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Nygren: Find Your Balance in a Rocky Market

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm pleased to be joining by Bill Nygren--he is the portfolio manager of Oakmark Fund. We're going to look at some of the market turmoil and see if it's opening up any opportunities.

Bill, thanks for joining me.

Bill Nygren: Thanks for having me.

Glaser: It seems like at least the financial media is saying that this sell-off is due to issues in China. Do you buy that explanation? Do you think that the Chinese economy has that big of an impact on U.S. equities, for example?

Nygren: Well, I think sometimes we just forget that the market doesn't really need a reason to have a 10% correction, which we basically had over the past four trading days. They occur pretty frequently--about once every year and a half, on average, historically--and they are really nothing for investors to worry about as they are pretty common.

I think you are right--the media is attributing this recent concern to China. But for long-term investors, like we are at Oakmark Fund (OAKMX) where we're trying to estimate the value of a business five to seven years from now, it's hard to imagine China being important enough to cause a 10% reduction in values. China is something like 16% of world GDP. A 5% to 10% change in China output would only affect global GDP by 1% and U.S. multinationals by less than that, as much of China GDP relates to Chinese-based companies. So, we're seeing this as increased opportunity of values falling substantially less than prices.

Glaser: I did want to look at some specific sectors--the first being energy. Oil prices have fallen pretty considerably as well along with the market. When you look at an energy company, how do you decide how it's going to be able to withstand a lower energy price if it does stay this low for a while?

Nygren: Well, I think that's where quality of balance sheet becomes so important. We want to invest in companies that can weather a reasonable-length depression in the commodity price. One of the advantages of oil investing compared with other international commodities is that because decline curves are relatively rapid on existing wells, it doesn't take very long for production to slow down. Because of that, market forces have to push the price more toward a level that justifies new investment by oil companies.

You could contrast that with some of the metals businesses where you could go a decade or so with existing mines and not have a collapse in supply. What excites us about the oil and gas opportunity--and I think here, too, you're seeing a big reaction to the short-term drop in Chinese demand--what excites us about this is that the market seems to be pricing a lot of these companies as if $40 oil is going to be a permanent fixture, but we're quite confident that prices need to get back up to that $70 or $80 level to incentivize oil companies to invest in new wells. Without that, a couple of years down the road, we're going to be in seriously short supply.

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Glaser: You have a big stake in financial services. Are you at all worried that if the Fed doesn't raise rates in September because of this turmoil, they stay lower for longer and that that will have a big impact on those investments?

Nygren: I think it's a mixed bag if rates don't go up. From the plus side, that means that there's no competition from fixed-income markets because a 2% yield on the S&P 500 looks awfully good compared with the current level of interest rates. If rates did rise more rapidly, you might see some of the money that has gone into the equity markets in search of higher yields find its way back into fixed income.

The other side of the coin, though, is that banks aren't earning as much on equity as we think they should earn or as much as we think they will earn when rates normalize. So, a typical investment for us in the banking sector where we think the company should be able to earn better than 10% on its equity, you might have to cut that number 10% or 15% if we don't see any increase in interest rates. But again, the flip side of that is the market probably places a higher P/E multiple on that lower stream of earnings because equities become the only game in town.

Glaser: You mentioned earlier that you're seeing some values open up. I know you can't talk about specific purchases you're making right now, but generally what are some of your favorite securities or favorite businesses at the moment?

Nygren: I would say the areas that we have found interesting over most of this year are financials and very high-quality businesses that are trading at pretty small P/E premiums. Those continue to be a couple of the most attractive opportunities. In the banking sector, we own a bunch of them--most of the large multinational banks. In the high-quality area, a company like Google (GOOGL) is a good example where if you strip the cash off its balance sheet, the cash-adjusted P/E on next year's earnings is only about 17 times--about a 10% premium to the S&P 500. We think it's too good of a company to continue to sell at such a small premium to the market.

The other area that has more recently been looking more attractive to us has been the industrials space. As concerns about economies slowing worldwide have crept into the market, these stocks have been hit much more severely than the more stable businesses; for the investor who is trying to invest where the opportunity is greatest on a five- to seven-year timeframe, some of these more cyclical businesses, I think, are starting to look pretty interesting.

Glaser: Finally, I wanted to ask you about your advice to an investor who is maybe fearful right now--who is thinking about selling a big of their portfolio. What's the best way to stay calm during fearful periods like this?

Nygren: Well, I think the first thing to remember is, over very long periods of history, equities have outperformed almost every other class of investments that there is--averaging something like 400 or 500 basis points a year better than the long-term bond market. Now, over very long periods of history, there have been corrections--there have been lots of bear markets. Nobody has shown any particular ability to be able to time the ins and outs of the market. So, despite the market having a 10% correction every year and a half, it still outperforms most any other investment that's available.

I think the most useful advice an individual can get is this: Because we don't know when things are going to get better, it's important to keep balance in their portfolios. For an investor who, two weeks ago, was at their long-term asset-allocation targets because bonds have done well and equities have done poorly, they should probably be trimming about 10% of their bond portfolio and putting that money into equities to restore balance in the portfolio. Over a long period of time, the best way for an individual to make sure that they can sleep at night and get through these tough periods is to have a balanced portfolio and use large moves in the market--either direction--to frequently restore balance to that portfolio. If you don't do that, the market is taking your portfolio out of that balanced position and giving you more risk exposure to a sector that's already performed well and maybe getting extended. So, I think most investors should take a deep breath, know that equities are good long-term performers, and take a look at their portfolio and see if they can take advantage of it.

Glaser: Bill, I certainly appreciate you taking the time today.

Nygren: Thanks a lot.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.