Oakmark’s Nygren Takes Private Equity Perspective

Most of that pessimism is coming from the energy sector, where analysts are anticipating yet another double digit decline in earnings. A year over year for that space, and it's become a very big drag on the index for the last several consecutive quarters, So not a huge, huge surprise, but nonetheless a continuous drag there. One of the most interesting things that came out of our work is just the divergence between what analysts are saying and what companies are

telling us is likely now. Naturally, we don't get every company in the index giving us guidance on what to expect, but of the companies that have given us guidance, our guidance model implies we could get up to triple the earnings growth rate in the index relative to consensus expectations. One of the segments of the index where analysts do appear to be inordinately pessimistic is actually financials, and our macro model for financials as we could get better earnings

growth on financials than consensus is expecting. Also, I'm particularly keen to discuss this topic with our guest, who does have plenty of financials exposure in his portfolio. So excited to dive right into this coming earning season and more with you today, David, Thank you well.

lot of cherries in the house. But our purchases always changed based on what the best opportunity was to make your dollar go the farthest. So when I started reading investing books when I was in high school, The value approach is what really appealed to me because it's how I was raised as a consumer, and I had decided by the time I was in high school that I wanted to pursue a career in investing, so I got

an accounting degree. I still think it's kind of odd today how many kids you talk to who want to be in finance but don't think it's worth studying accounting. To me, that would be the equivalent of if I said I wanted to spend my career in South America, but not bother learning Spanish. It's the language of investing. I think you need to know it in order to succeed as an investor. I got my business school degree

from the University of Wisconsin. I was part of their Applied Securities Analysis program, and then started working at investment firms. In nineteen eighty three, joined Harris Associates, where forty one years later, I'm still happily employed.

public equity investing. And what I mean by that is we look for companies that we believe other investors will look at very differently five to seven years from now than they view them today, and then we try to align with management teams that we think have the same vision of what the company could ultimately be worth. So it has us looking at companies that are currently out

of favor. Could be because of recent poor earnings performance, could be because there's a bad division inside the company that's losing money that's kind of masking what's going on at the other side of the company. When we make an investment, we're not focused on what next quarter or next year's earnings are going to be. We're looking out to what we think the company is capable of earning in a five to seven year period, and then we want to buy at a large discount to our estimate

of business value. We want that value to grow, and we want managements that think and act like owners.

Is it about a time sort of horizon shrinkage where they're really focused more on short term return prospects and that's led them into grow. So what's your thesis as to why you're one of few now?

also shortens their own investment horizon. Secondly, you're right that there is some performance chasing growth is outperformed value for a little more than a decade now, and I think you see both clients that move more toward growth because they want to be in the area that's been most successful, and then you see managers if their philosophies to what has been working. For example, today, I think there are very few investors who don't look for positive price momentum

in the stocks they consider purchasing. We're one of the few that the cheaper the stock gets, the more attractive it seems to us. And then the last thing, and I think this has been going on for a generation at least, is gap accounting that was kind of the basis for value investing. You know, you just buy stocks that look cheap on price to earnings or price to book value kind of patiently wait for them to move back to regress to the mean, and that's what value

investing was. But gap accounting was really made for an industrial world, and today in tangibles are so much more important. You know, the customer acquisition costs, R and D spending, brand advertising to name just a few. I think there are more companies today where gap accounting just doesn't do

justice to the business value that's being created. So the value investors that were kind of stuck in that world of thirty years ago of just buying the statistically cheat pes and price to books on gap accounting, their performance has not been very good for quite a while, and I think they've just kind of naturally drifted out of the business.

align with bigger businesses. So the first thing we do to narrow down our universe is we only look at big businesses for the Oakmark Fund, and by that we don't mean the two hundred and fifty largest market cap.

We mean the two hundred and fifty largest on fundamental metrics such as sales, earnings and shareholders' equity, because we think it's those fundamentals that bring the lower risk as opposed to a high market valuation bringing that risk, and then when you move to individual stock selection, I think the definition of value is always the present value of the future cash flows out to infinity that a company

would earn. But for shortcuts, we look at pe ratios, price to cash flow ratios, price to book value ratios, really whatever metric we think business buyers in that specific industry would use if they were acquiring an entire company. So you know, for example, in the banking industry, price to book might still be a perfectly good metric, or for consumer durables, price to earnings ratio might still work

pretty well. But if we're in the healthcare space, we're going to look at price to earnings before R and D spending because we want to adjust for those income statement of investments, the gap accounting doesn't give credit to.

third is liquidity. Our fund investors have the option of selling out our funds on any day. Our price quotes are kept up daily, and clearly that doesn't happen with private equity. But I think where the similarities are, and these are important too, is private equity is looking for companies that are selling well under what they think think the business might be worth. And that often means looking division by division at what you think the potential is

for each of those divisions. And in some cases that might mean selling off a division where the company doesn't have critical mass and that division might be worth more to someone else who's already in the industry. It might mean valuing separately two streams of income. You know, an example, one of our large holdings. Alphabet makes a lot of money on search, but they have reported losses for all

of their venture capital investing. Well, clearly you don't want to value all of that at a negative number, which is what would happen if you just slapped a PE multiple on their reported earnings. So we go to the trouble of separating out each of the income streams and trying to figure out what that what that industry would look like at its highest and best use, and what

it could potentially be worth. Will forecast out for seven years present value those numbers, and then we look for opportunities where we can purchase at two thirds or less of that value. That's typically what a private equity firm is doing, because then they'll go into the market and pay a premium to acquire the whole business. So another of the advantages of doing this in the public markets is we don't have to pay that premium, the acquisition premium that the PE firms are paying.

two examples of that. So the transition to less carbon intensive fuels has people worried about what the future of the oil industry will look like, or the transition to evs what the future will look like for the ice auto related businesses. We get comfortable that these companies are generating so much cash in their current form that by the time you get to seven to ten years from now,

you should have already received back your entire investment. So we think the market is overly penalizing these businesses for an uncertain future quite a way quite a ways out. The other thing that I think is pretty typical is depressed current results in one of the business segments. Oftentimes the companies were invested in have a couple of different divisions.

Maybe they fall between the cracks for the industry specific analysts, and one of the divisions might be cyclically out of favor, and the analysts aren't going to the trouble of trying to normalize that division when they compute what they think the appropriate pe multiple for a business like that would be today.

that you're looking at from a sector perspective. How do you begin the process of search?

company reports a disappointing quarter the stock all substantially. The second thing we look for is businesses that will grow or return dividends at least in total, at least what we expect to the market. We're trying to avoid value traps with that criteria, so that could ignite interests in companies that are paying large dividends but aren't growing very

much so are out of favor. And then last, we want to invest side by side with good management teams, not only competent, but managements that understand we own the business and are trying to maximize long term per share value. So it could start with seeing a management team that we're highly impressed with, and then you kind of hope that the stock looks cheap enough. When you start the other direction, you're starting with the stock you know is

cheap enough, and you hope it's well managed. There's no reason the process can't be reversed. And you know, if we see a management team move, maybe their company gets acquired, the former CEO then goes to a new business. You know that that triggers an interest for us, and then UH that that will be the catalyst for us doing more serious research.

for the five years after that. We're also looking at competitors' statements, trying to understand why one company may be performing better than the other, and is one performing so well it can't keep that up long term, or is one underperforming maybe for reasons that can be addressed and that gap can be eliminated. We read Wall Street reports. Our analysts here are all generalists, they know we're looking for cheap, well managed businesses, and they look across different industry sectors.

But we'll go to the Wall Street analysts who have been industry specialists their entire career to learn what we can from them about how an industry has evolved to the state that it's in today, what they know about the different management teams. So we're really trying to put together information that we can find from whatever source is out there.

it can be really important. Coming out of the Great Financial Crisis two thousand and eight, two thousand and nine, the idea that the world would be returned to normal within seven years was a pretty optimistic point of view. In twenty twenty, the idea that travel would return back to normal over the next five to seven years was

a wildly optimistic point of view. So normally the answer is we don't have a macro overlay, but when we do, it's because the idea that normal will be returning is an outlier view.

longer exists. So for us, we'll only buy a stock if we think it's a selling at a large discount to value, if it's growing and returning capital at a combined pace at least as fast as the market, and if it's managed by shareholder friendly management teams. We will sell if any one of those three is no longer true. So obviously our preferred reason to sell is we think a business is worth one hundred. It's selling at sixty and over a couple of years values grown to one

hundred and fifteen, and so is the stock price. We're happy to move on, take profits and reinvest in something that's selling at a large discount. Again, but we'll also sell if we lose confidence in the business being able to grow, because we want it to grow at least as fast as the market. And if we see management activity that we think is inconsistent with maximizing long term

per share value, will also sell. So maybe we've identified this nicely cash generative company that's been returning a lot of capital to shareholders, and suddenly they make a big acquisition, they issue stock to do it, and we think they paid too much for the business and it grew. The size of the business might help management increase their own compensation,

but it decreased per share business value for us. We would say we made a mistake in identifying high quality management, and we would sell I wanted.

hands and have allocated an appropriate percentage to us. Beyond that, the risk management for both Oakmark Fund and Oakmark Select is very similar. We start with an investment approach with the three criteria I've mentioned. Each criteria we believe lowers risk and increases return if you buy at a discount to value, if you're wrong, the stock usually loses less than if you pay a premium to value and you're wrong.

If the business is growing, then as time goes by, you're kind of growing your way out of a risky position. And if management behaves in the shareholder's interest, they're likely to take steps during the time you own the stock that increase value beyond what you were able to model the day you purchased it. So that's all important risk management. I think how we position size is important. We think we could be wrong on any one of our ideas, so in the Oakmark Fund, we don't want to have

more than four percent in any single idea. In the Select Fund, that number is more like a double digit percentage investment that we would typically trim if the stocks grew to the point that they were larger than that. In our portfolio, we position size based on attractiveness of

the idea, not on market cap. So in the Oakmark Fund, where we don't want to have more than four or five percent in one name, there are three names in the S and P five hundred we couldn't even market weight if we like them because they have more than five percent. We don't think that's appropriate for an individual investor, So we position size based on how attractive we think

the risk return profile is. It's kind of funny our two largest holdings and on any given day it can get bounced back and forth between them at about three percent of the Portfoliolio alphabet and five Serve alphabet is it between eighty and ninety percent of the SMP waiting five Serve is at fifteen times the SMP weighting. It's because we think about risk is losing money, not tracking error, not standard deviation. But if we're wrong, how much money

could we lose? And based on how attractive we think those two stocks are, we think they merit three percent each in the portfolio. It's just a very different way of thinking about risk than most investors approach that topic today.

do have banks, and we like them a lot. But we also have insurance companies, we have some of the credit card processing companies, asset management businesses, exchanges data, financial data companies. So across that forty percent, it's pretty widespread. But I'll start with banks. Most of them are selling at small premiums to book value, summer significant discounts, single

digit PE multiples. We think much better managed than they were when we went into the GFC fifteen years ago, and importantly, much more capital to support the assets that they have on their balance sheet. That serves to significantly lower the risk. We don't think other investors have lowered their required returns as they would appropriately do, as these companies have been de risked. Insurance businesses AIG Property and Casualty Core Bridge Life Insurance both single digit pes, both

discounts to book value. Company like Charles Schwab that sells in the upper sixties today, their earnings are depressed because of investments in intermediate term bonds that they had purchased several years ago. Those aren't the bonds that they purchased. We're at a price where the yields are not as high as what you can get in the market today. But we're already a couple of years into rolling off

five years worth of bonds. There we think after those are gone and they're replaced with current market yields, this is a company that could be earning close to six dollars a share, very financially advantaged relative to their asset management peers. So you know, it's not a monolithic forty percent of the portfolio. There are different reasons for each of them, but the theme is the stocks are really cheap relative to what we think the businesses are worth.

Is it feels like the stocks are perpetually cheap in financials right, And I can't help but wonder if they're this permanent elevated risk premium that investors are requiring to get into this space just as a reflection of a very dated analysis of financials based upon the financial crisis of two thousand and eight two thousand and nine, or if there's something more that's just holding them back.

Instead of saying, you don't want to go into a real estate collapse with companies that are levered bets on real estate loans, they said financial companies are too difficult to understand, and I'm never going to purchase them again the rest of my career. We think that, we think they're making a mistake doing that. I think there are other investors that fear over regulation of the sector, And a question we often get asked is isn't it possible that the banks could get regulated so far that they

almost become like electric utilities? And well, we think that's unlikely. That's not such a scary outcome, given that electric utilities sell at mid teens multiples and twice book value. The financial bank stocks will go up a lot if they got priced like electric utilities. And then, third, the question you're asking specific to banks is being applied more broadly today in a lot of academic circles with just value

stocks in general? Are there so few value investors out there that the cheap stocks just keep under And that's why it's so important to us that managements have the mentality that they are only going to reinvest their earnings in the business when they have great organic growth opportunities where they're competitively advantaged, and if those don't exist, they're going to give the capital back to shareholders, either as

dividends or share repurchase. We are very happy to invest when management teams look at their stock and say there's almost nothing we can invest in that will give us as high a return as the stock will, So we're radically reallocating capital to share repurchase. One of the names. We've got a large position in General Motors. They've been trying to diversify away from Ice Auto for probably the past decade, and just this past year they kind of said,

screw it. If the market's not to value us at even five times earnings, we're going to use all this capital to buy back stock. They're buying back about twenty five percent of the company this year and are committed to continue doing that. So in four to five years, either the market has to respond or they will have repurchased all the shares except ours because we're not selling

at this price. And I think if more managements had that mentality, that they view a cheap stock price as an opportunity rather than the problem, you'd see this undervaluation solving itself. They don't have to just be out there in a giant pity party. They can solve this problem on their own.

So I think it's good for investors to branch out. And I like the books that have a chapter each on lots of different successful investors from a lot of

different styles. There's a William Green book, Richard Wiser, Happier, there are some older books market Wizards, New market Wizards, And I find I learn as much reading about a growth investor or, a macro investor, a commodity investor and what has made them successful as I do reading another book about another investor that does things like we do at Oakmark. And I think you can broaden it and look beyond investors, look at people who've been really successful

building businesses. I love the book New Rules Rule by Read Hastings, the CEO of Netflix, which we've sold out of, because it's become a market favorite again, but when it was out of favor, it was an important holding for us. I think you can read books about successful politicians, successful athletes, you learn how they have had to make sacrifices throughout their lives to achieve the greatness that they achieved in

their specific, their specific careers. And I think that's a lesson that's really important to learn, especially as we have a younger workforce today that at a young age seems much more focused on work life balance than they ever used to be. So you know, maybe maybe you know, after forty years in this industry, I'm just becoming another crotchety old man. But I don't think that change is helpful for individuals that really want to try and rise to the top of the pyramid in their profession.