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Bill Nygren has been a manager of the Oakmark Select Fund (OAKLX) since 1996, Oakmark Fund (OAKMX) since 2000 and the Oakmark Global Select Fund (OAKWX) since 2006. He joined Harris Associates in 1983 and served as the firm’s Director of Research from 1990 to 1998.
Harris Associates L.P. has been adviser to The Oakmark Funds since their inception. According to oakmark.com, The Oakmark Funds have approximately $66 billion in Assets Under Management (as of 06/30/2016).
Nygren has received many accolades during his investment career, including being named Morningstar’s Domestic Stock Manager of the Year for 2001.
He holds an M.S. in Finance from the University of Wisconsin’s Applied Security Analysis Program (1981) and a B.S. in Accounting from the University of Minnesota (1980).
Nygren is one of the best investing minds on the planet.
Back in 2005, Nygren delivered a speech at the Thirteenth Annual Louis Rukeyser Investment Conference.
The speech was titled, The Hunt for Intrinsic Value, where he discussed his 80/20 investing strategy, and its a must read for all investors.
Let’s take a look at what he said…
This is an excerpt for the speech given by Bill Nygren titled, The Hunt for Intrinsic Value, which he delivered at the Thirteenth Annual Louis Rukeyser Investment Conference, March 31, 2005. The total speech was over 5,000 words so I’ve split it into two parts. Pay particular attention to his 80/20 investing strategy.
Here’s what he had to say:
To start preparing for this talk, I reviewed my notes from the past three conferences; each year I’ve been asked to give a speech titled “Searching for Value.” Since I want to keep the material fresh, I was excited to see I had a new topic this year: “The Hunt for Intrinsic Value.”
Okay, so maybe not a new topic!
This might be the only time of year when I wish I was a growth guy. Not much changes year to year for value investors. Our large holdings are the same names I’ve talked about for a few years — Washington Mutual, YUM Brands, H&R Block, First Data, Time Warner — and we still think they all are attractively priced.
But talking about the same stocks every year, there are only so many ways you can say that investors should stay calm, avoid over-reacting to the news, and structure their portfolios to benefit from the return to normal that inevitably, eventually takes place. As I was thinking about what seemed to be an impossible challenge of finding a fresh, entertaining way to again deliver that message for half an hour, it occurred to me that someone had already accomplished that feat — not once a year for four years, but every Friday night for thirty-five years.
Having grown up with Wall Street Week, I owe Lou Rukeyser a debt of gratitude. His consistent message was that investors en-masse cycle through the emotional extremes of fear and greed, and that this creates opportunity for unemotional long-term investors. This message initially gave me the confidence to reject the academic “efficient market” view of investing.
And, taking advantage of the values created by emotional investors is the cornerstone of the Oakmark approach to investing.
I think I enjoy being in Las Vegas casinos as much as anyone does, but it still seems ironic to me to have an investment conference here! All of you are here looking for investment ideas in which the odds are in your favor; yet we are gathered in a city that bombards us with opportunities to risk our money at unfavorable odds. If any of you have heard me speak before, you know that from a young age, I’ve been fascinated with the comparison between gambling and investing.
Both involve risking your capital for an uncertain return. Of course the problem with gambling is that the expected return is never quite as much as the amount of capital at risk. If a game has two outcomes — doubling your money or losing it — the probability of doubling is always a little less than fifty percent. That’s why, given enough time, almost every gambler in a casino ends up losing money. So, if you’re headed to the casino tonight, go for entertainment value because the economic value is negative.
An investor, like a gambler doesn’t know in advance whether a specific investment will make or lose money. But, unlike gambling, investing has expected returns that are positive. Unlike the average gambler, give an average investor enough time, and he or she will usually make a profit.
One of the challenges in investing is to prevent acting emotionally and reducing those expected gains. The legendary value investor, Warren Buffett, wrote about this in Berkshire Hathaway’s recent annual report. Commenting on the past thirty-five years, Warren said:
“American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns. All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.
There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance had been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies.”
“And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”
The Oakmark Approach
At Oakmark, we try to buy from fearful or bored investors and sell to greedy investors who want excitement.
Oakmark is a Chicago-based mutual fund manager. We invest about $30 billion on behalf of our shareholders. We manage seven different funds with varying mixes of bonds, domestic stocks, and international stocks. All six funds utilize a long-term value approach to investing.
We are not economists and, therefore, are not top-down investors. We are not market technicians and, therefore, don’t market time. Instead, we are bottom-up investors that rely heavily on our own proprietary research. Our approach to investing — buying undervalued stocks of growing businesses that are managed to benefit the shareholders — requires patience.
We believe that thinking about an investment timeframe of at least five years creates our biggest competitive advantage. In a world where many base their investment decisions on a steady diet of financial news, the investor who focuses on what a business might be worth five years from now can have a big advantage. It isn’t as entertaining or exciting as day trading, but we suggest getting entertained in a casino, not with an investment portfolio.
So, the question we face is, where are the opportunities today? What are investors bored with or fearful of? To answer that, let’s start with a look backward for perspective.
Five short years ago — which in some ways feels like a lifetime ago — cocktail party discussions were monopolized by talk of stock market riches. The S&P 500 sold at over 1,500, about twenty-six times expected earnings, and the NASDAQ sold at over five thousand and had a nosebleed P/E that was hard to even calculate because so few of its companies actually made any money.
As prices were climbing, each quarter produced a return that would have been fine for a full year, and large cap growth stocks reached unprecedented heights. Many great companies — and not just technology and telecom — achieved prices north of fifty times earnings. Investors worked feverishly to get more of their portfolios exposed to the growth money tree.
Redemptions from value mutual funds, like ours at Oakmark, were enormous, as were the subscriptions to growth funds. As a point of reference, in the two years before I became portfolio manager for The Oakmark Fund — early 1998 to early 2000 — fund assets fell from $10 billion to $2 billion on flat investment performance.
Those redemptions forced us, as well as most value managers, to consistently sell the very stocks that we felt were the markets’ most attractive. Growth managers getting flooded with inflows and value managers suffering from severe redemptions further exaggerated what had already become a two-tiered market. Many good businesses sold at single digit P/Es while many large cap growth companies sold at P/Es closer to one hundred than to single digits.
Almost everyone who was hunting for intrinsic value in 2000 bought average businesses at very large discounts to average P/E ratios.
We all know how this movie ended. The NASDAQ is off about 60% from its high, the S&P is down a little less than half that. But, despite a tough market environment, the boring stocks owned by value managers performed extremely well. Morningstar shows that the average small cap value funds more than doubled in price during the past five years, while the average large cap growth fund lost over a third of its value.
This divergent performance puts us in a very different position today. Small and mid cap stocks no longer sell at lower P/Es than large cap stocks. The large cap growth darlings of 2000 no longer sell at huge P/E premiums to average companies. In 2000, very few stocks sold near the average P/E ratio.
That average was just a number that was midway between two different universes. Today, most stocks sell within a few P/E multiples of the S&P’s seventeen or so times expected earnings. Since 2000, many investors have learned the lesson that a great company can be a lousy investment when the entry price is too high. But as is frequently the case, we think the market has gone overboard and over corrected.
It’s an upside-down world today. Momentum investors have moved from large cap growth to the mundane businesses value managers often own. The industrial stocks, commodity cyclicals, oil companies, and electric utilities have all performed well and have attracted the trend followers. In 2000, shareholders were telling us they were redeeming because they wanted more large-cap growth exposure.
Today, shareholders are redeeming saying that we don’t understand that this cycle is different and that energy stocks will make outstanding long-term investments even from today’s high levels. Though they could end up being right, it feels like, as Yogi Berra says, “it’s deja-vu all over again.”
If value managers limit themselves to buying average businesses at very cheap prices, we believe that today’s market offers very little opportunity. I think that’s why so many of our value peers are increasing their cash positions and saying they will wait for better opportunities. But we think buying above-average businesses at average prices is just as much value investing as is buying average businesses at below-average prices.
These aren’t the companies people expect value managers to own, and when we buy them, some get concerned that we aren’t staying in our style box. They want us constrained to mediocre or structurally disadvantaged companies, selling at very low P/Es.
But we don’t believe it makes any sense to limit our hunt for value to only undesirable businesses. At the right price, any business can be a good value and at the wrong price, a bad value. So, the value hunter has to stay open-minded.
In one of my favorite movies, Old School, when Mitch couldn’t find exactly what he was looking for, his friend Beanie said, “Well, Columbus wasn’t looking for America, my man, but that turned out to be pretty okay for everyone.” It’s not often that the best businesses are also the best values, but when it happens, we want to take advantage of it.
Before I talk about individual stocks, let me caution that even though Oakmark has a good track record, does extensive research, and evaluates our results over very long time periods, we still are wrong on about 40% of our stock selections. I’m going to talk about eight stocks we’ve purchased. If five do better than the market and three do worse, and if the magnitude of our wins is a little bigger than the losses, I’ll be very pleased and will consider this package a success.
Discussion of Oakmark Holdings
With that background, let’s look at some of Oakmark’s new holdings. First, Wal-Mart. This is a business we have admired for a long time. Wal-Mart’s focus on minimizing costs forced most of their mass merchant competitors out of business, and for such a major transformation of an industry, it has happened pretty quickly — occurring over about twenty years.
Despite loving Wal-Mart as a business, we had never liked it as a stock. Looking back five years ago, when Wal-Mart hit its all-time high stock price of over $70 per share, the stock was priced at fifty-five times earnings. At that price, there was no room for error in the forecasts; it needed to have fantastic growth to perform like an average stock.
Since 1999, earnings have grown pretty decently, about doubling, yet the stock has declined to just over $50.
At $50, with Wal-Mart expected to earn about $2.75 per share, the stock trades at eighteen times earnings. The S&P 500 trades at about seventeen times. When Wal-Mart sold at over twice the S&P multiple, 14% annual earnings growth wasn’t enough to prevent the stock from suffering a significant decline.
Now that Wal-Mart is priced like an average company, if the business performs like an average business, it should perform like an average stock. We think there are a number of reasons Wal-Mart is likely to perform better than that.
First, their existing discount stores are still showing decent comparable store sales increases. In fact, Wal-Mart has been so consistently delivering two to four percent same store increases that it is newsworthy when results fall outside that range.
Second, their wholesale club stores, Sam’s, have not yet matched profitability levels of their competitors; we see that as an opportunity.
Third, Wal-Mart is rapidly gaining share in supermarkets. Their advantages in logistics and their non-union labor force make it difficult for traditional grocery stores to compete.
Finally, Wal-Mart has a great opportunity to expand internationally. Wal-Mart has been partnering with established discount stores outside the U.S., supplying them with the Wal-Mart playbook, and helping improve their results. We think these opportunities will combine to produce continued superior growth and, if we’re right, a more sizable P/E premium.
In addition, Wal-Mart has started doing something with their excess cash that is new for them — repurchasing stock! Decent top line growth, margin improvement, fewer shares outstanding, and potential for P/E expansion — it sounds like a value stock to me.
Viacom was also added to our portfolio last year. Oakmark has a long history of investing in media companies, all the way back to the fund’s first days when Liberty Media was our largest holding. We have especially liked cable television names; consumers continue to show a willingness to pay more for increased programming choice.
Cable’s dual revenue stream of subscriber fees plus advertising — combined with share gains from broadcast television — has made this an above-average growth industry. Yet, we believe the market has a hard time valuing these businesses because they don’t fit very well into a P/E model; high debt levels, joint venture ownership structures, and high start-up costs for new ventures render traditional valuation metrics almost meaningless.
When valuing any media company, instead of looking at P/E ratios, we estimate the value of all their significant assets, deduct any claims against those assets, such as debt or preferred stock, and then get a per-share value estimate by dividing by the number of shares outstanding. We used this approach on Viacom just as we did for our other media holdings, which we also like at current prices, such as Time Warner, Liberty Media, and Disney.
We believe Viacom’s most valuable asset, and also most predictable grower, is its cable TV division. MTV, Nickelodeon, and Comedy Central have become extremely strong networks and are demanded by viewers on almost every cable system. We believe Viacom’s cable networks alone are worth close to the price of the stock. In addition, Viacom owns the television and radio assets they acquired from CBS and the Paramount movie studio.
We think investors have so overly zeroed in on the problems in the radio division that they have let the stock fall to a sizeable discount to the non-radio assets.
Two weeks ago (mid-March 2005), Viacom stock rallied on the announcement that they were considering splitting the company into two pieces — a growth company with the cable networks and Paramount, and a cash generating company composed of the broadcast television and radio assets. Even after the stock price increase, we believe Viacom remains undervalued versus other media stocks, and significantly undervalued versus private valuations. We especially like situations like this one where investors are focused on something other than what we think is most important.
[The 80/20 Rule]
As an aside, we used to own stock in a company called ITW — the old Illinois Tool Works — but they did such a great job managing their business that the price got too high for us. Their CEO, Jim Farrell, ran the business using the 80/20 rule to a degree we’ve never seen before.
ITW sharply improved margins of each business they acquired by focusing on improving the parts that accounted for 80% of the profit, rather than wasting time on the other 20%. Jim would tell his managers to spend 80% of their time with the top 20% of their employees, customers, and suppliers, arguing that the return on that time would be much higher than spending it on the bottom 80%.
Well, I have an investment industry application of the 80/20 rule: it is probably worth looking at a stock when 80% of analyst and media commentary is about problems in business units that account for just 20% of the value. Viacom qualifies under this rule due to investor focus on the radio business. We also own quite a few others:
- Washington Mutual — 80% of the news surrounds the mortgage business, ignoring the great retail-banking story.
- Time Warner — 80% of the focus is on AOL instead of their highly valuable cable and entertainment assets.
- Disney — 80% of the attention goes to the personalities of the executives and to whether or not Desperate Housewives can turnaround the ABC network. Very little attention is paid to their Crown Jewel — the ESPN cable networks.
- Limited Brands — a new holding that I’ll talk about shortly, where 80% of the ink is devoted to struggling apparel stores and very little is written about continued success in their specialty retail operations, Victoria’s Secret and Bath & Body Works.
Financial media and brokerage research can easily distract investors by focusing on the flow of daily news. But we believe that the investor hunting for intrinsic value needs to stay focused on the assets that make up the majority of the long-term business value. The investor hunting for intrinsic value can take advantage of the opportunities that are created when others get distracted.
This is Part 1 in the two part series, How to Find Undervalued Stocks Using the 80/20 Rule – Bill Nygren. To continue to Part 2, click here.
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