Part III: Sleeping Well, Market Outlook, and a Return to Normality
TMF: You've said before that investing keeps you engaged 24 hours a day. Is there anything investment-related that keeps you up at night or that has ever kept you up at night?
Nygren: I would say no. I'm a good sleeper. I think the process that we have is of being a risk-reducing process. There's less risk because we start at a lower price to value. There's less risk because our value is growing in a way that time can bail us out of mistakes that we make. Our process is less risky because we're identifying managements that are on our side.
So when we make mistakes, they are not usually as costly as they are for someone who uses a value or a momentum style. I think the consistency of my personality, with the investment approach that we use here, and my confidence in all the professionals that I work with at Harris Associates and Oakmark, I feel like we're always doing the best that we're capable of. I work with people who understand we're going to make mistakes. We expect them. We try to minimize their cost when they happen. We don't have anybody living under threats of things happening to them if mistakes happen. That's a culture that will encourage people to not admit to mistakes, and then allow them to become costly before they can be dealt with.
So no, I don't lie awake at night. I do think about investing most of the time I'm awake. I have always said that I think it's more important that someone's mind is constantly engaged in thinking about investing than it is actually spending time in the office, even though I do spend normal office hours in the office all the time.
Our firm has never been part of the culture of an investment person needing to be in the office 60 or 70 hours a week. We tend to be pretty much a 7:30 to 4:30 sort of shop. People go home, and they coach kids' sports teams and spend time with their families. But that doesn't mean they've stopped thinking about investing. Because so much of this job is trying to think, trying to understand, trying to see why things happen the way they do. Sometimes that's easier to do if you aren't sitting behind a desk and reading all the same publications that all the rest of us read anyway.
TMF: That sounds like a very healthy approach. But there are some investors out there who are kept up at night, given the market's fall over the past couple years. Is there reason to be afraid at the market's current levels?
Nygren: I guess I don't like the term "afraid." I don't think the market is at an unusually high risk. I don't think the market is priced in a way that makes it seem that there's an unusual amount of downside risk. If we think back about where we were four years ago -- a great environment to be a value investor. You had an overpriced market, yet the average stock was cheap. Even though the market was at 25 or 30 times earnings, it was there because the biggest cap, best growth companies were at ridiculous prices, while lots of mundane, traditional businesses were selling at 10 times earnings.
The tough years for us were '98 and '99, when we were only making a little bit of money, and everybody else out there was making tons of money for their clients. It got easier as the market started to come down and our stocks were going up. The cheap stocks went up; expensive stocks went down. That convergence was great for value investors, including the Oakmark family, from 2000 through about mid-2003.
The last year or so has, I think, been a very frustrating time for value investors, including ourselves, in that stocks haven't seemed to be overreacting by as much to create these great new opportunities. And it's hard to find the average business that's selling at half the market multiple. What has become available, though, is these great businesses -- McDonald's
Today, many of these stocks -- because of this convergence -- are available basically priced as if they're about average. Stock selling at 18 times earnings isn't something that usually gets a value manager very excited. We're more used to saying, if the market's at 18 times earnings, this stock that's at 8 times really ought to be at 14 times. But to buy the really great businesses at less than 20 times earnings in an environment where your alternative is a bond that pays about 4% for seven years, I still think equities are a great alternative to that. And I think we're likely to have a reversal of perhaps the last five years.
For the last five years, market returns were lousy. But it was relatively easy to perform very differently than the market either direction. I think the next five years we might have reasonably decent returns out of the market. Maybe not double digit, but still better than you could do in almost any other kind of investment. Earnings grow 5%, 6% -- 2% yield on top of that. If P/Es don't change, you're at 7% or 8%. I think the market is at 16 times consensus on next year -- doesn't seem like a crazy number. So unless you're really betting that long rates go way up, I think the market return looks like it could be decent. But I think it's going to be hard for people, through their investment style, to add significant value.
TMF: That's very interesting.
Nygren: So an index fund stunk for the last five years. I think it is going to be a much tougher competitor for the next five years. It's tough, when you start going down the list to these big-cap names that make up a great deal of the weighting of the S&P 500, and kind of one by one you say either they look fairly valued or a little bit undervalued. Whereas five years ago, you could go down that list and say this one looks way overpriced compared to this group of companies. That's hard to do now. If you concede that most of the largest names in the S&P look appropriately valued, it then becomes very difficult to stock select your way to tremendous performance.
TMF: Do you think that is reflected in the large cash holdings of a lot of your peers (Longleaf Partners Fund, the Clipper Fund, FPA Capital Fund, Berkshire Hathaway
Nygren: I think so. Part of it comes down to the question of if you can't find the incredibly cheap names, what do you want to do with your money while you wait? I would much rather today wait it out, owning the strong growth, high-franchised value, good structural competitive advantage companies that are selling at high teens multiples, as opposed to putting that money into cash and betting that I'm going to get a much better opportunity quickly. As each year goes by with corporate earnings going up 5%, 6%, and dividends exceeding the interest rate on cash, the people who have made the bearish bet, fall farther and farther behind the more time progresses.
TMF: Since you don't see much downside in these stocks....
Nygren: Right. If the S&P was at 30 times earnings and these big companies were selling at multiples that we thought didn't make sense relative to the interest rate environment -- or if we had the conviction that some of our peers do that the long bond is going to go way up and that the rate on the long bond is going to go way up -- we would not put names we thought were fully valued or overvalued in our portfolios. To think that while we wait for mundane businesses to be at single-digit multiples again, we own great businesses that are growing faster than the market and that the market doesn't look overvalued -- I just think that's the preferable alternative.
TMF: You've been doing this for 20-plus years, so you've seen a lot of different periods in your life. Would you say this period is showing that maybe investors have learned some lessons, or is this just an odd period of fairly rational pricing going on?
Nygren: I think it's a little bit of both. I think a lot of us value investors got spoiled by the environment of the last five years. It lasted so long. It was no fun while it was lasting and lasted so long that it felt normal. And really, the environment from like '98 to 2002, in a lot of ways, is one of the most bizarre periods certainly in my career. I think you could go back a lot longer than that -- where investment style alone told much more about your returns than whether or not you're invested in the market. We got so used to that, and you started having everybody become obsessed with which style box is a manager in. Because that was all that mattered. It would kind of make sense to me that -- maybe going forward -- that thing that everybody is focused on isn't going to make as much difference as it did looking backward.
But clearly, in the bubble of 2000, most investors strayed away from valuing businesses based on fundamentals, and they got hurt. I think that has brought a lot of focus back to fundamental valuations (justifying stock prices based on fundamental business valuation).
You see it in the reports out of Wall Street, where five years ago you were seeing the reports that said, "My DCF can only justify a value of 100 for this company, but I still rated to buy at 300." Today, the reports say, "We've just reviewed the 10-Q, and here are a couple of the interesting tidbits that we found out of the 10-Q." Five years ago, nobody was even looking at a 10-Q. So yes, there is a renewed fundamental focus, but I think this is more normal than an outlier, even though it's very different than what we've been through for the last five years. Because normally, what matters most is that somebody invested in stocks or not.
What matters most next is did they use a value style -- what kind of fundamental characteristics did their portfolio show of prices relative to growth. And then stock selection within the style was sort of third. And I think that's the environment we're in, where a good growth investor might be able to do better than a bad value investor. Or vice versa. Again, if you were a value investor from 2000 to 2003, whether you were good or bad, you did well. And whether you were good or bad in '98 and '99, you did poorly. Picking the box meant more than whether or not you selected a highly skilled practitioner from that box or a less-skilled practitioner.
To read more about Bill Nygren's views on investing and the market, see the interview series:
- Master Value Investor Tells All
- Is Time Warner Undervalued?
- Nygren's Master List
- 5 Stocks for the Next 10 Years
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