Profit Guru Bill Nygren

Profit Guru

calm and collected

The current market turmoil has thrown up a lot of interesting opportunities, says Bill Nygren of Oakmark Select Fund Mohammed Ekramul Haque & N Mahalakshmi

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he only investors who belong in the stock market bank’s operations crumbled and it had to file for bankare investors who can take a long-term time horiruptcy. Nygren openly admits he made a mistake with zon,” declares Bill Nygren, fund manager of the Wamu. “Selling was the right decision, but by the time we Oakmark Fund and the Oakmark Select Fund. sold, the damage had been done,” he wrote in his latest There’s no time like the present to drive home the truth of fund note to investors. Ironically Wamu’s retail banking that statement. Even as short-sighted investors stampede assets were sold to JP Morgan (another Nygren holdfor the exits amid a growing global financial crisis, value ing) before it went belly up. In an interview with Outlook investors like Nygren, 50, are gearing up to do what they Profit, Nygren explains what went wrong with Wamu, his do best – buy into fundamentally sound, long-term busioverall investment strategy and his take on the US econonesses at relatively cheap prices. my and stock markets. Nygren’s first brush with the world of investment took place at Northwestern Mutual Life, which he joined as an What is your prediction for the US stock markets ? analyst in 1981. Two years later, he moved to investment I think it’s very hard to predict what is going to happen firm Harris Associates. Today, Nygren is director at the in the short run; the longer you stretch your horizon, the firm, and his career graph depicts a steady climb. It was easier it becomes to forecast. If you think about a fiveafter being named director of research in 1990 that Nygren year time frame, it’s safe to assume that P/E ratios go pushed his firm to create a fund that would manage assets back to normal and it’s pretty easy to assume that the in a much more concentrated fashion than those handled economy will go back in five years to something resemby other money managers. That idea came to fruition in bling normal growth rates. In 2009, it is easy to assume 1996 when the Oakmark Select Fund was created. that corporate earnings will be down a little bit and mayInterestingly, Nygren never promised extraordinary be even that investors will award an above-average mulgains from his unique style of investment: instead, he told tiple to earnings, but I have a very hard time making that his bosses that over the next five years, they could probprediction. ably hope to see one exceptionally good year, one year that Thinking five years ahead, I think corporate earnings would ‘hopefully, not be horrible’, and three will be higher, P/E multiples for the S&P years of mediocre returns. Happily for ev500 will be higher and that will create very eryone involved, the fund experienced five good returns from the US stock markets. This is an exceptionally good years: since inception, it These returns will offer a very substantial attractive has handed in a 29 per cent return (annupremium relative to fixed-income markets, opportunity to alised) compared with the S&P 500’s 11.5 especially treasuries. So we think this a per cent and 16.8 per cent a year return for very attractive opportunity for investors to commit new the S&P MidCap 400. In fact, so impressive commit new capital, with the caveat that incapital, with was the fund’s performance that it ranked vestors who worry about day-to-day price the caveat that among the top 1 per cent of all funds tracked fluctuations should stay away. Regardless of investors who by Morningstar, a fund tracker, during the opportunity, the only investors who bethe period. long in the stock market are investors who worry about To date however, the fund’s performance can take a long-term time horizon. daily price is more modest, but still creditable with an fluctuations 11.9 per cent return (annualised). As of toWhere do you see value emerging in the US day, Bill manages $3.6 billion worth of assets equities now? should stay under the Oakmark Fund and $2.5 billion in First, I’d like to say that I find the S&P 500 away the Oakmark Select Fund. attractive across the board. To me, this is Nygren’s investment style is simple: he not a time when only one or two sectors are buys stocks when they fall to or below 60 cheap and the rest of the markets are fairper cent of the estimated business value and sells them ly valued. This is a time when most large-cap US stocks when they hit 90 per cent. To calculate business value, he appear to be selling well below business value. uses the discounted cash flow (DCF) method, eschewed by In concept, I would say the characteristic that is most other value investors. He says, he understands the probovervalued in today’s market is safety: look at treasury lems in depending solely on DCF to estimate business bills that yield almost nothing and how large the premivalue, but points out that his rule about buying only when um is for holding long-term corporate bonds instead of stocks fall to 60 per cent of business value itself offers a long-term treasury bonds. Within equity markets, compacushion against making grave mistakes in calculating nies that have performed the best have been those that business value. have seen the least volatility in their business models. I Nevertheless, this astute investor has made his share believe it is becoming increasingly difficult to justify ownof mistakes. After the tech bubble (which Nygren ing those stocks versus the rest of the market where pricdid not participate in) burst, value investors found a es have come down sharply. happy hunting ground in financial stocks. Many of them believed that these stocks were intrinsically Could you elaborate on your investing strategy? higher than the prices they were trading at. Nygren was There are three things that we look for when considering one of them. But that was a bet time proved wrong, as the investing in any company. First, the stock price should be risks attached to these stocks were found to be greatly at a significant discount to the intrinsic business value. under-estimated. To us, the intrinsic value would be the highest price an Nygren had bought into regional bank Washington Muall-cash buyer would pay for the entire business and still tual (WaMu) enthusiastically (at one point, the stock acmake a reasonable return on investment. For most largecounted for 15 per cent of Oakmark’s portfolio), prompted cap companies that we invest in, it’s not very different by bullishness on the institution’s retail asset base which from estimating the discounted cash flow (DCF) to estihe thought was not fully valued by the markets. When mate the intrinsic value of the stock. For smaller comthe credit crisis ripped through the financial sector, the panies, it could end up being different as we explicitly 12 December 2008 Outlook Profit

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Profit Guru

Nygren Says 8 On BARACK OBAMA

Looking at Obama’s advisors, I think, they will ensure whatever policies come out of the Obama administra tion do not have unintended negative consequences on the markets

8 On MARKETS FIVE YEARS FROM NOW

Corporate earnings will be higher, P/E multiples for the S&P 500 will be higher and that will create very good returns and offer a very substantial premium relative to fixed-income markets

8 On HIS INVESTING STRATEGY

Basic strategy is to buy a company only when it is trading at 60 per cent of its value and to sell when they achieve 90 per cent

8 On VALUE INVESTORS

“Value investors usually have suspicions about the ability of companies to perform dramatically better than their competitors. They don’t like to project s pernormal growth for very long and that makes it much harder to justify paying above-average multiples

consider the synergies a buyer of the entire business could achieve. For large-cap companies, we basically look at a price that is at a significant discount to the DCF valuation. Our basic strategy is to buy a company only when it is trading at 60 per cent of its value and to sell them when they achieve 90 per cent. The second criterion is that a company’s growth plus dividend should at least match the figure for the market. We don’t care in what form our returns come, via growth or capital gains, but we want the combination between dividend yield and expected growth in business value to at least match what we receive in the S&P 500. The third thing that we look for is companies that view their shareholders as partners. We like them to think as owners and not professional managers and that especially comes into play when they consider business opportunities. Whether it’s about selling business units or perhaps even the entire company or re-purchase shares versus making acquisitions to grow the business, we want management to take the course of action that maximises per share business value. We also want them to feel the responsibility of communicating to us, the owners, as candidly as possible and offer timely explanations of results without hurting their competitive positions. It’s only when we have all these things – a discounted value, a value that is growing over time and a shareholder-oriented management – that we can take a long-term time horizon that gives value investors a significant advantage, because the longer it takes for the stock price to catch up with the business value, the higher the business value will be.

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You have said that you look for businesses that have achieved large increases in value and whose stocks have under-reacted. How do you identify and measure Outlook PrOfit

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this increase in value? Generally, this would be either a corporate event (such as a division sale), improved earnings or improved balance sheet. Value change resulting from transactions is a good hunting ground because changes in value can be large – and can happen quickly. Measuring how value changes from balance sheet improvement that occurs over time requires simply looking at the change in net debt per share. An improvement in earnings per share is equally easy to measure, but then some judgment needs to be applied to determine whether or not the improvement is sustainable. Corporate transactions involve comparing proceeds from a division to its estimated value while acquisitions require examining both the acquired properties and the consideration given in return (for example if stock is issued, one has to consider whether it was issued at a premium or discount to the intrinsic value). In the end, value estimation has to be an ongoing process, and always requires estimating the value of each asset a company owns, subtracting claims that are senior to equity against those assets, and dividing what remains by the share base. A lot of value investors believe the discounted cash flow (DCF) method is not a good way to calculate growth rates for the near and long term. What do you think and how do you calculate value? I think the most important thing is to use multiple methods of valuation and make sure they converge to the same business value. DCF is definitely not an exercise in precision, that’s why we demand such a high gap versus our business value estimates. We approach it by looking at comparisons of similar businesses that have been acquired, the price-to-sales ratio it was sold at, the price-tocash flow, P/E, P/B etc. We try to find the metric buyers in that industry would typically use to identify business value. We look at where comparable companies are trading in the markets and we look at a dividend discount valuation. If you see radically different figures of business value with different methods, that’s a good indicator that some of your assumptions are inconsistent between models. In fact, by looking at multiple models and forcing them to come to similar conclusions, I think we probably decrease the probability of having one minor error influencing our business value estimates too strongly. How much weight do you give to past financials and track records? Every time we look at a business, we try to ascertain how sustainable their results are: a company that has a good track record earns a substantial premium to its cost of capital. Before we forecast that to continue, we have to be assured that there is a sustainable competitive advantage. The easiest example of that would be branded consumer products. A brand is a very valuable asset, but is usually not on the balance sheet. We do study historical track records, and I would say that it is a very good way of judging the management team. We look for companies that try to maximise business value for shareholders. We also look at not just the records the managers have in their current jobs but also in their previous ones. When the CEO brings in a new CFO, we look at how capital was allocated at the firm where the CFO came from. If the management team has been working at the same company for a long time, then we would give more weight to the long term-track record of the company.

What competitive advantage should a company possess? Which ones are the most sustainable? Competitive advantages can arise in many different areas. The most frequent kind is a proprietary product, which is demonstrated by patent protection. A strong brand name is another obvious advantage. Less obvious, and harder to maintain, are corporate cultures or low-cost production. None of these appear as assets on the balance sheet, so they are not reflected in any statistical analysis. Basically, any company that earns an above-average return on assets either has a competitive advantage or is earning above its sustainable rate. It is our job to decide which one it is.

makes it much harder for us to justify paying above-average multiples. Value investors usually have suspicions about the ability of companies to perform dramatically better than their competitors. How do you identify and avoid value traps? To me, a value trap is a stock that looks cheap today, but as time marches on, the value declines and the stock remains at a discount. One way we try to avoid such traps is to pick investments that are expected to grow in value at least as fast as the average stock. Many times, value managers are attracted purely by statistical cheapness (such as low P/E, low price-to-book or low price-to-sales). More often than not, businesses selling at the lowest valuations are structurally disadvantaged, and their best days are behind them (often demonstrated by persistent declines in market share). Such businesses are unlikely to pass our hurdle of achieving at least average expected value growth.

What are your criteria for selling stocks? When the price goes up to 90 per cent, that’s the easy one! Our sell criteria are the opposite of our buy criteria. When the company performs fundamentally as we expected them to, its business value grows as we expected it to, the stock price grows even How do you see the US corfaster and eventually goes porate earnings growing up to 90 per cent of our esin the next five years? timate of business value, If you look over a long term, then we sell it and start over. corporate earnings have The other two criteria come been able to grow several into play more often when percentage points higher we are selling our mistakes, than inflation and if you that is, where after a year or think of inflation at 2-3 per two of owning a stock, we cent, I believe it is reasonare no longer as confident able to expect corporate as we were when we purlong-term earnings at 6 per chased it. cent although who knows It could also be because what is going to happen over the managers are not really the next few months? The behaving like the owners of economy has really slowed the business or because the down but if you think about company is not achieving the next five years, it makes the fundamental results sense to think about what that we had anticipated and is normal growth and sevwe are no longer confident eral points above inflation Any company that earns an above-average that it will achieve aboveis what it has been for S&P return on assets either has a competitive average, long-term growth. earnings growth. advantage or is earning above its sustainable I think it is important for rate. It is our job to decide which one it is investors to have the disciYour reading of financial pline to sell. firms seems to have gone wrong recently. Can you tell us what caused that? Do you average down your purchases (buy again when The biggest thing that we have seen hurt the US is the the price is lower, so the average buying price for the very large decline in US home values. Home values, hisentire lot dips)? torically, in the US, have been viewed as stable and we We don’t have a specific rule on that. If the stock price have never witnessed a period where nationwide prices goes down and our estimate of business value is grow- of average homes declined so significantly. And that has ing, we would generally add to the position but really changed a lot of things. From the peak of the housing mara decision on whether to add to our position or not is ket a year and a half back, home prices have fallen by 15driven by how large the discount is to our estimate of fun- 20 per cent and most analysts are of the view that they are damental value. going to fall further. The whole history of home mortgages is that if you lent 80 per cent or even 90 per cent on the What is the maximum earnings multiple you would be value of the home, your losses would be tiny. willing to pay for a company with promising growth? Even if the borrower was not able to pay, the value of the We don’t really have a maximum multiple. But that doesn’t home was strong enough, so the lender of the loan lost mean we would be okay with paying something like 30 very little money when he/she re-possessed the home. times earnings. We try to come up with multiple models After prices fell by 20 per cent, that changed drastically of business values so we are not strictly driven by P/E ra- and banks focused more on the value of the collateral i.e. tios. To pay a very high P/E ratio, we would have to believe the house rather than the ability of the borrower to pay. that there is something else happening fundamentally to So they witnessed very large losses. Now, across all types the company, so the earnings now is being dramatically of investment portfolios, there has been a re-assessment understated. I think, like most value investors, we don’t of what the appropriate level of mortgage holding should like to project supernormal growth for very long and that be. Because these holdings proved riskier last year than 12 December 2008 Outlook Profit

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the years before, anybody going through that reassessment has decided that they should be holding less mortgages than they now do and I believe that has resulted in a wave of selling in the mortgage market. Some of it was fundamental but a large part of it was forced selling by companies that had lost money on mortgages that were leveraged. And even though they think mortgages are fundamentally inexpensive today, they still have to sell them. Eventually, the supply-demand balance will return to our mortgage market and when that happens, mortgage prices should return to their fundamental values, which is a discounted cash flow value offering an appropriate premium to treasuries. And I believe this will happen relatively soon.

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migration into the US of people who have the means to buy single-family homes. So in the long term, there will be demand for such homes. Eventually, we will work our way through the excess supply we see today. The people who defaulted on their single-family homes still need a place to live – it’s just that they will probably end up renting a house rather than owning one. The market will continue to stabilise and from that level, it will continue to grow. Do you expect them to fall more in the next one year? We have a futures market in the housing sector for people who want to speculate on short-term housing prices and that says prices will continue to fall over the next year. But short-term price speculation is really gambling. When you start making long-term forecasts, that’s when you have the laws of economics working in your favour – supply and demand will return to balance, corporate profits will return to levels that justify capital expenditures on those businesses and stock prices will return to levels where they provide an opportunity return relative to that offered in the bond markets. When we think long term, there is a basis for statements talking about what direction stock prices should go.

What went wrong with the Washington Mutual bet? Washington Mutual was held in all the three funds I comanage. We sold our position during the quarter when it appeared that regulators were increasingly looking at mark-to-market implied losses, which eliminated the chance that Washington Mutual could, over time, earn back its mortgage losses. Selling was the right decision but by the time we sold, the damage had been done. Owning Washington Mutual was a big mistake for which I fully accept Most value investors don’t like the idea In today’s responsibility. of heavy debt and tend to avoid bank economic climate, Though we believed home prices had stocks because the business allows we need to been rising at an unsustainable pace, we for high leverage. Should bank stocks consider a broader took comfort that previous home price should be valued differently? bubbles had corrected with home prices You can look at the book values of bank array of outcomes plateauing for several years rather than stocks, then look at how much their liathan we previously falling sharply. Expecting that to continbilities are overstated because the cost of considered, ue, I took too much comfort in the fact that their deposit base is much lower than the the overwhelming majority of mortgages cost of debt. After that, look at the assets especially for Washington Mutual owned had balances of and see if they are valued on the balance companies that less than 80 per cent of appraised value. Besheet at prices that reflect real economemploy financial lieving that the collateral was so valuable, I ics. Then you must make a reasonable leverage wasn’t as concerned as I should have been estimate of the adjusted economic book with softening underwriting standards. Afvalue that incorporates the value of the ter all, if the borrower defaulted, the house deposits, and the premium or discount could still be sold for more than the mortgage debt. on their investment portfolios. After nationwide prices fell by 20 per cent – and further From that level, it is very hard to justify a significant prein hot markets – the collateral was no longer worth more mium because banking is a very competitive business but than the loan, and serious losses resulted. A mortgage mar- the value of a strong deposit base is a very big positive ket previously viewed as secure became very risky. Sellers for the banking industry. The deposit base is a significant flooded the market, and prices fell sharply. Because of its asset that makes these companies worth more than their leverage, Washington Mutual’s assets, marked-to-market, book values in the long term. And the other point I will were no longer greater than its liabilities. make about financials is that many companies are getting Ironically, the asset we’ve always believed was under into territories that the banks had operated in and they appreciated, its strong retail deposit base, is now owned underestimated the risk levels. by another of our holdings, JP Morgan. Though there are It will be a long time before they return to compete with many lessons to be learned from this error, perhaps the banks, so I think this is the kind of environment where most important is that in today’s economic climate, we strong banks will become stronger and there are a lot of need to consider a broader array of outcomes than we pre- US financial companies that appear to be attractive inviously considered, especially for companies that employ vestments today. financial leverage. As we consider the mistakes we have made recently, as What books are you currently reading? Any well as the rapidly weakening economy, our focus is in- recommendations? creasingly on the strength of the balance sheet. We don’t As a value investor, I’m drawn to anything written by know what the magnitude or duration of this economic Warren Buffett. I find his thinking to be clearer than decline will be. We want to make sure that the increasingly that of almost any other investor. Plus, he’s a very enattractive stocks we purchase have the financial strength tertaining writer. I also suggest books that have sepato make it through to the recovery. rate chapters on many great investors. John Train’s Money Masters is a good example. After reading several When do you think housing prices will stabilise? such books, one can see that numerous approaches can That’s awfully hard to guess over the short term, but over succeed, but one also sees the commonality of intense efthe long term, there continues to be growth in the popula- fort and discipline that is required to become a successful tion segment that owns homes. There is continuous im- investor. p Outlook Profit

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