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Nygren: A Lot of Value Still Out There

John Coumarianos

John Coumarianos: Hi. I am John Coumarianos, mutual fund analyst at Morningstar, and today we have the privilege of being joined by Bill Nygren. Bill manages the Oakmark, Oakmark Select and is co-manager of the Oakmark Global Select Fund. Bill is also a former Morningstar Equity manager of the year.

Thanks for joining us Bill.

Bill Nygren: Thanks for having me John.

John: Bill, you join us at an interesting time in the markets. They have bounced very hard in the past few weeks. I think we have gone from about 6,500 to around 8,300 on the Dow.

But I can remember 10 years ago when the Dow crossed 10,000 for the first time, so we are still quite a bit below that. I was wondering if you could speak about your portfolios in general, how the prices of your holdings compare to your estimates of their intrinsic value. Is that gap still very wide?

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Bill: Yeah, for us that gap is very large. The typical stock that we are buying today or that we already own in the portfolio we think is selling at about half the value that it should be at within the next two years.

And I think it is kind of funny. You highlight the bounce that we have seen in the market. But when the market was falling from a level that none of us thought was crazily overvalued, losing half its value, everyone in the media just assumed that the decline was fundamentally based.

So we see a stock go from $50 down to $15 say. Now it is bounced to $25 and everyone is saying, "Wow. It is way ahead of itself, " instead of saying, "Did it really deserve to fall from $50 to $25?"

So we think there is a lot of value out there. There is still a big spread in valuations. I think there is opportunity to add value both in asset allocation, shifting more to stocks, and also through stock selection.

John: OK. Bill, as you estimate the intrinsic values of your companies, what is the biggest obstacle you face now when you do that? There is a lot of talk now about how it is unclear what future earnings are going to be.

Bill: I think as a value investor, what most of us do is take advantage of people believing that normal is never going to happen again. If you think about normal in terms of say a trend line of earnings for the S&P 500 and a multiple of about 15 times on that, which has been about where the market has averaged over the last 80 years, that puts you at a level five years from now 15 times an earnings number of somewhere around 110 or 120. It puts you at something like 1,700.

So there is a tremendous gap relative to that value. I think that puts a lot of pressure on the people who want us to believe normal is never going to happen again.

So our typical project when we look at a stock is to say, "What do we think this company can earn five years from now? What is its industry position going to be? What will its cash flows be like?" And we try to make an estimate based on a five year out value.

Now, our assumption is things are normal five years from now. Most all the time that is a good assumption. Today a lot of people are questioning that.

John: Bill you have struggled a little bit over the past couple of years with some financials, and yet you seem undeterred. You own, for example, Capitol One, which is a credit card company and has exposure to the consumer. There is a lot of fear surrounding having such direct exposure. What is your thesis for Capitol One in particular?

Bill: The basic thesis is that the credit card business is a necessary business. Consumers depend on it. Our economy depends on it and somebody has to provide credit card financing.

We think Capitol One does that as well as anyone does. They have got a great source of funding through retail deposits. We believe those are overstated on their income statement, so overstated liabilities are effectively a hidden asset.

And the company sells at a big discount to book value. So we look out five years and we don't see a reason this company couldn't be earning five or six dollars a share. It is a stock that sells in the low 20's today.

John: Another distinctive thing about your funds Bill is although we might not call you exactly a go anywhere value investor, your funds have moved around the style box a bit and they have gone mostly from mid-value and mid-blend years ago to the large blend and even large growth a little bit to those areas.

I noticed recently, of course, that you picked up Apple, which seems like an unusual position for a value investor. Can you talk about Apple?

Bill: Well at the time we bought Apple in the first quarter the stock was selling at about $80 a share. We were projecting it would have almost $30 a share of excess cash by the end of the year. So we were only paying about $50 for the business.

On reported numbers, that business was earning almost $5 a share this year, and we think the gap accounting for iPhone sales is understating income. Since Apple updates software over an 18 month period, they have to amortize the income from selling iPhones into their income statements over an 18 month period, whereas if they sell you an iPod they recognize that all instantly.

A couple the quality of Apple selling at less than 10 times earnings, to us that is a bargain. The fact that it grows as rapidly as it does is a bonus.

John: Right. So it sounds like you are almost echoing Warren Buffet's argument that growth is a component of value and there really isn't this big difference that a lot of people think there is.

Bill: Well, I have always said I think the biggest difference in investors is not whether they are value or growth. It is whether they are fundamental or momentum. And we are definitely a fundamental shop.

You mentioned moving around the style boxes. Back when we were called a mid-cap fund, most of the big businesses had been moved out of the large-cap universe by small tech companies with ridiculously high valuations.

We stayed with the large businesses that we thought were undervalued, and that meant we got called a mid-cap fund. As those high price tech names came down and then the big business got back into the large-cap universe, then we were called a large-cap fund.

So we think it is a lot more that the market was changing and that the opportunity was changing rather than we were doing anything different.

John: OK. Well great, Bill. Thanks so much for joining us today. We really appreciate it.

Bill: Thanks, John.

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