Bill Nygren is a partner and the chief investment officer for U.S. equities at Harris Associates. He is also the co-portfolio manager of three Oakmark Funds. He is a legendary value investor and one of the investors I admire the most. In my book, he's a first-ballot Hall of Famer. This is my fourth interview with Bill, and you can find the previous three here, here, and here. As you can tell, he is incredibly generous with his time and is always willing to share his wisdom and experience.
What follows is a recent interview I conducted with Bill over email.
John Rotonti: What is the ultimate role of an analyst?
Bill Nygren: I think too often, young analysts believe that the goal of an analyst is to demonstrate how much they know about a company and build a perfect earnings model. I don't think I've ever seen an analyst model their way to a great stock idea!
I view the goal of the analyst as developing conviction that the consensus is wrong about something important. Then their job is to communicate why they believe they are correct and the consensus is wrong and to compute the valuation impact. Once we own a stock, their job is to actively monitor new information to assess if their view or the consensus view is coming to fruition.
There are a lot of important areas the consensus can be wrong: management quality, business quality, long-term potential differing from current results, valuable non-earning assets, and so on. To make excess profits, you need to hold a nonconsensus view and be right.
Rotonti: How does the role of analyst and portfolio manager differ at Oakmark and is there a clear career path of going from analyst to portfolio manager?
Nygren: Our analysts are all generalists. Their job is to find mispriced companies and to do so, they look across all industries. So, our analysts think like portfolio managers. They aren't just asking whether Charter is more attractive than Comcast. Rather, they are thinking about how it compares to EOG (EOG -0.48%) or Wells Fargo (WFC 2.73%). When an analyst becomes a partner, they are typically added to one of our portfolio teams.
Rotonti: Does Oakmark have an investment committee and if so, what is the role of the committee?
Nygren: We have a Stock Selection Group that includes me as CIO, our Chairman Tony Coniaris, and a third person who rotates among our partners. This group votes on which stocks are on our Approved List, the list from which we purchase stocks for all of our portfolios. So, none of us have the power to walk in one day and start buying, say, Microsoft. It first needs to be written up and presented in front of all our investment professionals, then the three of us vote on whether it goes on the Approved List.
Rotonti: How often do you hear stock pitches and what are your analysts expected to deliver during a stock pitch? How often does your team discuss existing positions in the portfolio?
Nygren: Informally, our analysts are talking all the time about stocks that we already own or that might be attractive. Formally, our investment team meets every Tuesday morning to review new stock ideas. At that meeting, we also review existing holdings and do Devil's Advocate reviews of our large positions. For a new idea, the analyst prepares a report that includes brief background on the business and management, their valuation models showing why the stock is cheap, forecasts showing how we expect value to grow, and discussion about management's history and why we should trust their goal is to maximize long-term per-share value. The report also includes an earnings model and several standardized attachments. The report is distributed by noon Monday, and the entire investment team spends Monday afternoon and evening trying to find holes in the arguments. Then on Tuesday, we all sit around a large table and discuss our concerns before voting on whether or not the stock gets added to our Approved List. It can be an intimidating environment for a new analyst, having a dozen people attacking your idea and telling you why they think you are wrong. But, analysts quickly learn it isn't at all personal and we are simply trying to identify as many of our mistakes as possible before we invest client capital in them.
Rotonti: In your third quarter 2022 commentary you estimated that an "unprecedented" $28 trillion in capital had been wiped out so far this year and you wrote that you "hope the Fed considers that number as it attempts to balance slowing inflation and slowing the economy." I feel like you don't usually comment on Fed policy in your letters. What compelled you to opine on the Fed this time around?
Nygren: The reason I highlighted how much capital has been lost in 2022 was that I wanted to validate the feelings of fear and frustration that so many investors are experiencing this year. The amount of wealth that has been lost is truly staggering because during a typical equity bear market, the bond market rallies. The simultaneous bear markets in stocks and bonds are rare, and they're exceptionally painful to retirees who have portfolios balanced between equities and fixed income.
You are right that we almost always stay away from macro commentary and, more specifically, Fed policy. The reason I mentioned it was because $28 trillion of lost wealth is such a big number compared to the $1 trillion COVID-19 giveaways or the half-trillion-dollar student loan forgiveness, yet those numbers were getting tremendous airtime and were cited as reasons interest rates need to go a lot higher. The big increase in rates we've seen this year hit some industries quickly, such as housing and autos. But most industries will slow with a lagged effect. I'm sure the Federal Reserve Board of Governors understands that, but I was hoping to give pause to any investors who thought it was obvious that they should wait for even worse news before they considered investing in either stocks or bonds.
Rotonti: How do you factor interest rates into your stock picking and portfolio management?
Nygren: Nominal interest rates factor into our growth assumptions (over time, companies can generally pass through most inflation) and real interest rates affect the P/E multiple. Additionally, for financial companies, interest rates affect net interest margin, which is a much larger impact than just adjusting the growth rate for nominal rates.
Just as in bonds, higher rates decrease the value of near-term cash flows less than more distant cash flows. So, on a relative basis, when interest rates rise, value declines less for low P/E stocks than high P/E.
Rotonti: Does Oakmark have an economist or macro strategist? If so, what role does that person play?
Nygren: We do not. We are very much "bottom up" at Oakmark and have a much longer time horizon (five to seven years) than most investors. Our forecast is always that the economy will be at a "normal" level by the end of our time horizon. Typically, that is a very center-of-the-road forecast. Sometimes when investors embrace extreme forecasts (either positive or negative), our view that the world will eventually be "normal" is an outlier that influences our portfolio construction. A recent example was a couple years ago when nobody understood COVID-19 very well: the belief that travel would eventually return to levels that were considered normal pre-COVID-19 made most travel-related businesses appear very cheap. Owning companies like Booking Holdings, Hilton, and MGM boosted our performance as both business and vacation travel resumed.
Rotonti: In your opinion, is the S&P 500 cheap and are you finding cheap stocks to invest in?
Nygren: We don't market time, so we rarely have a view as to whether the market is cheap. Our focus is always on which stocks look compelling relative to the market. Having said that, a mid-teens S&P multiple is not at all extreme relative to history. What is unusual is seeing banks sell at less than half the S&P multiple or energy companies selling at double-digit free cash flow yields. The spread in P/E multiples of the S&P 500 companies is quite wide today, so we see more opportunity than usual in the low P/E stocks.
Rotonti: What is an investment thesis?
Nygren: Consensus opinion is reflected in stock prices. We think of an investment thesis as how our opinion of a company's value differs from consensus. That difference could be in expected future earnings, appropriate P/E multiple, risk level, return of capital, etc.
Rotonti: Please remind us of your definition of a high-quality business and how business quality factors into your decision-making process?
Nygren: I recently read an interview with Berkshire Hathaway's Todd Combs where he said the worst business imaginable is one that grows and needs infinite capital. I thought that was an interesting way to describe it because it shows that worse businesses exist than the typical low-multiple, low-growth cash cows. Inverting that definition of worst would say the best businesses grow rapidly without needing much capital. Companies that we own or have recently owned that would fit that definition of great businesses would include Mastercard Moody's, and Alphabet.
Our process incorporates quality in several ways. First, our analysts forecast out earnings for the next seven years, then apply a P/E multiple to that seven-year forward estimate that assumes the business becomes average over the next five years. So, a higher-quality company would be accorded a higher current P/E multiple based on its higher expected near-term growth, higher cash return to owners, and lower discount rate due to lower risk.
Rotonti: Can you please remind us what valuation tools and metrics your team uses? Do you build discounted cash flow models? Do you look at P/E ratios and free cash flow yields? Something else?
Nygren: Yes, to all. Depending on the company, we could use any of those methods and often we will use multiple valuation methods for one company to make sure that they are all getting us in the same ballpark. Our goal is to compute a reasonable estimate of the price a buyer could pay for the entire business and still earn an adequate return on their investment. Price-to-sales might give a better estimate than price-to-earnings when the potential profitability is obscured by growth spending or by a subscale company. Price-to-book can be useful for banks, especially when current earnings are far from trend. The trick is to find the balance between being very disciplined in applying different valuation metrics yet giving enough freedom to find the most appropriate metrics for each company.
Rotonti: When picking stocks, do you consider an upside potential-to-downside potential ratio? If so, what do you look for?
Nygren: Kind of. First, instead of looking at how much a stock should go up if our forecasts prove accurate, we look at what percentage of our estimated business value the total debt and equity of a company currently sell at. Though that might sound like a distinction without a difference, it is a very meaningful difference for levered businesses. Here's a simple example: Business 1 has no debt, its market cap is $80 billion and we think it is truly worth $100 billion. If we are right, the stock has 25% upside. Now consider Business 2, which is also deemed to be worth $100 billion, but it has $80 billion of debt and the stock sells for $10 billion. You could say that if we are right, the stock could double from $10 to $20 billion. But we would look at those two companies and say Business 1 is cheaper. Its total price is $80 billion whereas Business 2 has a total price of $90 billion. So, we could be off on our valuation estimate of Business 1 by 20% before we were paying the full value, but our cushion is only 10% on Business 2.
We also penalize companies where we believe the range of possible earnings is wider and where we believe management or business quality are less positive. Though we don't end up with a simple upside to downside ratio, we are trying to measure both upside and downside. We adjust both our buy/sell targets and our position sizes accordingly.
Rotonti: Do the numbers pretty much tell the whole story of a business?
Nygren: No. Numbers are probably more effective than words for telling the story of where a business has been. However, finding good investments is more about identifying businesses where the future will be different than the past -- and for that, I believe you need to explore the qualitative side.
Rotonti: How do you measure management quality, and can you please give us an example of a CEO (either in your portfolio or not) that you think does it right?
Nygren: The best management teams focus solely on maximizing the long-term per-share value of the company's stock. "Long-term" is important because a management focused on maximizing short-term earnings might damage a company by mistreating customers, employees, etc. If the management is focused on the long term, they must treat all stakeholders appropriately. "Per-share" is important because that is really the only metric the owner of the shares cares about. If a management doubles the value of a business but doubles the share count in the process, the owners have gained nothing. I don't think many managers or investors would think any of that is controversial.
Where we spend much more time than most investors is analyzing how free cash flow gets invested. Our view is that free cash flow belongs to the owners and should be returned to them through share repurchases or dividends unless a business has investment opportunities, due to competitive advantage, that are expected to earn excess returns. A recent example that concerns us would be in the energy industry. Many of the large companies have decided to diversify by investing heavily in renewable energy, an industry where they have no obvious edge, but these managers are generally applauded for investing in green technology.
Last year we went to ConocoPhillips to meet with its management because we thought the stock looked too cheap. CEO Ryan Lance told us that Conoco would only invest where it was advantaged, and there was no reason to believe Conoco was competitively advantaged in green energy. Because shareholders have a much broader opportunity set to invest in, Conoco would return capital to shareholders rather than investing in an area there was no reason to expect excess returns. We bought the stock immediately.
Rotonti: What is one company you'd love to own stock in at the right price?
Nygren: The premise of the question naturally leads to naming some incredible businesses (like Microsoft, Mastercard, or Moody's) that we'd love to own if only it weren't priced like it was such a great business. The reality is that we believe there is a fair price for every business and at the right price, that stock can make a good investment. Some of the businesses we own (like Ally, APA, and General Motors) are not great businesses and being mediocre is aspirational, but the prices are so low that they don't need to get an average P/E to be great investments. So, my answer is that I'm excited to own any company when it trades below "the right price," and if I've properly defined "the right price," then I'm equally happy to buy a mediocre company at half "the right price" as I am a great company.
Rotonti: When do you trim and when do you sell out of a stock completely?
Nygren: Allow me to give some background. We buy stocks only when we believe they are selling at a large discount to intrinsic value, when we expect that value to grow at least as fast as the S&P, and when we believe management is capable and economically aligned with shareholders. When all three of those conditions are present, we will purchase the stock. We think of 2% of the portfolio as a normal-sized position but based on our estimate of the risk/return trade-off of the stock, we will invest between 1% and 3% of the portfolio.
We sell when we lose any one of those three pillars. If we lose confidence in either management or the ability to grow intrinsic value, we will sell out of the entire position. If the stock rises to a price above our estimate of intrinsic value, we will also sell the entire position. We automatically trim an Oakmark position when appreciation takes it above 4% of the portfolio (twice a normal position). Over the years we own a stock, we will trim or add to the position size as our assessment of the risk/return trade-off changes.
Rotonti: I think you have eight stocks in the Oakmark fund that have weightings of less than 1%. Are these positions you are building up or selling off? Is it normal for the fund to have so many positions less than 1%?
Nygren: The Oakmark Fund typically owns about 55 stocks, give or take, and its typical stock is owned for about five years. So, over the course of a year, you'd expect roughly 11 stocks to get added to the portfolio and 11 to get sold. If 22 stocks are in transition over the course of a year, that would mean five to six per quarter would be either on their way in or out. Having eight is a touch high, and it is because the extreme volatility in 2022 gave us more opportunity than usual to make changes in the portfolio. There is no change in our thinking that if a stock is worth owning, we should invest at least 1% of the portfolio in it.
Rotonti: The Oakmark Fund has about 55 holdings and the Oakmark Select Fund has about 20-25 holdings. Is it easier to manage a fund with 55 stocks or 20-25 stocks and/or which takes more of your time?
Nygren: It might seem like it would be easier to manage a portfolio with fewer stocks, but the opposite is true.
The Oakmark Fund owns most of the large-cap names on our Approved List. Our job as managers is to figure out which stocks we'd prefer to exclude from the portfolio because we have less confidence in our thesis or because we believe we have more attractive stocks that express the same thesis (such as banks are too cheap compared to their history). We end up owning about 55 of the 75 or so stocks that are on our Approved List that are large enough businesses for Oakmark. When each of the three of us who work on the large-cap strategy list how the portfolio would be invested were we the sole decision maker, we end up disagreeing on only about three names, so those are the stocks we focus our discussions on.
For Oakmark Select, we are winnowing down the list of 55 stocks we own in Oakmark plus some smaller businesses that we consider too small for Oakmark to a portfolio of our favorite 20 stocks. When the concentrated strategy team goes through the same exercise of each constructing a model portfolio, there might be 10 names that one manager would include that the other wouldn't. So there is more work in getting to a consensus on the concentrated portfolio than the diversified portfolio.
Another way of looking at it is that each individual stock has a larger impact on the portfolio performance in a concentrated portfolio. So, selecting a stock to include requires a higher confidence level than for a diversified portfolio.
Rotonti: You own both Amazon (AMZN -1.14%) and Netflix (NFLX -0.51%). Do you feel like Amazon or Netflix has more upside potential?
Nygren: You can see our thoughts on risk and return potential from how positions are sized in our portfolios. At the end of September, we owned more Netflix than Amazon.
Rotonti: Alphabet's stock sold off about 10% after it reported third-quarter earnings. Why do you think it sold off so much and can you please remind us of your investment thesis in the company?
Nygren: Alphabet had reported incredible growth numbers during COVID-19 and as we reemerged. Third-quarter growth slowed dramatically as the economy slowed. I think sometimes investors forget that Alphabet isn't a typical technology company. Rather, it is a media business that sells advertising.
When we value Alphabet, we look at the two segments -- search and "other bets" -- and value them separately. Because "other bets" is effectively venture capital investment, it loses money and creates the appearance of search selling at a higher P/E multiple. On a sum-of-the-parts analysis, the multiple on search is much lower than the stated Alphabet P/E.
Rotonti: What is your thesis in EOG?
Nygren:
- Underinvestment in energy infrastructure for a decade means prices will stay high for longer.
- Earnings will finally be returned to shareholders.
- Investors are not paying up for low-cost production or large inventory backlogs. EOG has both, and management has one of the strongest track records in the industry.
- The stock sells at about 9x the earnings they will achieve at $90 oil.
Rotonti: What is your investment thesis in KKR (KKR -1.35%)?
Nygren:
- Investors are not paying for the large investments in KKR deals on KKR's balance sheet.
- Earnings are depressed by growth spending in new asset categories (like infrastructure and a retail distribution network).
- Adjusted for those, KKR is selling at a discount to other asset managers despite faster growth.
Rotonti: Why does Wells Fargo deserve to be your second-largest position?
Nygren: Wells Fargo used to generate one of the highest ROEs of the big banks and it was afforded a premium valuation as a result. Under prior management, compliance lapses led to the fake account scandal and tremendous regulatory costs. We believe that under the leadership of CEO Charlie Scharf, the regulatory issues and costs are finally moving in the right direction and Wells will emerge as a high-return retail bank, and furthermore, that Wells now sells at a lower price-to-book multiple than its peers, and we expect it will close the gap.
Rotonti: What is your investment thesis in Goldman Sachs (GS -0.20%)?
Nygren: That an investment bank employing best-in-class talent, building generational client relationships, and possessing one of the strongest brands in the industry can earn a sustainably high return on capital and, therefore, deserves to sell at a meaningful premium to book value. Back when investment banks were privately owned, partners bought shares at book value then sold at book when they retired. They became wealthy because book value grew so much. We think these economics should be rewarded in the public market with a stock price at a large premium to book value.
Rotonti: What is your thesis in Charles Schwab (SCHW 0.59%)?
Nygren: It has a lower cost infrastructure than any other large asset gatherer and that allows it to provide a better value proposition to its customers. That means it grows faster, which further reduces costs and allows it to pass some of those savings on to customers and so on. Because Schwab gets most of its earnings from the spread between what it earns on cash and what it pays to customers, Schwab was massively underearning when rates were zero. Based on our estimate of what Schwab can earn in a normal interest rate environment, this great business is priced like it isn't even as good as the average S&P 500 company.
Rotonti: You recently initiated a position in Salesforce (CRM -1.59%). Why?
Nygren: Though we've long admired Salesforce, we had two hang-ups that prevented us from investing. First, the price always looked expensive relative to other software companies; and second, we were not convinced the founder was solely focused on maximizing per-share value. We recently saw important changes on both fronts. First, the stock fell from over $300 to $140 over a two-year period when the company continued to grow rapidly. The result was the shares that had sold for 10x revenue became available at 4x revenue. Second, the appointment of Bret Taylor as co-CEO and Amy Weaver as CFO ushered in a new era where management prioritized "profitable growth" and shareholder return. We are already seeing improved operating margins and a $10 billion share repurchase authorization. With the stock trading at a large discount to most SaaS acquisitions and with better alignment with management, we believed Salesforce finally met our investment criteria.
Rotonti: Fiserv (FI -0.13%) is a top 10 position out of 56 stocks you own in the Oakmark Fund. What is your thesis on Fiserv?
Nygren: Our thesis is that investors are overestimating how fast fintech start-ups will take market share from a large incumbent like Fiserv. Furthermore, inside of Fiserv is one of the most interesting fintech companies, Clover, which is rapidly growing by integrating point-of-sale processing equipment with business management software.
Rotonti: As the CIO of a firm that manages $100 billion and one of the most sought-after investors in the world, how do you spend your day? Do you work from home or in the office?
Nygren: I hated working from home during the pandemic. Though I'm very proud of the job our team did to get through that period, I hope we never have to do it again. Our offices are in a Chicago Loop high-rise, and I think I was the first one back in the entire building. I enjoy being with our investment team and am energized by the office working environment. Our process is team based and very collaborative, so we all benefit from being together in the office. I think people just starting their careers are making a big mistake when they try to work from home as much as their employers will allow. It lengthens the time needed to move up the learning curve and reduces opportunities to gain visibility outside of one's small circle of co-workers. I have no doubt that it will slow their career advancement.
Rotonti: How often do you travel for work?
Nygren: I enjoy accompanying our analysts to meet the management teams of companies we own or are considering purchasing. A Zoom call is no substitute for meeting face-to-face at corporate headquarters. I probably average five days per month of business travel.
Rotonti: How often do you do media requests and CNBC interviews?
Nygren: I do CNBC interviews not quite monthly and perhaps additional media requests once to twice a month. CNBC is particularly convenient as the studio they tape from is just down the street from our office. I'm always ready to talk to reporters or podcasts on topics like stock selection and value investing. Our marketing department is very good at getting multiple uses from each interview.
Rotonti: What is your five- to seven-year outlook on the Chicago Cubs?
Nygren: Certainly, the hoped-for dynasty following winning the 2016 World Series didn't materialize! Nor did the "tweak, not a rebuild." But they've been stockpiling talent for several years and finished last year well. Before the 2022 All Star Game, the Cubs were 35-57 (.380). Post the All Star break they were 39-31 (.557). Their second-half win percentage was better than the full-season percentage for either the Phillies or Padres, the two teams that played to represent the National League in the 2022 World Series. I'd like to think that the Cubs could be .500-plus for the full 2023 season and maybe make the playoffs, then make a deep playoff run in 2024.
Rotonti: What is your favorite wine?
Nygren: You're hitting all my hobbies! My favorite wines are made in California and Oregon. I prefer the small producers to the corporate-owned wineries. It's just more fun when you can get to know the people who have bet their livelihoods on making great wine. It is impossible to pick one favorite because each different varietal can be perfect for the right occasion. The wine that tastes great sitting on your porch on a 90-degree day isn't going to be the one you'd pick to have with a steak dinner. Three lesser-known wines that I love are Audeant Pinot Noir Willamette Valley, Cattleya Call to Adventure Chardonnay, and Zeitgeist Cabernet Napa Valley. I'm a value buyer of wine, just like stocks, so all three of those are well under $100 per bottle.
Rotonti: What is your favorite thing to do in Chicago?
Nygren: I mostly work when I'm in Chicago. I spend the majority of my free time in Southwest Michigan where I find relaxing comes more naturally. I love getting fresh produce at the local farms, the Lake Michigan beach, and bike riding on less congested roads. I can be very happy effectively doing nothing. It's starting to get cold in this part of the country so I'll start a fire in the fireplace and watch college football on a Saturday afternoon while paging through Value Line.
Disclosures
The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change and may change based on market and other conditions and without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.
Certain comments herein are based on current expectations and are considered "forward-looking statements." These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.
Portfolio holdings are not intended as recommendations of individual stocks and are subject to change. The Funds disclaim any obligation to advise shareholders of such changes. Information about portfolio holdings does not represent a recommendation or an endorsement to Fund shareholders or other members of the public to buy or sell any security contained in the Funds' portfolios.
