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The Epitome of an Active Manager

With conviction and creativity, Oakmark’s Bill Nygren invests in any company that he views as a bargain—even Apple.

Shannon Zimmerman, 02/13/2013

Renowned value investor Bill Nygren manages three funds and roughly $11.8 billion for Chicago-based Oakmark Funds. Nygren joined Oakmark’s parent organization, Harris Associates, in 1983, and he is a key architect of the absolute-value strategy that drives stock-selection at the firm.

For Nygren, any company, irrespective of the sector in which it resides or its relative valuation profile, can be a bargain if the firm’s share price implies a steep enough discount to an estimate of its true worth. Oakmark’s valuation work is stringent, too, with the shop’s managers typically requiring a discount of at least 40% before adding a company to a portfolio.

As executed by Nygren, Oakmark’s straightforward approach has generated some unusual portfolios. In December, two of this value manager’s funds—Oakmark Fund OAKMX and its concentrated sibling, Oakmark Select OAKLX—tilted toward the growth square of the Morningstar Equity Style Box. In Oakmark Fund, companies from the technology and consumer discretionary sectors—areas of the market more traditionally associated with growth—accounted for more than 40% of assets.

As that allocation suggests, Nygren is a highly active manager. Just 22% of Oakmark’s assets overlapped with the Russell 1000, the large-blend category index. Only 4.5% of Oakmark Select’s assets aligned with the index’s exposures. Nygren is also a highly successful manager. Both of his domestic-equity charges have earned Morningstar Ratings of Gold, thanks in part to long-term trailing returns that rank among the peer group’s elite.

To get a better sense of Nygren’s stockpicking strategy and where it’s leading him, I interviewed him at Morningstar’s headquarters in November. Our conversation has been edited for clarity and length.

Shannon Zimmerman: I get email from investors in your funds because I’m the analyst who covers them here at Morningstar. People are sometimes confused and say, “Wait a minute, Oakmark is a value shop. Nygren is a value investor. What’s Apple AAPL doing in a portfolio? What’s eBay EBAY doing in a portfolio? Why does he have this much in tech? These aren’t traditional areas that are associated with value investing.” How can it be that a value investor is in these sectors that are not traditionally associated with value?

Bill Nygren: Well, there was a time back around 2000 when technology stocks were all selling at 50, 80, or 100 times earnings, when advisors and investors were begging us to please own just a few of them. And we didn’t own anything in technology, and people got the mistaken idea from that that technology was just a sector we would never purchase. We had nothing against the companies. There are a lot of good technology companies, but when you pay 50 to 100 times earnings, an awful lot has to go right for you to make money as an investor.

You fast-forward a decade, and a company the quality of Apple was available for less than 10 times earnings when we purchased it. The stock has done incredibly well, but the earnings have done just as well. Even today with Apple stock just below $600 a share— when you subtract out the cash that they have on the balance sheet and look at the earnings from their operations, investors are asked to pay only about 10 times earnings for Apple.

Zimmerman: It’s quite remarkable.

Nygren: If you just talked about the statistics, and you said, “A cash-heavy balance sheet, 10 times earnings,” investors would say, “Yes, that’s where a value manager belongs.” The fact that we happen to get rapid growth and we aren’t having to pay for it, to us that’s a bonus rather than a red flag.

Zimmerman: Is it fair to say that growth-versus- value is a distinction without a difference for you and your colleagues at Oakmark?

Nygren: I think so. So many investors think of growth and value as a continuum, with value at one end and growth at the other end. We think about it very differently than that. We think about growth as being one of very many attractive features that a company may or may not have.

A business may be nicely cash-generative. It may have low cyclical risk. It may have better organic growth or less organic growth. Typically, investors get really excited about high organic-growth companies, and they bid up multiples to levels that when we analyze them, we say the likely outcome is that the investor won’t do well, even if the company does.

Sometimes, there is so much skepticism about historical growth continuing, as there is with Apple today and has been with Apple for the past five years, that even though a company has unusually high historic growth, its P/E multiple doesn’t reflect that. When that happens, we love to get growth in the portfolio. We just don’t want to have to overpay to get it.

Return of Bank of America
Zimmerman:
Bank of America BAC is a company that had been in Oakmark and Oakmark Select. Was it ever in Oakmark Global Select OAKWX?

Nygren: Yes, it was.

Zimmerman: At Oakmark Select, it had been out of the portfolio for about a year. Then in the third quarter of 2012, it came back in a pretty big way. It’s a top-five position at Oakmark Select, about a 5% position. What’s interesting is that the stock price had a nice runup over the first part of the year and you entered in the third quarter. Given that Oakmark requires a substantial discount to intrinsic value to make it into a portfolio, talk a little bit about your thinking in getting back into the company.

Nygren: I wish every time we sold a stock, it was because the valuation had gotten up to the level we thought it would get to [laughter]. Unfortunately, we also sell when companies aren’t following the fundamental path that we were expecting.

When we sold Bank of America, that was more the issue. It was not that the stock price had gotten too high, but it was that the company was not standing up to the ever-increasing demands that the government was making for capital.

We feared that there was more potential for shareholder dilution, which has been a very significant negative across the financial- services sector over the past four years. Over the ensuing year, Bank of America did a good job of shedding assets—some through sales, some through maturities of securities that they owned—and they’ve actually gotten to a point now where their capital position is just about the strongest among the major U.S. banks.

We no longer had the fear that it was going to be years longer before Bank of America could return capital to shareholders. They’ve got a management team in place that is no longer the old acquisitive Bank of America management team where you could really question whether or not value was added for the shareholders. But this management team is very oriented toward return of capital, and the company has got a tangible book value of about $15 a share.

We believe that’s a dollar-good number. We see no reason that the company shouldn’t be able to earn at least 10% on its book value. That would be $1.50 or higher in earnings. The world that most of the bears on the banking industry are worried about is a world where there is no loan growth. If there is no loan growth and there is no need for capital to continue building up in the business, that’s a $1.50 that can be returned to share-holders. A typical bank today is paying out about 30% of its earnings as dividends. So that would be something like a $0.45 or $0.50 dividend on a stock that today is sub-$10.

We don’t see many companies today in the market yielding over 4%, and the company would be using the rest of that capital to repurchase shares. That will be about $1 per share for share repurchase, meaning that it could take out 10% of its shares annually. So even if there is no growth in the basic business, we think earnings per share at Bank of America could still grow at a double-digit rate.

Zimmerman: Over what period of time? Because if the core business isn’t expanding, isn’t that problematic over the long term?

Nygren: If the core business never expands and they take out 10% of their shares every year, which is the path that this management team is on, that never becomes a problem.

Zimmerman: How did you get comfortable with the current management team and their ability to allocate capital in ways that you would clearly find to be shareholder-friendly?

Nygren: The easiest way is they went through a period where they were constrained by capital, and there wasn’t much that they could do with that. So, you know that when they are capital constrained they can’t go out and make larger acquisitions. As they are exiting that period, it’s seeing the stock ownership that they have, the incentives that are in place for them where they make more money if the stock price goes higher, and it’s hearing them talk about how they think about capital allocation.

We have met with Brian Moynihan numerous times. He consistently talks about using share repurchase as a hurdle and how almost no acquisitions can be as value-additive as buying back Bank of America stock at less than two thirds of book value. You can’t go out and buy a healthy bank in an acquisition at two thirds of book value.

Zimmerman: Do you think that as Countrywide recedes in the rearview mirror that attitude might change over time?

Nygren: Maybe the fear of making a bad acquisition might diminish. But the discipline of saying, “We can buy our own stock at two thirds of book value versus however much we’d have to pay for an acquisition,” that discipline will remain and will guide the firm toward maximizing the value that it can add through its capital allocation.

Zimmerman: How do you have confidence in the value of a bank’s book? What is the work that the team at Oakmark does to really scrub a bank’s financials, which probably are the least transparent of all of the industries?

Nygren: I’m not sure it’s much less transparent than other sectors. Sometimes other sectors are just as hard to peel away the onion and figure out what’s really in there as the banking industry is. Investors’ concern about what’s on a bank’s balance sheet is probably at an all-time high. They got burned five years ago. Most of the assets on the banking industry’s balance sheet relate to home loans, and banks got sloppy with how they decided to lend money. There is no faster way for a bank to get in trouble than to lend money to people who won’t pay it back.

That changed abruptly at the end of 2007. So now, we’re into five years of good old-fashioned bank-lending standards. Most anyone would say that loans that have been put on the books in the past five years are of substantially higher quality than what were put on the five years ahead of that and are probably at least dollar-good today.

Then, you look at the liabilities side of the balance sheet, and the banks are paying almost nothing for retail deposits. In today’s world, that advantage of cheap funding isn’t getting them an awful lot because you can’t earn that much by investing those funds. But we think as interest rates normalize and get back up to levels that have been more historically average—and that might be three, four, five years away—the liabilities side of the balance sheet will prove to be a good asset for the banks because savings deposits are on the books dollar-for-dollar, but they don’t have to pay as much on that as they would on a bond.

80/20 Rule
Zimmerman:
The last time we spoke, we talked about Walt Disney Co. DIS, and you were thinking about Disney during a period when theme-park attendance was on the decline. Talk a little bit about that, your area of focus, and what made you feel good about purchasing shares when the theme-park attendance wasn’t what Wall Street wanted it to be.

Nygren: A situation we like is when we think investors are applying the 80/20 rule inaccurately; 80% of their attention is on 20% of the business value. That was a situation that we saw at Disney, where theme-park attendance had been down a little bit and almost everything that was written about the company was about the outlook for theme parks and how that was likely to change over upcoming years.

When we looked at business value, the cable networks that the company owned—ESPN and the Disney Channel, along with some other lesser networks—we thought they were at least 80% of the value of the company. We believe the price we were paying was less than the cable networks alone, and with that focus, we didn’t have to spend that much time worrying about whether next year’s traffic at the theme parks was going to be up or down a little bit.

Zimmerman: What accounts for the mindset that gets people focused on the wrong part of a company’s business?

Nygren: Investors tend to be very news-flow-oriented, and when a company is announcing theme-park attendance at regular intervals, it gives analysts a metric to look at and care about. Despite ESPN churning out double-digit increases year after year after year, it just never really grabbed analysts’ focus the way theme-park attendance did.

Zimmerman: One company that is prominently represented in each of your portfolios is Medtronic MDT, a top-10 position in Oakmark Fund, Global Select, and Select. As the dust settles on the election, what do you think the impact might be on a company like Medtronic?

Nygren: When it comes down to how we at Oakmark think about investing, we’re looking for something like a five-to seven-year timeframe. The outcome of an election is unlikely to be a big mover of what we think any of the businesses that we own are worth. I know health care was an area that had important differences between the presidential candidates. But you have one candidate who’s trying to increase access to the health-care system, which probably means slightly higher revenues, slightly lower margins. And relative to the other candidate,

I’m not sure it made that much difference in the profitability of the companies. But we basically own something like Medtronic because it’s at a relatively low multiple. We think it’s got a good growth rate, and we think Medtronic has been one of the leaders at showing the economic benefits of its products.

Zimmerman: In terms of our data, the last time Medtronic entered Oakmark Select’s portfolio was December 2008, which was a pretty wild-and-woolly time for the stock market. Can you give us a sense of the dominant themes of the conversations that you were having in the research meetings around Medtronic, and how much airtime, if any, did regulatory or political risk take in those discussions?

Nygren: One of the things that drives our discussions at a firm that’s as value-oriented as Oakmark is stock-price valuation. Investors tend to be concerned and very attuned to risks of a broad array of outcomes from companies, and that was especially the concern in the health-care companies three or four years ago with the change in the health-care legislation. But the part that investors probably don’t pay as much attention to as they should is the price that they’re paying, and we think price is just as important if not a more important factor for risk as the potential business outcomes.

So, with a company like Medtronic, it had a strong above-average growth rate. The company had done a good job in making acquisitions and bringing out new products. It used to sell at 20, 30 times earnings. Back in 2008, it got down to a single-digit P/E multiple. At that price, we thought there was a lot of room for some of the negative outcomes to modestly affect Medtronic’s fundamental outlook, but they still wouldn’t be negative for the stock because the starting price was so cheap.

We continue to feel that way about Medtronic today. The company is allocating more of its capital to share repurchases. We think that’s a risk reducer for shareholders. Additionally, the low P/E multiple continues, and we think the business outlook is just as good for Medtronic as it was four years ago.

Manager Search
Zimmerman:
Oakmark Select is not actually bursting at the coffers, so to speak, but with assets at $3.2 billion, it is a pretty sizeable fund for 20 stocks. Oakmark Global Select certainly isn’t too big yet, about $600 million the last time I looked, but it also has a concentrated portfolio. Both of those portfolios have very stringent valuation requirements, as well. Then, even though Oakmark Fund is more expansive, it’s not a huge portfolio. It has $7 billion and also has stringent valuation requirements. When you think about those constraints, what’s the capacity for those funds? How much in the strategy do you think you can run?

Nygren: When you think about capacity for funds, what you have to think about is how quickly is someone trying to get in and out of a position and how big a position are they trying to build relative to the types of companies that they’re looking for, the universe of investable companies.

All that we’re trying to buy in Oakmark Fund is big businesses. We’ve limited ourselves to that, whether the fund had $1 billion or $10 billion in assets; that’s our investable universe in the Oakmark Fund. We typically take positions of about 2% of the portfolio. So when you’re buying big businesses and you’re only trying to put 2% of a portfolio to work, we really don’t think about Oakmark as having a capacity limit that’s anywhere near the current size.

Oakmark Select is a little different. In Oakmark Select, we’re trying to buy both mid-and large-cap companies. I would like to be able to buy a 5% position in Oakmark Select without having to own more than 5% of the company I am purchasing. That means we can’t buy companies that are much beneath the size of Oakmark Select.

The midpoint of the mid-cap universe is something like $5 billion or $6 billion. If Oakmark Select got to that level, we would either have to look at further constraining our investable universe or closing the fund. We did reach that level once before, and we made the decision at that point in time that it was best for our shareholders to stop new investors from coming into the fund.

With Oakmark Global Select, like Oakmark and Oakmark International OAKIX, we are limited to large-cap stocks on a global basis. So because of the limit we’ve put on our investable universe there, Oakmark Global Select has a large runway on capacity before we’d have capacity issues.

Zimmerman: Oakmark has lost a couple of managers to retirement in 2012, including your partner at Select, Henry Berghoef. How goes the search to replace Henry?

Nygren: The search is going well. The biggest problem we’ve got at Oakmark, thankfully, is we have so many talented people that are younger than myself, that we could name anyone of half a dozen people as comanager for that fund. Clyde McGregor has got the same issue with Oakmark Equity & Income Fund OAKBX. We’ve got a lot of talented in-house candidates, and it will not be a problem at all finding somebody who can step into Henry’s shoes and Ed’s shoes.

Zimmerman: Well, you raised an interesting point in your answer and you avoided the word “succession.” Is succession part of the thinking as you look for the next person who will be your comanager at Select.

Nygren: Well, both Henry and Ed are older than me and Clyde. So people probably never viewed them as the ones who would be around when Clyde and I retire.

I think it’s quite likely that the managers that Clyde and I name will be younger than we are. In fact, it’s almost a certainty; we’re two of the older people at Harris Associates. But this is an industry where there are no physical demands in the work. Your indoors is air-conditioned. It’s not the kind of business that when somebody is 50 years old, you have to start thinking that maybe they don’t have much time left.

Zimmerman: Look at Marty Whitman, how long he stayed in the game.

Nygren: It’s not like professional athletics. There are a lot of leaders in the investment fund industry who are in their 70s.

There was just an article in The Wall Street Journal with numerous 70-plus-year-old managers being asked about succession plans. We think about succession at Harris Associates. Accidents happen. People don’t stay as healthy as we would like them to. So we are thinking about it. We would have succession plans in place if something unexpected happened to Clyde, me, or David Herro, but it’s not something that any of us are thinking about as a near-term need.

Zimmerman: What’s the nature of the relationship between comanagers on your funds or David Herro’s? I think people have the impression, “Bill Nygren runs this fund, and David Herro runs that fund.” Oakmark obviously has a capable research staff. What’s the day-to-day division of labor among you and your comanagers?

Nygren: On a day-to-day basis, Henry and I always spoke to each other for Oakmark Select. Kevin Grant and I always talk to each other about the Oakmark Fund. We bounce ideas back and forth off of each other. But when it comes to external communication, I’ve handled more of that responsibility than Kevin has. Over time, you’ll see that come into a better balance. The same thing will happen when Clyde and I name comanagers who are going to work with us on those funds; over time, we’ll see them take on more external communication responsibility, as well.

Shannon Zimmerman is an associate director of fund analysis at Morningstar.
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