Wed, 8 Oct 2014
The Oakmark manager on what attracted him to financials, plus the benefits of bringing a private-equity perspective to public-equity investing.
Russ Kinnel: Hi, I'm Russ Kinnel, director of manager research at Morningstar. I'm very happy to be joined today by Bill Nygren, manager of Oakmark Select (OAKLX) and Oakmark Fund (OAKMX), former Morningstar Fund Manager of the Year.
Thanks for joining us, Bill.
Bill Nygren: Thanks for having me, Russ.
Kinnel: I'm really interested in some of the changes I've seen in your portfolio. You've added Fidelity National Financial (FNF), Citigroup (C), and your overall financial weighting is fairly sizable now. I was wondering if you could just update us on what financials are like today versus '08.
Nygren: Russ, I think the financials today are very attractive because of what they went through in '08. And so many investors lost so much money in the financials, not anticipating the housing collapse, that they kind of swore off financials and thought they were too opaque to understand.
We think the real problem with financials was--especially the banks--they did basically what they told us they were going to do. They collected retail deposits, they lent them against real estate stock, and we just never anticipated that real estate could crash the way it did in '08.
So, I think rather than think banks are too tough to understand, '08 actually proved banks are doing what they've always done. And when you look at how they're different today, lending is done based on old-fashioned lending standards. They are actually making sure that the loans they make are to people who are likely to pay them back. Housing prices are already down a lot. I think a repeat of a 20% drop is quite unlikely. And almost as important, capital levels are so much higher today. A lot of banks back in '08 had maybe 5% of their assets represented in equity. Today, most of the large banks are over 10%. That means it would take twice as big of a drop in real estate to cause the same degree of problems.
So, we think the banks are a much safer place to invest today. The market doesn't price them at anything like the levels it used to; you can buy almost any large bank at less than book value, and we think they're going to be good businesses going forward.
Kinnel: Of course, if you want to beat the market, sometimes that means buying the stuff that people don't like. It's tough to beat the market if you're always buying the most loved stocks.
Nygren: I think sometimes people forget that risk isn't just about the business; it's also about the price you pay. If you buy a bank at three times earnings, that's a risky investment. But a bank at 80% of tangible book, we don't think there's any reason to believe that's a riskier investment than most of any stocks in the stock market.
Kinnel: And I mentioned Fidelity National and Citigroup. Any thoughts on what in particular makes those attractive?
Nygren: I think the Citi story is very similar to the other large multinational banks. You've got a stock that's trading just over 50; it's got a book value that's almost $70 a share. Tangible book is in the low- to mid-60s. We think trend earnings are probably $6 a share, and that doesn't give them credit for two of the important assets they have that most other banks don't have. Number one, their tax-loss carryforward is very large, a result of them having made so many mistakes going into the correction in '08. But something like the next $100 of earnings that they have per share won't get taxed, and that's a big advantage. We value that at something close to $10 a share.
The second advantage that they have is they've got a lot of excess capital. They're already well in excess of the Basel requirements, and we think there's another $8 or so per share of excess capital and, because of the tax-loss carryforward, that's going to be growing very rapidly. So, we think Citi is worth a lot more than book value, and the stock available today at something like 75% of book strikes us as very attractive.
Fidelity is a little bit of a different story. The stock sells around $28. The earnings consensus this year is somewhere around the $1.75. That means it's at about a market multiple. And we're not arguing that it deserves more of a multiple than that, but rather, earnings today are closer to a trough than they are to normal.
Fidelity is the largest title supplier in the country, and title-insurance volume right now is about 40% below normal levels. New home completions are below normal; existing housing turnover is below normal. And even [refinance] volume--now that interest rates have stayed low volatility at low levels the past couple years--even that has gotten to be below an average level. So, we think Fidelity is capable of something more like $4 a share of earnings in a normal environment, and that means today's price is about half the market multiple.
Kinnel: And then something pretty different that you bought was Amazon.com (AMZN), which sold off in the first half. What attracted you there?
Nygren: I think, today, it's either financials that are attractive or it's really good businesses that are perceived as selling at too high a multiple for value managers to buy. And Amazon certainly qualifies because they are hardly earning any money at all and the stock price is in the low 300s. So, the P/E multiple today is enormous. But we think, with retailers, it's really important to look at a price/sales ratio. And on that basis, Amazon starts to look more reasonable relative to other retailers.
And importantly, a lot of Amazon's business today is coming from selling other people's merchandise, where they are basically operating as the mall owner as opposed to the retailer. On those sales, they only get to report their commission as revenues. So, if you bump that up to what the real gross merchandise volume is, Amazon is really selling at about a 20% discount on a price/sales basis compared to the retailers that we're all worried [Amazon is] slowly putting out of business.
And investors fret over how much income is being depressed by the investments Amazon is making trying to grow larger. But we think investors ought to applaud those investments because that's what is allowing Amazon to grow its sales at 20%-plus per year, while the average retailer struggles to even have positive same-store sales numbers.
Kinnel: I'd like to switch gears a little bit: You are running relatively focused equity funds. What should an investor expect from funds like that? What kind of time horizons do they need to make funds like that work?
Nygren: I think there is a big debate going on in the industry today about whether investors should be all passive and take advantage of really low fees or whether the active-management fees they pay are worthwhile. And we think what we do well at Oakmark is stock-picking. So, we want to construct the portfolios to have the maximum impact of our best ideas.
The Oakmark Fund owns about 50 to 60 names--that's maybe between half and a third of the number of names in the average mutual fund. Oakmark Select slims that down to just our 20 favorite ideas. So, an investor in either of those funds ought to expect much higher day-to-day price volatility than they get in a typical mutual fund but, over a longer period of time, a much bigger impact from our stock-selection skills. So, if you believe your manager has stock-picking ability, concentrating it into their best ideas is a very sensible thing to do.
And one of the ways I like to describe it is like this: If someone is building a portfolio of mutual funds, rather than have my 150 best ideas, wouldn't they rather have my 50 best ideas in Oakmark and then two other managers who they think are exceptional and just get their 50 best ideas as well? Because the last thing you want to do when you combine a portfolio of mutual funds is basically end up inadvertently reproducing the index and then you've just created an index fund, but you're still paying active-management fees for it.
Kinnel: And of course, with a fund like yours, you're not aiming to have modest outperformance each year. It's about long-term compounding that you're aiming for; when you look at a stock, you're not thinking, "This is going to be a great three months for it."
Nygren: Right. Certainly, we would all love to have outperformance all the time, every week, month, quarter, year--but that's just not reality. If you apply a disciplined style that works over a long period of time, there is no way to avoid the quarters, or even years, where you underperform. I think an investor in any stock ought to have at least a five-year time horizon, because the last thing you want to be in a volatile market is a forced seller. So, I would encourage people, if they aren't thinking at least five years out, they probably shouldn't be in stocks at all.
Kinnel: You're looking out, yourself, five or 10 years down the road for individual stocks. It's not so much about one year. And when I talk to managers after a bad year like '08, they get excited. And when things get pricier, they are very much the opposite of fund investors.
Nygren: I think a lot of investors today, both amateurs and professionals, have adopted this really short timeframe, where they think everything is about trying to outguess everyone else on the next quarter. I like to say what we do at Oakmark is we bring a private-equity perspective to public-equity investing. If you think about what a private equity firm does well, they think about how investors might view their investment differently five to seven years down the road. And then you start thinking about business fundamentals: What kind of market share does a company have? What kind of competitive advantage does it have? How can things change over a long time horizon? Do they have industry headwinds or are there tailwinds like with our Amazon investment--the transition of retailing from bricks and mortar to online? Or with a company like Google (GOOG) that we own--from print advertising to online. Those kinds of trends over five years can be very, very powerful. I think it gives us an advantage today that most investors overreact to very short-term news; that can really create opportunity for someone who is focused on a five- to seven-year time horizon.
Kinnel: Bill, thanks for joining us.
Nygren: Thanks for having me, Russ.
Kinnel: You're welcome. I'm Russ Kinnel.