Profit Guru Bill Nygren

8/14/2019 Profit Guru Bill Nygren

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calm andcollected

th urr rk uri hs hrw up f irsig ppruiis,

sys Bi nygr f okrk S Fumh ekru Hqu & n mhkshi



59

12 December 2008 Oulook PrOfit

The only investors who belong in the stock marketare investors who can take a long-term time hori-zon,” declares Bill Nygren, und manager o theOakmark Fund and the Oakmark Select Fund.

There’s no time like the present to drive home the truth o that statement. Even as short-sighted investors stampede

or the exits amid a growing global nancial crisis, valueinvestors like Nygren, 50, are gearing up to do what theydo best – buy into undamentally sound, long-term busi-nesses at relatively cheap prices.

Nygren’s rst brush with the world o investment tookplace at Northwestern Mutual Lie, which he joined as ananalyst in 1981. Two years later, he moved to investmentrm Harris Associates. Today, Nygren is director at therm, and his career graph depicts a steady climb. It wasater being named director o research in 1990 that Nygrenpushed his rm to create a und that would manage assetsin a much more concentrated ashion than those handledby other money managers. That idea came to ruition in1996 when the Oakmark Select Fund was created.

Interestingly, Nygren never promised extraordinarygains rom his unique style o investment: instead, he toldhis bosses that over the next ve years, they could prob-ably hope to see one exceptionally good year, one year that would ‘hopeully, not be horrible’, and threeyears o mediocre returns. Happily or ev-eryone involved, the und experienced veexceptionally good years: since inception, ithas handed in a 29 per cent return (annu-alised) compared with the S&P 500’s 11.5per cent and 16.8 per cent a year return orthe S&P MidCap 400. In act, so impressive was the und’s perormance that it rankedamong the top 1 per cent o all unds trackedby Morningstar, a und tracker, during

the period.To date however, the und’s perormanceis more modest, but still creditable with an11.9 per cent return (annualised). As o to-day, Bill manages $3.6 billion worth o assetsunder the Oakmark Fund and $2.5 billion inthe Oakmark Select Fund.

Nygren’s investment style is simple: hebuys stocks when they all to or below 60per cent o the estimated business value and sells them when they hit 90 per cent. To calculate business value, heuses the discounted cash fow (DCF) method, eschewed byother value investors. He says, he understands the prob-lems in depending solely on DCF to estimate business value, but points out that his rule about buying only when

stocks all to 60 per cent o business value itsel oers acushion against making grave mistakes in calculatingbusiness value.

Nevertheless, this astute investor has made his shareo mistakes. Ater the tech bubble (which Nygrendid not participate in) burst, value investors ound ahappy hunting ground in nancial stocks. Many o them believed that these stocks were intrinsicallyhigher than the prices they were trading at. Nygren wasone o them. But that was a bet time proved wrong, as therisks attached to these stocks were ound to be greatlyunder-estimated.

Nygren had bought into regional bank Washington Mu-tual (WaMu) enthusiastically (at one point, the stock ac-

counted or 15 per cent o Oakmark’s portolio), promptedby bullishness on the institution’s retail asset base whichhe thought was not ully valued by the markets. Whenthe credit crisis ripped through the nancial sector, the

bank’s operations crumbled and it had to le or bank-ruptcy. Nygren openly admits he made a mistake with Wamu. “Selling was the right decision, but by the time wesold, the damage had been done,” he wrote in his latestund note to investors. Ironically Wamu’s retail bankingassets were sold to JP Morgan (another Nygren hold-

ing) beore it went belly up. In an interview with OutlookProft, Nygren explains what went wrong with Wamu, hisoverall investment strategy and his take on the US econo-my and stock markets.

What is your prediction or the US stock markets ?I think it’s very hard to predict what is going to happenin the short run; the longer you stretch your horizon, theeasier it becomes to orecast. I you think about a ve-year time rame, it’s sae to assume that P/E ratios goback to normal and it’s pretty easy to assume that theeconomy will go back in ve years to something resem-bling normal growth rates. In 2009, it is easy to assumethat corporate earnings will be down a little bit and may-be even that investors will award an above-average mul-tiple to earnings, but I have a very hard time making thatprediction.

Thinking ve years ahead, I think corporate earnings will be higher, P/E multiples or the S&P500 will be higher and that will create verygood returns rom the US stock markets.These returns will oer a very substantialpremium relative to xed-income markets,especially treasuries. So we think this a very attractive opportunity or investors tocommit new capital, with the caveat that investors who worry about day-to-day pricefuctuations should stay away. Regardless o the opportunity, the only investors who be-

long in the stock market are investors whocan take a long-term time horizon.

Where do you see value emerging in the USequities now?First, I’d like to say that I nd the S&P 500attractive across the board. To me, this isnot a time when only one or two sectors arecheap and the rest o the markets are air-

ly valued. This is a time when most large-cap US stocksappear to be selling well below business value.

In concept, I would say the characteristic that is mostovervalued in today’s market is saety: look at treasurybills that yield almost nothing and how large the premi-um is or holding long-term corporate bonds instead o

long-term treasury bonds. Within equity markets, compa-nies that have perormed the best have been those thathave seen the least volatility in their business models. Ibelieve it is becoming increasingly dicult to justiy own-ing those stocks versus the rest o the market where pric-es have come down sharply.

Could you elaborate on your investing strategy?There are three things that we look or when consideringinvesting in any company. First, the stock price should beat a signicant discount to the intrinsic business value.To us, the intrinsic value would be the highest price anall-cash buyer would pay or the entire business and stillmake a reasonable return on investment. For most large-

cap companies that we invest in, it’s not very dierentrom estimating the discounted cash fow (DCF) to esti-mate the intrinsic value o the stock. For smaller com-panies, it could end up being dierent as we explicitly

This is anattractive

opportunity tocommit newcapital, with

the caveat thatinvestors who

worry aboutdaily price

uctuationsshould stay

away



consider the synergies a buyer o the entire businesscould achieve. For large-cap companies, we basically look

at a price that is at a signicant discount to the DCF valu-ation. Our basic strategy is to buy a company only when itis trading at 60 per cent o its value and to sell them whenthey achieve 90 per cent.

The second criterion is that a company’s growth plusdividend should at least match the gure or the market. We don’t care in what orm our returns come, via growth orcapital gains, but we want the combination between divi-dend yield and expected growth in business value to atleast match what we receive in the S&P 500.

The third thing that we look or is companies that view their shareholders as partners. We like them to think asowners and not proessional managers and that especiallycomes into play when they consider business opportuni-ties. Whether it’s about selling business units or perhaps

even the entire company or re-purchase shares versusmaking acquisitions to grow the business, we want man-agement to take the course o action that maximises pershare business value. We also want them to eel the responsibility o communi-

cating to us, the owners, as candidly as possible and oertimely explanations o results without hurting their com-petitive positions. It’s only when we have all these things– a discounted value, a value that is growing over time anda shareholder-oriented management – that we can take along-term time horizon that gives value investors a signi-icant advantage, because the longer it takes or the stockprice to catch up with the business value, the higher thebusiness value will be.

You have said that you look or businesses that haveachieved large increases in value and whose stockshave under-reacted. How do you identiy and measure

this increase in value?Generally, this would be either a corporate event (such asa division sale), improved earnings or improved balancesheet. Value change resulting rom transactions is a goodhunting ground because changes in value can be large– and can happen quickly. Measuring how value chang-

es rom balance sheet improvement that occurs overtime requires simply looking at the change in net debtper share. An improvement in earnings per share is equally easyto measure, but then some judgment needs to be ap-plied to determine whether or not the improvement issustainable. Corporate transactions involve comparingproceeds rom a division to its estimated value whileacquisitions require examining both the acquired proper-ties and the consideration given in return (or example i stock is issued, one has to consider whether it was issuedat a premium or discount to the intrinsic value).

In the end, value estimation has to be an ongoing pro-cess, and always requires estimating the value o each as-set a company owns, subtracting claims that are senior toequity against those assets, and dividing what remains bythe share base.

A lot o value investors believe the discounted cash flow(DCF) method is not a good way to calculate growthrates or the near and long term. What do you think andhow do you calculate value?I think the most important thing is to use multiple meth-ods o valuation and make sure they converge to the samebusiness value. DCF is denitely not an exercise in pre-cision, that’s why we demand such a high gap versusour business value estimates. We approach it by lookingat comparisons o similar businesses that have been ac-quired, the price-to-sales ratio it was sold at, the price-to-

cash fow, P/E, P/B etc. We try to nd the metric buyers in that industry wouldtypically use to identiy business value. We look at wherecomparable companies are trading in the markets and welook at a dividend discount valuation. I you see radicallydierent gures o business value with dierent meth-ods, that’s a good indicator that some o your assumptionsare inconsistent between models. In act, by looking atmultiple models and orcing them to come to similar con-clusions, I think we probably decrease the probability o having one minor error infuencing our business valueestimates too strongly.

How much weight do you give to past fnancials andtrack records?

Every time we look at a business, we try to ascertain how sustainable their results are: a company that has a goodtrack record earns a substantial premium to its cost o capi-tal. Beore we orecast that to continue, we have to be as-sured that there is a sustainable competitive advantage. Theeasiest example o that would be branded consumer prod-ucts. A brand is a very valuable asset, but is usually not onthe balance sheet. We do study historical track records, and I would say that

it is a very good way o judging the management team. Welook or companies that try to maximise business value orshareholders. We also look at not just the records the manag-ers have in their current jobs but also in their previous ones. When the CEO brings in a new CFO, we look at how capital

was allocated at the rm where the CFO came rom.I the management team has been working at the samecompany or a long time, then we would give more weight tothe long term-track record o the company.

Oulook PrOfit 12 December 2008

0

Po GuuPo Guu

8 On BAR AC K OB AM A

Look ingat Obama’s advisors , I think, t hey will ensure

w hatever policies come out of t he Obama administ r a

tion donot hav e unintended negativ e consequences on

the mark ets

8 On M ARK ET S FI VE Y EARS F ROM N OW

Corpor ateearnings will be higher, P/ E multiples f or the

S&P 500 will be higher and that w ill cr eate ver y good

r etur ns and oer a ver y substantial premium relativ e to

x ed-income mark ets

8 On H IS I NV E ST ING STR AT EGY

Basic strat egy is to buy a company only when it is trading

at 60 per cent of its value and tosell when they achiev e

90 per cent

8 On VALUE IN VESTORS

“Value investors usually have sus picions about the

ability of com panies t o perfor m d r amatically better

than t heir com pet itors. The y don’t l ike t o pro ject s

per nor mal grow th f or v ery l ong and that makesit

much harder to j ustif y pa ying above-aver age mul tiples

Nygren Says



What competitive advantage should a company pos-sess? Which ones are the most sustainable?Competitive advantages can arise in many dierent areas.The most requent kind is a proprietary product, which isdemonstrated by patent protection. A strong brand nameis another obvious advantage. Less obvious, and harder to

maintain, are corporate cultures or low-cost production.None o these appear as assets on the balance sheet, sothey are not refected in any statistical analysis.

Basically, any company that earns an above-average re-turn on assets either has a competitive advantage or isearning above its sustainable rate. It is our job to decide which one it is.

What are your criteria or selling stocks? When the price goes up to 90 per cent, that’s the easy one!Our sell criteria are the opposite o our buy criteria. Whenthe company perorms undamentally as we expectedthem to, its business valuegrows as we expected it to,the stock price grows evenaster and eventually goesup to 90 per cent o our es-timate o business value,then we sell it and start over.The other two criteria comeinto play more oten when we are selling our mistakes,that is, where ater a year ortwo o owning a stock, weare no longer as condentas we were when we pur-chased it.

It could also be becausethe managers are not really

behaving like the owners o the business or because thecompany is not achievingthe undamental resultsthat we had anticipated and we are no longer condentthat it will achieve above-average, long-term growth.I think it is important orinvestors to have the disci-pline to sell.

Do you average down your purchases (buy again whenthe price is lower, so the average buying price or theentire lot dips)?

We don’t have a specic rule on that. I the stock pricegoes down and our estimate o business value is grow-ing, we would generally add to the position but reallya decision on whether to add to our position or not isdriven by how large the discount is to our estimate o un-damental value.

What is the maximum earnings multiple you would be willing to pay or a company with promising growth? We don’t really have a maximum multiple. But that doesn’tmean we would be okay with paying something like 30times earnings. We try to come up with multiple modelso business values so we are not strictly driven by P/E ra-tios. To pay a very high P/E ratio, we would have to believe

that there is something else happening undamentally tothe company, so the earnings now is being dramaticallyunderstated. I think, like most value investors, we don’tlike to project supernormal growth or very long and that

makes it much harder or us to justiy paying above-av-erage multiples. Value investors usually have suspicionsabout the ability o companies to perorm dramaticallybetter than their competitors.

How do you identiy and avoid value traps?

To me, a value trap is a stock that looks cheap today, butas time marches on, the value declines and the stock re-mains at a discount. One way we try to avoid such traps isto pick investments that are expected to grow in value atleast as ast as the average stock. Many times, value man-agers are attracted purely by statistical cheapness (suchas low P/E, low price-to-book or low price-to-sales). Moreoten than not, businesses selling at the lowest valuationsare structurally disadvantaged, and their best days arebehind them (oten demonstrated by persistent declinesin market share). Such businesses are unlikely to passour hurdle o achieving at least average expected value

growth.

How do you see the US cor-porate earnings growingin the next fve years?I you look over a long term,corporate earnings havebeen able to grow severalpercentage points higherthan infation and i youthink o infation at 2-3 percent, I believe it is reason-able to expect corporatelong-term earnings at 6 percent although who knows what is going to happen overthe next ew months? The

economy has really sloweddown but i you think aboutthe next ve years, it makessense to think about whatis normal growth and sev-eral points above infationis what it has been or S&Pearnings growth.

Your reading o fnancialfrms seems to have gone

wrong recently. Can you tell us what caused that?The biggest thing that we have seen hurt the US is the very large decline in US home values. Home values, his-torically, in the US, have been viewed as stable and we

have never witnessed a period where nationwide priceso average homes declined so signicantly. And that haschanged a lot o things. From the peak o the housing mar-ket a year and a hal back, home prices have allen by 15-20 per cent and most analysts are o the view that they aregoing to all urther. The whole history o home mortgagesis that i you lent 80 per cent or even 90 per cent on the value o the home, your losses would be tiny.

Even i the borrower was not able to pay, the value o thehome was strong enough, so the lender o the loan lost very little money when he/she re-possessed the home. Ater prices ell by 20 per cent, that changed drasticallyand banks ocused more on the value o the collateral i.e.the house rather than the ability o the borrower to pay.

So they witnessed very large losses. Now, across all typeso investment portolios, there has been a re-assessmento what the appropriate level o mortgage holding shouldbe. Because these holdings proved riskier last year than

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12 December 2008 Oulook PrOfit

Any company that earns an above-averagereturn on assets either has a competitive

advantage or is earning above its sustainablerate. It is our job to decide which one it is



the years beore, anybody going through that reassess-ment has decided that they should be holding less mort-gages than they now do and I believe that has resulted ina wave o selling in the mortgage market. Some o it wasundamental but a large part o it was orced selling bycompanies that had lost money on mortgages that were

leveraged. And even though they think mortgages areundamentally inexpensive today, they still have to sellthem. Eventually, the supply-demand balance will returnto our mortgage market and when that happens, mortgageprices should return to their undamental values, whichis a discounted cash fow value oering an appropriatepremium to treasuries. And I believe this will happenrelatively soon.

What went wrong with the Washington Mutual bet? Washington Mutual was held in all the three unds I co-manage. We sold our position during the quarter whenit appeared that regulators were increasingly looking atmark-to-market implied losses, which eliminated thechance that Washington Mutual could, over time, earnback its mortgage losses. Selling was the right decisionbut by the time we sold, the damage hadbeen done. Owning Washington Mutual was a big mistake or which I ully acceptresponsibility.

Though we believed home prices hadbeen rising at an unsustainable pace, wetook comort that previous home pricebubbles had corrected with home pricesplateauing or several years rather thanalling sharply. Expecting that to contin-ue, I took too much comort in the act thatthe overwhelming majority o mortgages Washington Mutual owned had balances o

less than 80 per cent o appraised value. Be-lieving that the collateral was so valuable, I wasn’t as concerned as I should have been with sotening underwriting standards. A-ter all, i the borrower deaulted, the housecould still be sold or more than the mortgage debt. Ater nationwide prices ell by 20 per cent – and urther

in hot markets – the collateral was no longer worth morethan the loan, and serious losses resulted. A mortgage mar-ket previously viewed as secure became very risky. Sellersfooded the market, and prices ell sharply. Because o itsleverage, Washington Mutual’s assets, marked-to-market, were no longer greater than its liabilities.

Ironically, the asset we’ve always believed was underappreciated, its strong retail deposit base, is now owned

by another o our holdings, JP Morgan. Though there aremany lessons to be learned rom this error, perhaps themost important is that in today’s economic climate, weneed to consider a broader array o outcomes than we previously considered, especially or companies that employnancial leverage. As we consider the mistakes we have made recently, as

well as the rapidly weakening economy, our ocus is in-creasingly on the strength o the balance sheet. We don’tknow what the magnitude or duration o this economicdecline will be. We want to make sure that the increasinglyattractive stocks we purchase have the nancial strengthto make it through to the recovery.

When do you think housing prices will stabilise?That’s awully hard to guess over the short term, but overthe long term, there continues to be growth in the popula-tion segment that owns homes. There is continuous im-

migration into the US o people who have the means tobuy single-amily homes. So in the long term, there will bedemand or such homes. Eventually, we will work our waythrough the excess supply we see today. The people whodeaulted on their single-amily homes still need a placeto live – it’s just that they will probably end up renting a

house rather than owning one. The market will continueto stabilise and rom that level, it will continue to grow.

Do you expect them to all more in the next one year? We have a utures market in the housing sector or people who want to speculate on short-term housing prices andthat says prices will continue to all over the next year. Butshort-term price speculation is really gambling. When you start making long-term orecasts, that’s when

you have the laws o economics working in your avour –supply and demand will return to balance, corporate pro-its will return to levels that justiy capital expenditureson those businesses and stock prices will return to levels where they provide an opportunity return relative to thatoered in the bond markets. When we think long term,there is a basis or statements talking about what direc-

tion stock prices should go.

Most value investors don’t like the ideao heavy debt and tend to avoid bankstocks because the business allowsor high leverage. Should bank stocksshould be valued dierently? You can look at the book values o bankstocks, then look at how much their lia-bilities are overstated because the cost o their deposit base is much lower than thecost o debt. Ater that, look at the assetsand see i they are valued on the balance

sheet at prices that refect real econom-ics. Then you must make a reasonableestimate o the adjusted economic book value that incorporates the value o thedeposits, and the premium or discount

on their investment portolios.From that level, it is very hard to justiy a signicant pre-

mium because banking is a very competitive business butthe value o a strong deposit base is a very big positiveor the banking industry. The deposit base is a signicantasset that makes these companies worth more than theirbook values in the long term. And the other point I willmake about nancials is that many companies are gettinginto territories that the banks had operated in and theyunderestimated the risk levels.

It will be a long time beore they return to compete withbanks, so I think this is the kind o environment wherestrong banks will become stronger and there are a lot o US nancial companies that appear to be attractive investments today.

What books are you currently reading? Anyrecommendations? As a value investor, I’m drawn to anything written by Warren Buett. I nd his thinking to be clearer thanthat o almost any other investor. Plus, he’s a very en-tertaining writer. I also suggest books that have sepa-rate chapters on many great investors. John Train’s

Money Masters is a good example. Ater reading several

such books, one can see that numerous approaches cansucceed, but one also sees the commonality o intense e-ort and discipline that is required to become a successulinvestor.p

Oulook PrOfit 12 December 2008

62

In today’seconomic climate,

we need toconsider a broaderarray o outcomesthan we previously

considered,especially or

companies that

employ fnancialleverage

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Profit Guru Bill Nygren