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Nygren: The Market Is About Where It Belongs

Jeffrey Ptak, CFA

Jeff Ptak: Hi, I'm Jeff Ptak, global director of manager research, coming to you from the 27th Annual Morningstar Investment Conference, held here in Chicago. I'm very pleased to welcome a special guest, Bill Nygren, portfolio manager of the Oakmark Fund (OAKMX), Oakmark Select (OAKLX), and Oakmark Global Select (OAKWX) funds.

Bill, welcome. We're very pleased to have you participating in this year's conference.

Bill Nygren: Thanks for having me, Jeff.

Ptak: It's our pleasure. So, Bill, I know that you're a bottom-up stock-picker. You go security by security, but given the perspective that you have on markets, we're always curious to know what you're seeing from your vantage. How target-rich does the equity market look to you right now? Does it appear rich, undervalued, about right? How are things looking?

Nygren: I think when you start thinking about that question, it helps to look backward a little bit. Seven years ago, the market was at a very low P/E on very low earnings. From that level, we tripled. So, if you think about that as a once-in-a-generation opportunity, the market clearly isn't as target-rich as it was then. However, where we're at today is an upper-teens multiple. That's not that different than long-term historical averages. Competing investments like bonds and cash offer de minimis returns.

So, I think the market is about where it belongs, and people have to remember that that doesn't mean it's time to sell the market. If the market is about where it belongs, it ought to return several hundred basis points a year more than the bond market. And if you select securities well, going to some of the out-of-favor areas, I think you should be able to do a little better than that--maybe getting up to upper-single-digit long-term rates of return. That may not sound exciting compared with a triple over six years, but it pretty significantly beats other opportunities today.

Ptak: Jeremy Grantham of GMO was a keynote speaker yesterday. One of the things he noted was the fullness of corporate profit margins--his argument being that they are unsustainably wide. So, to what extent should that color an investor's views about the potential for future stock returns? Should one think that markets can't do quite as well for them in the next seven years as perhaps they have in the past five or six?

Nygren: Well, I clearly don't think the market will do as well as it has in the past five or six years. That would be heroic to think it could triple again. At Oakmark, when we try to estimate what a business is worth, we're always thinking about where earnings will be five to seven years from now--what kind of multiple would be appropriate?

So, we generally include a lot of reversion-to-the-mean thinking in our analysis. But when you look at profit margins and the growing percentage of profits that are coming from outside the United States that are taxed at a fraction of what the United States tax rate is, when you look at how much return we're getting on intellectual property today rather than metal bending, I think there are some pretty strong reasons why today's higher margin levels are sustainable.

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Ptak: Some of the names in your portfolio have been prodigious share repurchasers, and so some questions have been raised about whether that's the best use of capital. Can the capital be more effectively reallocated--maybe in the form of [capital expenditures]. And so, what's the progression that you and your analysts go through in assessing management's capital-allocation skill, especially when you're seeing that they're putting a significant portion of operating cash flow into repurchases, dividends, and the like?

Nygren: One of the criteria we use at Oakmark is that we want to only invest in companies where management is on the same side of the table as the shareholder. To us, what that means is they are focused on maximizing long-term value per share. Everybody talks about maximizing shareholder value--the elite management teams think about per share. So, how do you go about doing that?

That means investing excess capital in the highest rate of return that's available. If there is strong demand for your product, that might mean building a new plant in capital expenditures; if you can extract synergies from acquisitions, maybe it means making an acquisition; or if those opportunities aren't available and your own stock is at a discount, growth through shrinking the denominator is just as good as growth through growing the numerator.

So, we want managements to compare all of the available options that they have and pick the one that maximizes long-term per share value. With a lot of companies, the stock market doesn't seem to pay up much for growth that comes from share repurchase. But if that's coming from sustainable excess-cash-flow generation, to us, that growth is every bit as good as organic sales growth.

Ptak: Let's talk for a minute about margin of safety. I know that that's a concept you're very fond of and adhere to in investing, but I would imagine that the margin of safety that your portfolio is affording to you right now is certainly narrower than it would have been two or three years ago. So, my question is, does that inform other choices that you would make in the way you're structuring the portfolio--say, the types of names, the market sensitivity--knowing that perhaps they are more fully valued than they were earlier in a cycle?

Nygren: Well, I don't think it's changed what we've done much. One of our biggest areas of investment is financials. And because they are still so out of favor with investors, because of what they went through seven years ago, I don't think the margin of safety there has changed much from what it was a of couple years ago. In fact, with all the capital that the banks are being asked to build for regulatory purposes, you could argue that those businesses are becoming much safer businesses, and because of the way they're managing their balance sheets, they're actually increasing the margin of safety for us.

Now, as companies get to extended P/E multiples, that's where I think it's really important for investors to consider whether or not they still have a margin of safety. When we get to P/E multiples that are a significant premium to the market, then that, to us, would be a red flag to start thinking about whether we still have enough margin of safety to be invested here.

Ptak: Bill, thanks so much for your insights. We very much appreciate them.

Nygren: Great. Thanks again for having me.

Ptak: My pleasure. From the 27th Annual Morningstar Investment Conference in Chicago, I'm Jeff Ptak. Thanks for joining us.