturally pushes us into these names that do have a little more economic sensitivity, where we believe the market is rewarding you much more than it typically does to accept that risk in your portfolio.
I think there are a couple other things. Some sectors that we’re heavily invested in, such as financials, today, they seem to be part of, for lack of a better word, the risk-on, risk-off movements in the market. We think that’s disconnected from business value. Early in my career, financial stocks were generally not thought of as cyclical, tended to have betas less than 1 and were considered part of the safer section of one’s portfolio. Really, since GFC in 2008-09, the wild swings that we’ve seen in especially bank stocks have elevated the betas and the perceived economic sensitivity of that sector. So, yes, our portfolio has a lot of that risk in it, but we think it’s really more a day-to-day volatility risk than it is that the business models have become so economically sensitive.
And then, the last one I would mention, we’ve got a large position in the real estate company CBRE. Historically, that had been a very cyclical business because most of their revenue depended on transactions. And when real estate transactions cyclically fell, the company’s earnings would go to just about nothing. So, it was a very cyclic stock. Today, the services part of their business, such as janitorial services for tenants in their buildings, those aren’t cyclical really at all, and those are becoming the more dominant part of the business value. So, again, I think that’s the difference between a backward-looking statistical analysis that would suggest unusual economic risk for this business and a forward look based on where they’re actually earning their money today that would say it really isn’t all that cyclical.
And then, before we leave this topic, I think it’s also important to look at what the word recession really means. If you’re under 40 and in the investment business, you’ve seen two declines that were called recessions. Personally, I think first half of last year was a recession, even though it didn’t get called that. But the two that were called recessions were the COVID outbreak and the great financial crisis. And both of those are more, what I would call, generational downturns. Most of the recessions during my business career have been the type, much like the first half of last year, where you’re surprised the first quarter was actually down, then there’s debate of will there be a second quarter that’s down or not? And by the time you know you’re in a recession, we’re already working our way out of it. That type of recession was never as negative, say, for financial services as the past two were. I think also if we are facing a recession soon, it’s pretty unusual to start with an auto sales number that’s maybe 20% below average. Typically, we go into a recession with auto sales above trendline and then sales fall 20%. Auto sales might not even fall in a recession. We’ve never seen that where before the recession, sales are so far below trend.
And then, the last point is, recessions typically hit unskilled labor harder than they hit any other sector of the economy. And that’s where there’s been such a shortage lately. You still can’t drive down any rural road in a community that’s got lots of machine shops without seeing signs for unskilled labor wanted $20 an hour, plus health benefits, plus vacation. The bottom quartile has seen real wage increases. There’s very strong demand for labor. And that, too, just is very unusual for a prerecession environment. And I think that might be a real surprise that if we do go into a recession, that the marginal borrower—banks tend to call it nice names like slightly below prime—those borrowers, if they’re employed, they’re going to pay off their car loans and their credit card debt. So, I think if we do go into a recession, we’re unlikely to see the kinds of charge-offs that have typically accompanied recessions for the banking industry.
Ptak: One thing that’s changed since we spoke to you last back in 2019 is interest rates. They’re twice as high as they were then, give or take. It seems like this should benefit the stocks of firms that aren’t expected to derive as much of their value from distant cash flows, yet growth stocks have still bested value stocks with maybe the possible exception of a relatively brief period that’s since passed. Why is that? Why has growth continued to do well versus value?
Nygren: No, you’re absolutely right. The experience we had in 2022, where finally the Russell Value outperformed Russell Growth—I think it was by like 2,200 basis points—we looked at that coming on the tail of a horrible decade for the Russell Value Index and thought maybe things have finally turned. And then, in the first half this year, the Russell Growth has outperformed Value by 2400 basis points. So, it’s already reversed everything that value had gained last year. And that is contrary to what you’d think the duration of equities would suggest. Low P/E stocks, because they’re returning more of their cash flow early on, are the equivalent of short-duration bonds. And the growth stocks that maybe aren’t even making money today but are expected to make a lot of money 20 years from now, those would be the equivalent of very long-duration bonds. And when rates go up, you would expect long-duration bonds to fall the most and growth stocks to fall the most. And clearly, that’s not what’s happened this year. Though, if we look back over the whole 18 months, the two sectors, growth and value, haven’t performed that differently.
We were talking a little bit earlier about some of the sectors that we find attractive, tending to have more economic sensitivity than those sectors that we think are less attractive today. So, the industries like banking, like auto, oil and gas, those sectors, that’s where single digit P/Es are available. They would be the shorter-duration names. But because recession fears have remained so strong, I think that’s what’s held those names back and had them perform beneath the level that you would have expected, given their durations.
Benz: Some have argued that value, as it’s traditionally defined, is as cheap as it’s ever been. Do you agree or do you think that’s maybe too simplistic of a view?
Nygren: Well, I think statistically we can, prove might be too strong a word, but at least show that growth is very highly priced relative to cheap stocks than it has been over the past 30 years. A metric we like to look at is, if you take the S&P 500 and rank order them from highest P/E multiple down to lowest, what’s the 50th rated one, so the bottom of the first decile, and what’s the P/E on the 450th one? So, 50 names are more expensive, 50 names are cheaper. And then, we look at the ratio of those two. Typically, your expensive stocks over the past 30 years have been about 4 times as expensive as the cheap stocks. So, if the 50th cheapest stock had a P/E multiple of, say, 10, and the 50th most expensive had a P/E multiple of 40, you’d say that ratio is 4. Today, that ratio is between 6 and 7. So, the spread between low P/E and high P/E is about 60% bigger than it has been on average over the past 30 years. That’s why we’re excited about the outlook for value, and we think the price-sensitive investor is going to have a much better than normal opportunity ahead of them.
Is it the cheapest it’s ever been? That same metric was a little bit higher after the market sold off, after the COVID pandemic had just started, and it was significantly higher at the end of the internet bubble in 2000, where expensive stocks were 10 times as expensive as the cheap names. The expensive names back then were at about 90 times earnings, and the cheap names at about 9 times. So, yes, it’s a really attractive time to be looking at inexpensive stocks, but I think we’d be pushing it a little bit to say it’s the best ever.
Ptak: I wanted to go back to interest rates, if I could. Before interest rates rose, firms could lever up easily, buy back shares, acquire. Now that it’s not as easy, are you finding it’s exposing management teams who use share repurchases, mergers to paper over other capital allocation mistakes they were making, which perhaps weren’t as conspicuous then?
Nygren: I can see why you’d think that would be likely, but I just don’t think there were many companies that were levering up to repurchase shares. Most of the companies that we invest in— and we love share repurchase as a capital allocation tool—but most of the companies are very strong net-cash generators, and they were buying back a lot of their own stock without increasing the leverage in the company. That’s something we advocate for. We tell any management team that if they don’t have opportunities to pursue organic growth, where they think they’re significantly competitively advantaged, or make acquisitions where they are a uniquely situated buyer that can pay substantially less than the business might be worth to them, that we want them to consider share repurchase as a very viable option for deploying their capital. And actually, we like it when companies set share repurchase as a hurdle that an acquisition would have to exceed, or even an internal reinvestment would have to exceed, before they go forward with that. So, that actually has not been a big problem in the companies that we’re looking at or invested in. They were big share repurchasers before interest rates went up, and they continue to be big share repurchasers.
Benz: Oakmark recently had more than 37% of its net assets in financial-services firms. Financials cover a lot of ground from credit card issuers to private equity firms to traditional banks, each of which you own. So, every stock has its idiosyncrasies, but bigger picture, what has made financials such a target-rich part of the market as you see it?
Nygren: I’m glad you pointed out how diverse the financials section is in the S&P categorization, because sometimes investors see that we have an upper-30s percentage invested in financials, and to them, that means banks. About 40% of our financial investment is in banks. So, that’s only about 15% of our portfolio. It’s not nearly as concentrated as it looks on companies that could have credit problems if we go through a really serious recession.
I think part of what’s made this so target-rich is how deeply scarred investors were from the GFC, especially value investors. Value investors typically own more than their share of businesses that are viewed as not being quite as good as average businesses, and I think that would include most of financial services. Most of these names, if you look over 30 or 50 years, they tend to sell on average at maybe 80%, maybe as much as 90% of the S&P multiple, but rarely do they get above that, with the exception of some of the really high-quality companies that are called financial services today, like MasterCard, Visa, Moody’s.
But value investors especially were the ones who were willing to say, I think a bank’s really cheap at 8 times earnings, and I’d sell it if it got to 12 times earnings. And all of us owned a lot of the banking industry going into the GFC, and it was very costly to us. A lot of our peers concluded that the lesson they learned from the GFC was you shouldn’t ever own banks because you just can’t learn enough about what’s really on their balance sheet. And I think one of the recurring themes throughout my 40-plus-year career has been investors learning the wrong lesson from a negative event. Sometimes the market goes down, and individual investors “learn the lesson” that they shouldn’t own stocks. Well, that’s the wrong lesson. The lesson is either maybe you were too heavily invested in stocks, so you couldn’t take advantage of it, or maybe you weren’t being price-sensitive enough. I think investors who walked away from the banking industry learned the wrong lesson.
The lesson we learned was real estate can go down in value, and if you know real estate is going to go down in value, you don’t want to own a business whose balance sheet is highly levered to loans against real estate. Our losses had nothing to do with us not understanding what was on the balance sheet. It was we had no concept at the time of how far real estate prices could fall. So, I think growth investors rarely own the banking industry. A lot of value investors continue to not own much in this space because of bad memories of 2008. And I think that’s blinded investors to just how good these businesses have become relative to what they were in the early 2000s. The typical bank has almost twice as much capital today relative to the asset base it has. There’s more focus on loan quality. Going into GFC, the focus was almost entirely on collateral, very little focus on the ability of the borrower to repay. Today, it’s much more good old-fashioned banking where you want to lend to people that are likely to repay you, and if that goes wrong, you’ve got collateral as a backup.
I think the competitive advantage of the larger banks today has grown tremendously to what it was 20 years ago, the move toward mobilization, everything you have to spend at a bank to be able to allow customers to do their banking from their mobile phones. If your bank is 10 times as big as another bank, it doesn’t cost you 10 times as much to develop that app. Regulation expenses have grown a lot. And same thing, a big bank is more heavily regulated, but not 10 times as much as a bank that’s a 10th the size. Same thing for fraud risk. You spend more as a big bank, but it’s not proportionate to the asset base. So, I think the big banks have become much stronger, much more competitively advantaged, much lower risk because of higher capital and better lending standards, and there’s just a large part of the investment community that wants nothing to do with them. To us, if you’ve got a management team that’s willing to buy back stock when it’s cheap, that’s a really nice combination.
Ptak: Wanted to ask you about at least one of your holdings within financials, that’s Capital One. It’s a top holding. It’s a bank, and therefore it got clipped when Silicon Valley and Signature failed, but it differs from those other banks in key respects. Can you talk about those differences and how they bolstered your conviction in owning Capital One and how those distinctions came into play when you assess solvency risk of other financials you owned, like Charles Schwab?
Nygren: I think when SVB went down, it clearly surprised the market a lot. It’s not like the stock was trading at a couple of dollars a share. It was still over $100 a share when it became insolvent. And like a lot of the investment community, we were immediately spending time trying to understand just what went wrong at SVB. It was a bank we didn’t know well, we didn’t own it, and we were getting up to speed.
What you quickly saw at SVB was high concentration in its deposit base. And if you think about the banking industry, at its most simple terms, it’s collecting deposits that investors have short-term access to, and then taking those assets and lending them out so the asset side of the balance sheet has longer duration. If you deposit money in my bank and I lend that out as a home loan or an auto loan, and then you come back tomorrow and say, “Wait a minute, I need to take my money out,” I can’t go to the person I lent the money to so they could buy a car and say, “Oh, sorry about that, you’ve got to repay that loan.”
So, banks need to manage that asset-liability mismatch that’s a natural part of the banking industry. And I think if you looked at the deposits at SVB, most of it came from the startup technology community. A lot of it not very financially-savvy depositors, and they tended to look to the same guru—I guess is a reasonable word—for advice on what they should do with that money. And when that startup guru said, “Hey, there’s some problems at SVB, maybe you should move your money somewhere else,” everybody followed pretty much in lockstep, and you had to run on the bank.
When we looked at Capital One—and, of course, we’re immediately trying to compare the deposit franchises of all the banks that we owned to what SVB had. And one of the big differences is at Capital One, almost none of the money is above the deposit limit. Capital One depositors have transactional balances, unlike the SVB depositor who had investment deposits. So, when interest rates were almost nothing, it didn’t matter if you were earning that nothing at a bank or in a Treasury bill or in a money market fund. But when rates started to go up, you could take that money out of the bank and instead of earning zero on it, get 3% or 4% in a Treasury bill. So, there was a large flight of investment deposits from a lot of the banking industry. Cap One basically immune to that. And then, you look at the mark-to-market risk.
One of the reasons that the startup community was told maybe you should pull your money was the duration risk at SVB meant that on a mark-to-market basis, because rates had skyrocketed, there really was no equity left in the business. And if everybody pulled their money out, there wasn’t going to be enough to pay the last people that pulled their money out. Well, unlike the asset side of the balance sheet at SVB, Capital One is mostly credit cards and auto loans. So, you don’t have the long duration of either direct mortgages or mortgage-backed securities. And in fact, what really comforted us about not only Capital One, but Ally that we own, was that if you did a mark-to-market on their balance sheet, like if they went out the next day and securitized everything, they could actually do that at a price that was higher than those assets were on the balance sheet. So, if you’re getting 8% on a car loan and the securitized market is only demanding 6%, then you can securitize that for more than 100 cents on the dollar. The combination of a long-tenured, widely diversified deposit base of transactional deposits got us comfortable that not just Cap One, but everything we were invested in in the banking industry, had a very strong deposit franchise that was not nearly as at risk of deposit flight as the banks that went under.
And then, secondly, when we priced to current interest rates, we made sure we had significant positive equity at all the companies we were invested in. When you look at Charles Schwab, they had invested in moderate-duration securities, so they had a little bit of that asset-liability mismatch. And there is a meaningful hit to their book value if they were forced to sell everything instantly. We think the nature of Schwab’s business, again, largely a widely diversified customer base with transactional deposits at the bank, made it highly, highly unlikely that they’d be forced to sell those longer-dated securities and take a mark-to-market loss. At Schwab, where the profits are really coming more from what I would call the money management side and asset-gathering side than they are from the bank, having some of those longer-duration securities—and I think at Schwab, it caps out at about five years—it just means they’re going to earn not quite as much money for the next couple of years as they would have earned if they’d kept all those dollars short.
So, we think the Schwab franchise is fantastic. It’s significantly lower cost than the other wealth management firms, which is why they continue to see customer growth and growth of the share of the wealth management industry. We think it’s basically a wealth management business with significant competitive advantages that’s married to a bank whose value isn’t nearly as much as the wealth management side of the business. So, to us, Schwab is a great business that maybe will only earn 90% as much as they could have for the next couple of years as those longer-dated securities mature and they get the opportunity to reinvest at current rates.
Benz: If you were to break down Oakmark Fund’s portfolio based on the extent to which your excess return expectations hinge on management taking a certain action, like cutting costs or exiting an area or entering another business versus business as usual, just waiting for sentiment to turn? What would that breakdown look like?
Nygren: That’s a tough one, because even business as usual, often what we think of as usual, is something the market isn’t pricing in yet. And I’ll go back to the banking sector where we think one of the reasons that the banking sector is on much better footing today than it was 15 years ago, is all of the large banks have come to the conclusion that rather than stating goals in terms of revenue growth, where they all used to say they wanted to outgrow their peers on revenue and that created a real problem in a strong economy. As the economy starts to turn over and they’re trying to hit a revenue-growth goal, it meant this downward spiral of credit quality. And today, every large-bank CEO is comfortable measuring growth with a statistic that includes a denominator, so growth in revenue per share or earnings per share. And that means they’re comfortable deploying their excess capital in share repurchases. So, you don’t have this magnification of a natural business cycle that was happening because companies were trying to invest too much at the top.
But the Street today doesn’t believe that. The typical individual investor doesn’t believe it. We look at a company like Cap One that we were talking about earlier, and we think without any growth at all in their revenue, they should be able to grow earnings per share upper single digits just from share repurchase. The stock isn’t priced like that, but what we would call business as usual of them maintaining credit standards, staying in the same lines of business they’re in, using excess capital to pay a dividend and to repurchase shares, it’s business as usual to us, but it’s not business as usual to the average investor.
I think it’s a pretty small percentage of our portfolio where we are expecting management to do something radically different than they’ve done in the recent past. One of the things that separates us from private equity—you’ve probably heard me say, I think, Oakmark’s approach to public equity investing is really much more like private equity, where we think out five to seven years, how will people view this business differently than they do today? That type of approach, the biggest difference between us and private equity firms, the private equity firms want to throw out management and put their own management in place. We want to invest with management that’s already demonstrated they can do what has to be done to have that higher value be achieved five to seven years down the road. So, we don’t want to go into those situations where you either need a new management team or you need existing management to do something that is an unproven skill set for them. We’d rather let somebody else make that their expertise and we’ll invest in the situations where management has already proven that they can do what we think needs to be done to maximize value.
Ptak: First, we’ve got religion, I guess, you would say on cost-cutting amid the slowdown, how do you and your analysts assess whether a management team is cutting fat as opposed to muscle? Maybe I’ll ask that question in the context of Disney’s streaming business. Iger has been slashing costs, but I suppose that courts the risk of potentially putting content-generating assets at risk. So, how do you think about that question in the context of a firm like Disney?
Nygren: I’ll answer first with Disney specifically. When Iger was previously CEO, he had a great reputation for focusing Disney’s spending on potential mega hits, and they were very, very good at that. The management between Iger and Iger coming back, they’d gotten away from that, and it was more a scattershot investment and not the targeting on mega hits. I think what Iger is doing now is getting back to what he did so very successfully in his prior tenure at Disney. Because he is attempting to do something that he’s got such a great track record with, we don’t think that spending is putting the content-generating assets at any level of risk. In fact, we think it’s probably the value-maximizing strategy.
The way you phrased the question, companies that are cutting costs to offset declines they might be seeing in the slowdown, we’ve never liked companies that base their cost-cuts to become efficient on them falling short of near-term financial goals. But I think a lot of companies do that. They face a disappointing year. They see that earnings projections are maybe 5% below what they told the Street they were likely to achieve. All of a sudden, out of the blue, they find an opportunity to achieve major cost-cuts. We think the well-managed companies are constantly trying to run as efficiently as they can. They don’t wait until they’re getting negative results on the basic business to put a cost-cutting effort in place. They do it whether results are good or bad. We think that’s a much better way, much more sustainable way to run a business.
How do you know if they’re cutting too far? We’ll compare a company that’s cutting costs to best practices in the industry. If they’re cutting R&D, are they still spending as much as the average high-quality company in their industry? Same thing for advertising expenses. If they’re cutting regular SG&A costs, how does that compare to SG&A for their peer group? I think an example where we thought companies had gone a little too far was about the time that Buffett and the 3G folks acquired Kraft, it became very popular for packaged goods companies to dramatically slash their advertising expenses and their new product expenses. We looked at that and said, these are really expenditures that benefit over an extended period of time. It’s only because gap accounting has become archaic, and it’s based only on tangible assets. If it’s intangible, you run it through the income statement. We said, if you recast the balance sheet and income statement and said that advertising, R&D, new-product spend, that that was really a longer-term investment, you put it on the balance sheet, you depreciated it over, say, five or seven years, then what would the income statement look like? We concluded that the P/Es it looked like these companies were selling at were substantially below the real economic P/Es. We’ve seen that also in the drug industry when R&D spending has been dramatically cut by a CEO that’s trying to maximize short-term earnings. So, as much as we love companies to get efficient, when it’s really cutting back on longer-termed investments to a level that it looks like they aren’t investing even as much as the peer group is, that’s a red flag to us, and it makes us cautious on investing in a company like that.
Benz: We wanted to ask about KKR, the private equity firm that’s a top holding. You initially bought the stock in late 2020 and you’ve gradually added to your stake, though you did trim the position recently. What was it that convinced you initially that the stock was mispriced? And then, what happened in the time since then to deepen your conviction?
Nygren: Well, first in terms of adding and reducing the positions, unlike some value investors that are very rigid that they’ll only buy at $0.60 on the dollar, they’ll hold the position until it gets to $0.90 on the dollar, and then they automatically sell the whole thing. We try to be more flexible than that. And within that 60 to 90 range, if it gets toward the higher end of that range, we don’t like the market to increase our weighting in the company as it’s getting closer to a price we’d sell it at. So, we trim names that have performed well, and we add to names as they’ve come down. And with a business that’s sensitive to stock market valuations, we felt we had multiple opportunities in the couple of years that we’ve owned KKR to trim and increase our positions as the stock has fluctuated within that 60% to 90% of value range.
Specific to our decision to buy KKR rather than any of the other private equity investment firms that are public, we thought there was a very interesting difference in that KKR was keeping most of their earnings and investing in their own product, so their own leverage-buyout funds or infrastructure funds. They would keep the capital inside KKR, invest in their products. So, when you look at the balance sheet, there’s a very large line called “investments.” Most of the other private equity firms were paying out almost all of their income, so they did not have that big “investments” line.
When you looked at P/Es across the industry, it was a really tight range. They were really close to each other. And we thought that’s interesting because this large asset called investments at KKR wasn’t generating a lot in the way of income. So, effectively, we looked at it as if you had two divisions inside the same company—one was an investment holding company, and we had a pretty good estimate of what those assets were worth because KKR tells us those numbers every quarter. And then the other part of the business that was more pure money management, private equity partnerships, which was more consistent with what the other companies were. And when we added the two pieces together, putting an industry-like multiple on the mature private equity business, adding an asset value for the less-mature real estate and infrastructure funds that they had started that hadn’t ramped up to normal profitability yet, and then an asset value based on the current investment value of those investments in their own products, we got a number that was substantially higher than where KKR was selling in the marketplace. And when we did that same kind of math on the other public P/E firms, they looked about appropriately priced.
So, we thought hidden in plain sight was this incremental value at KKR of the large investment holdings that they have. Their track record has been very good. We think those investments are likely to grow at least as fast as cash investments would grow, hopefully higher. And we thought it better reflected the economics to look at the division separately. And that’s what really highlighted the unusual value at KKR.
Ptak: Since we’re talking private equity, do you feel like you’re getting more fat pitches to swing at, so to speak, with capital being a little tighter and perhaps activity in the private market cooling off, bringing private-market valuation comparables down a bit and with them public company multiples so that you’ve got more cheaper stocks to look at?
Nygren: Maybe there’s a little bit of that, that there’s less P/E competition today. But I think the even larger factor is there’s just less long-term value competition than we’ve ever seen in the market. As a category, active value continues to see outflows both in the mutual fund space and in the institutional space. And there just aren’t as many investors that take the view that Oakmark does that says, let’s try to identify what this business might be worth five to seven years down the road, discount that back to the present. And if we get a large gap between the current stock price and what that present value of a DCF would be, that’s an attractive opportunity. Between the high percentage of the market today that’s either in indexes or in industry-specific ETFs, and those sectors are growing rapidly, there’s just less money that’s chasing the really attractively priced opportunities and then patient capital willing to wait five years or longer for that value to be recognized in the market. Maybe that’s part of the reason that we could see a historically unprecedented decade of growth beating value and this wider spread than we’ve seen—except for a couple of very brief exceptions—this wide spread of P/E multiples that we’re seeing in the market today. That can be frustrating to us on a short-term basis, but I think it is creating an opportunity for smart value stock-pickers to add more value than they have historically.
Benz: You’ve written about how you and your colleagues write postmortems on holdings that lose money. General Electric, which you owned from 2014 until relatively recently, seems like it would make for an interesting case study. What would you and your team have as takeaways from that experience, and what do you make of the stock’s recent resurgence?
Nygren: Instead of a relatively brief postmortem, we unfortunately could write a novel on our mistakes with General Electric. There are a couple really important lessons, one on the quantitative side. What the GE team was doing, especially in the power division, was pulling forward reported earnings as much as they could so that reported earnings were not matching with the cash flow that they were actually generating. I don’t think there was anything illegal or even immoral about the way they were doing it, but the culture was very much one of trying to maximize reported earnings. While we were aware that some of that had gone on in the power division, we didn’t realize how much of it was going on in the other GE divisions as well.
What interested us when we met with GE management was that they were changing how they compensated management from an earnings-based basis to one that was based on cash flow generation. We thought that was going to make a significant change in the way they ran the business, would focus them more on goals that were aligned with outside shareholders. The deeper we dug in the business, the more excited we got because we thought there were two exceptional businesses inside of GE: The engines business and the healthcare business. We thought those two businesses alone were worth more than what we were paying for GE stock.
I think we massively underestimated how long it would take to turn their corporate culture around, even though they were changing the way top management got compensated. Instead of that happening within a year or two, that probably took more like five to 10 years and a couple management changes to get to the level they’re at today.
The other thing we underestimated was how much damage could be done to the balance sheet off of the legacy insurance assets, where we had made what we thought was a reasonable estimate of what those costs could be. As each year went by, changes and increases in the estimates of insurance losses kept reducing our estimate of business value. It was one of those terrible situations, which we pride ourselves on trying to avoid, of where the stock was falling faster than we thought the business value was falling. The curse of value investing is when you start saying the stock is down a lot, but the business value hasn’t fallen as much as the stock has, so it’s actually become even more attractive. So, we talked ourselves into maintaining our GE position. One of the reasons was they changed out management once, and we thought that increased the probability of them being able to surface the business value.
I think recently what has really helped them is the new CEO that came in, prior Danaher CEO, Larry Culp, we thought of him as one of the top CEOs in the industry. Our valuation methodology had us sell GE too early. It got to about the same discount as other companies in our portfolio were at last year. Taxes gave us an incremental reason to sell our GE stock, and we thought we were reinvesting in things that were just as cheap. Some of the things were as cheap as GE. They’ve gone up a lot since we redeployed that capital, and some weren’t. Unfortunately, I think the positives that have come out of both GE Healthcare and GE Aerospace in the past year, year and a half, exceeded even our view of what those businesses might be worth. Our view was viewed as optimistic back just a year ago or 18 months ago. So, we certainly didn’t cover ourselves in glory, either in the way we got in or the way we got out of that one.
Ptak: On a happier note, I did want to ask you about your investment in oil producer EOG Resources, which has been a strong contributor to Oakmark Fund’s performance in recent years. I think it’s more than quintupled from its March 2020 low. Much as you admire the management team, how do you fundamentally justify continuing to own the stock after a run like that?
Nygren: Well, if you remember the environment we were in in March 2020, oil was selling at a negative price for a few days. The world had shut down, so their energy usage had fallen off a cliff, and there was nowhere to store oil that was being produced. Our estimate of business value of EOG was never based on where oil was selling in 2020.
It was based on what price did we think oil would have to sell at to encourage companies to make the investments that are needed to allow supply and demand to match, given that global demand for oil keeps rising as long as global GDP rises. So, we are much less focused on a five-fold increase in the stock price, and I wish we’d been smart enough to wait to buy it until March of 2020. We weren’t. So, we were never looking at a 500% gain in our own holdings. But our estimate of value is always forward-looking, not based on where the stock has come from. So, our business value of EOG today would be the same whether the stock had fallen from 500 down to 100 or gone up from 20 up to 100. We think EOG is likely to be able to earn double-digit dollars of EPS in typical environments. We think a typical environment is $70 to $80 a barrel for oil, which is where we’re at today. It’s a management team that has been very focused on being a low-cost producer. We don’t feel like we have to pay up relative to other energy companies for that lower level of volatility that they have in their results, because their cost base is lower. They’ve invested aggressively in long-term inventory, so they don’t have to spend as much to maintain production levels at where they’re at today. Again, an advantage versus other companies that are selling at pretty similar EV to EBITDA multiples as EOG is at today.
And then, lastly, this is a management team that has treated shareholder capital like it’s their own. They’ve run a conservative balance sheet. They’ve been willing to return excess capital to shareholders rather than just chase the next hot area for exploration expenditures. So, we think it checks all the boxes for us. At Oakmark, we say we’re looking for a company that’s selling at less than 60% of what we think it’s worth. EOG easily meets that today. We want a management that will be able to return capital to shareholders and grow the business at a combined rate that’s at least as much as the S&P. We think it checks that box. And we want management that thinks and acts like owners. And we think their history at this company, as well as the way they talk about the future, shows that they are running the business for the long-term benefit of the owners.
Why does a value like EOG even exist today? I think we talked earlier about investors that are worried about cyclical risk. Certainly, the energy industry has some cyclical risk, especially in short-term results. But I think even more important is what I would call a somewhat misguided ESG approach that says they don’t want to own fossil fuels, period. I think the Ukraine war gave us a pretty interesting example of the societal benefit there is to being energy self-sufficient. And we’ve seen some of the ESG investors take on a little more nuanced view of how they treat energy compared with as negative as they were.
And then also, as we’ve seen our own domestic policy discourage production, we’ve seen increasing demand for Venezuelan oil. And Venezuelan oil produces about 50% more carbon per barrel than U.S. producers do. So, if we’re patting ourselves on the back because we reduced U.S. production, I think it’s pretty misguided because if you take a more global view, we’re actually creating more carbon emissions today because the U.S. production has been discouraged. And again, I think ESG investors are starting to understand that they can’t reduce demand for fossil fuels down to zero. This industry is not going to run off in the next five to seven years, which means it is worth paying for long-term inventory and a long-term multiple on earnings. You still haven’t seen many ESG investors boost their stakes in oil companies. But I think that investor group is likely to come back to this industry, again, in a more thoughtful approach than the original “energy is bad” approach that they had.
Benz: For our last question, Bill, we wanted to ask you about indexing. There seems to be an overall trend toward investors gravitating to the broad market index fund as the safe choice. It seems like in institutional settings, especially investors seem to consider anything else too risky and hard to defend. So, what’s the case for a truly active approach like the one that you use at your funds?
Nygren: Well, first off, I would say if you think indexing is the safest way to invest your money, then I think we have a different view of risk at Oakmark than that index-fund investor does who thinks they’re avoiding risk. Some people measure risk as deviation from the S&P 500. If that’s the risk you’re trying to eliminate, certainly an S&P 500 index fund accomplishes that. If you are an investment manager and you index or closet index to the S&P 500, you’re probably minimizing your chance of underperforming by enough to get fired, which is a very real risk if you’re in this business. But investors, I think, have become blind to how concentrated indexes have become. If you’re investing in a Russell Growth Index or a Nasdaq-100 Index, under SEC rules, you can’t even call that a diversified fund anymore. They have maybe half their portfolio in the 10 largest positions and over 25% in positions that are each over 5%. So, they have to actually file as nondiversified funds, alerting investors to the excess risk level.
Even the S&P 500 relative to Oakmark Fund, our largest position happens to be Alphabet in Oakmark Fund, but it’s half the weighting at like 3.5% of our portfolio of what the largest names are in the S&P 500. Both Apple and Microsoft are roughly twice the level of investment that we have in Alphabet. And ironically, we have to put disclaimers on any of the material we publish that basically say, because we’re so concentrated, the investor needs to realize they’re potentially taking on excess risk. The indexes are more concentrated than we are now, and they don’t have to make that same disclaimer.
I think the case for long-term value investing is if you really view your risk not as deviating from an index, but as losing your capital, buying at a discount to value reduces your risk. Insisting that your companies grow per-share value over time reduces your risk. Having a management team that’s open to transactions that increase per-share value instead of maybe just increasing company size, that lowers your risk. And long-term value investing allows you to accomplish what the academic community says doesn’t exist. The academic community says the only way you can increase your return is by taking on a higher risk of losing capital. We believe by buying cheap businesses that are growing, that are well-managed, we can simultaneously reduce risk and increase return. And the number of investors that have left this space of trying to buy cheap and sell when things become more fully valued just makes it an even greater opportunity for us today.
So, I think that’s the case. I’ll sum up by using one of my favorite Warren Buffett quotes, where he says that he and Charlie would much rather earn a lumpy 15% than a stable 12%. We at Oakmark completely echo that philosophy. And we would tell investors that we believe being willing to accept a greater day-to-day volatility, being willing to accept big deviations from S&P returns, both when the S&P is good and when it’s bad. If you can handle that level of risk, the likely return, we believe, is that lumpy 15%. So, I think it’s a great time to be a value investor today.
Ptak: Well, Bill, we’ve really enjoyed chatting with you again. Thanks so much for sharing your insights with us. It’s been a treat.
Nygren: Thanks for having me. I love the line of questioning. I think you’re leading questions into what will really help investors become successful long term.
Benz: Thanks so much, Bill.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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.
(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)