An Interview With Clyde McGregor, Portfolio Manager, Oakmark Equity and Income F
by Maria Crawford Scott
When markets turn choppy, some investors turn to balanced funds for more stability. Last year, while the S&P 500 was down 11.8%, balanced funds on average lost 2.7%.
On the other hand, the returns of balanced funds are not often thought of as particularly impressive compared to their 100% equity counterparts.
One balanced fund that has fared particularly well over the long term is the Oakmark Equity and Income Fund. The fund was among the top 25% of all balanced funds for the last year, three years and five years for the year ending December 31, 2001. The fund also managed to return an impressive 18% during 2001.
Most funds with the name equity-income tend to be primarily equity funds that focus on dividend-paying stocks. However, Oakmark Equity and Income is a balanced fund, maintaining roughly a 60%/40% stock to bond weighting, and its stock holdings are not required to be dividend payers.
Currently the fund has about $1.2 billion in total assets.
In early January, portfolio manager Clyde McGregor discussed the management of the fund with Maria Crawford Scott.
What is the investment philosophy and objective of the fund?
All of the funds we manage use a deep value approach. The only different aspect of the Equity and Income Fund is that it has a stated obligation to own bonds–it is truly a balanced fund, with roughly a 60/40 philosophy–60% stocks, 40% bonds. That varies, of course–our stocks will vary between 50% and 65%. Right now we are at 60% stocks, although we've actually been above that level for most of the period since September 11. We were as low as 53% at one point a couple of years ago.
On the equity side, we build from the bottom up, so our commitment to stocks is more dependent on our ability to populate the portfolio with deep value stocks.
We look to invest in companies that are selling at a discount to their intrinsic value, which means paying no more than 60 cents on the dollar. Second, we want to buy the shares of companies whose intrinsic values are growing–which is how we avoid value traps. Third, we look to invest in companies whose managers treat their shareholders more or less as their partners.
Another way I think about our approach is: Would I buy the shares of XYZ today at its current market price if I were buying the entire company and could never sell it again? That's the short summary of how we do the equity side.
On the fixed-income side, we have a minimum, stated in the prospectus, of 25% of the portfolio in U.S. Treasuries, and that is strictly Treasury securities, not agencies. We could potentially go as high as 50% in Treasuries, so on the fixed-income side the biggest piece is always going to be straight-old U.S. Treasuries. Half of the Treasuries today are in the Treasury's inflation-indexed bonds, which are a little bit more idiosyncratic than straight Treasuries, but they're still obligations of the U.S. Treasury.
We do have some agency issues, but they never make up more than 3% of the portfolio. And we can go as high as 20% in high-yield bonds. I would like to own a lot more high-yield bonds today, but right now they only make up 2% of the fund because we can't find enough high-yield bonds that meet our criteria. When we invest in high yields, we virtually never invest in new issues. What we are interested in are companies that have come through reorganization, are on the upward trend and are current on their debt payments, but where the rating agencies, which tend to move slowly on upgrades, have not yet recognized this.
We also do a tiny amount of interest rate anticipation in the Treasury portfolio, but for the most part it's a far more passive approach than the stock side.
In terms of the objective of the fund, do you go into the fixed-income portion primarily to generate income, as opposed to using it for risk reduction?
Yes. It's not the return-oriented part, but rather the income-oriented part of the fixed-income market that attracts us.
Yes, they are a consideration, but they're not required. One of the things I observed that was already taking place when we started the fund in 1995 was that an increasing proportion of our value ideas were non-dividend-paying stocks. In the 1980s, most of our value ideas were dividend-paying-stocks, but by 1995 it was clear that if we constructed this fund to be only dividend-paying stocks, we were going to severely limit ourselves relative to the investing universe that we were finding attractive. As it's worked out, our five best ideas in the history of the fund were all zero-dividend-paying stocks. We have not been able to find a wealth of good income-producing stocks to populate the portfolio. I would say at least a quarter of the stocks in the portfolio are zeros on the dividend side.
Now, I don't like that outcome at all–I would like to be generating more income for shareholders who are interested in that. We have income in the name for a reason, and it bothers me that we haven't done as well on that side.
But times have changed. Twenty years ago, you would have had a bunch of utilities in the portfolio. Well that's been a very interesting and rapidly evolving area in the last few years–and thankfully, we didn't have much exposure there. On the electric utility side, you've had these companies going into deregulated markets, buying operations in Europe, and I, at least, am not confident that these people are fully on top of what they're doing–that's not what you want to go into if you are trying to put a margin of safety in the portfolio.
That isn't to say that I won't own stocks that are "risky." Some people would say that Novell, which is a good-sized position in the portfolio, is a very risky stock. But there we have $3 per share of balance sheet values in cash and real estate that isn't reflected in the stock's price. So we feel the margin of safety is much greater in a situation like that than it is in a rapidly evolving electric utility company, even if it has a pretty stable cash flow.
What we always try to do is to gather yardsticks or measuring tools from people who are within a business or industry. Multi-industry companies tend to be ones that work very well for this fund because they often have a variety of operations that when taken together as part of the total corporation are underpriced, but individually they would add up to a sum that is far higher. But the question becomes how do you measure the value of these individual operations?
My best example here is one from the past, way back when Bill Smithberg was the CEO of Quaker Oats. One day he said to us, in a one-on-one meeting, that he was willing to pay one times sales for any good regional brand that he could flow through his national distribution operation. Now, that to him was so obvious that it was a throw-away line. Yet to us, it became the basis for our making some very successful investments in the food industry in the late 1980s. And Wall Street didn't understand that kind of math.
That's a dated example, although it is the simplest. Right now, we think there's an opportunity in the energy industry. Now, a lot of value investors have moved to energy because the stocks are down. But that's not why we are in them. Instead, we are constantly evaluating the balance sheet values of energy companies versus the futures curve for oil and natural gas.
Most of the time we find that it is cheaper to prospect for oil in the futures market than to do so by buying the common stocks of companies available to us. But right now, the opposite is the case–stocks are cheap versus the futures curve, as equity investors are implicitly forecasting that the futures curve is too high and that the oil and gas prices are going to come down.
Now, that may be the case–I don't know how to forecast much of anything, including the price of oil six months or a year out. But we're just making a naïve statement that we can buy Burlington Resources, which is a pretty good sized holding in our fund, and liquidate it against the futures curve tomorrow at a profit. What we're getting is: 1) that discount, and 2) an option on the price of oil and gas in the future. Normally, the stock market is willing to pay a lot for that option. We normally see oil and gas companies trading at 20% higher than their liquidation values.
When we can find these instances of inefficiency, we study them and if we decide it's an overreaction to recent trends, we go in there.
We go wherever value takes us, and value takes us in directions we don't expect based on our ability to get these measuring sticks that are working for a moment in time.
In the last year, when the technology sector was getting battered, we found that there were a number of software companies that had wonderful balance sheets, and that had stable or improving business prospects. Synopsys and Novell were the two that we ended up placing in this portfolio. In both cases, there was no debt on the balance sheet, solid cash per share and the cash per share was actually growing rather than shrinking.
Novell has been an okay stock for us, Synopsys has been a great stock. But this is an area not normally associated with value investors.
We have been finding more of what we at least perceive to be opportunity in what I would term "broken growth stocks."
International Game Technology, the slot machine company, is another special case, which we bought after September 11. Everybody thought the world was coming to an end for the travel industry. But we looked at that, and the reality was that 80% of their sales go to casinos that people drive to. So we thought: Is that business going to go away? We actually thought that people might do more of that kind of traveling as they were doing less flying. And I actually played a slot machine for the first time in my life in August just to see what it was like.
No–and that's when I realized what a great business it is for the casinos and IGT! I got ahead at one point, then quickly went through about $80 and thought: "This is really something. I'm done. I'm out of here!"
I lose money through occasional stupid investments for myself, but throwing money into that machine was a real eye-opener. And seeing all these other people doing it around me, I wondered: Do they really have this kind of money to throw away? But in any event, people apparently do.
We go wherever value takes us.
We pay careful attention to insider buying and selling of stock. But it's more how a company's capital allocation has been executed over the previous five years that we really examine.
Rockwell is great example of this. They paid out handsome, extra dividends to shareholders when they sold an operation. They basically decided that they had an unwieldy conglomerate that no longer made sense under the current economic realities. So they changed that. They spun off Rockwell Collins last year. Collins is the second largest company in aircraft avionics, making things like the control and communications systems inplanes. By carving it into a separate subsidiary, Rockwell enhanced the value of the combined company. We actually still own Collins, as well. But Rockwell, by their capital allocation, demonstrated that they are a management team that we are comfortable with.
A different kind of example, which was a very big help to us in the first half of last year, but now is a relatively small position, is J.C.Penney.
Penney had big management problems for many years. Then, in July or August of 2000, the board of directors announced that the CEO was going to retire and they were bringing in Allen Questrom, who was perhaps the most highly regarded retail turnaround expert in the country. When we saw that–a guy with whom we've been invested in the past, who we know fixes businesses fairly well and does so in a way that doesn't dilute the heck out of his shareholders–we began to look carefully at Penney.
And what we found was that they had this drugstore business, Eckerd, which was worth $20 a share, yet the stock was $10 or $12. So, we were getting nothing for the department store business–actually, we were getting a negative number and we didn't think that it warranted a negative number. Of course, it remained to be proven whether Questrom could make the department services worth anything. But we felt the drugstore business was worth more than the price of the store.
What's happened, strangely, is that the drugstore business has gotten tougher across the board. But the department store business for Penney has every month for the last 10 months surprised the analytical community on the upside in terms of their same-store sales. So it looks like Questrom is working his magic even in a somewhat dreary, tired, 140-year old company.
I don't know what the long-term future is there, which is why we haven't kept loading up on the stock at these higher levels. But by the same token I'm kind of curious to see how it works out. But there's a case where you had a demonstrated history of shareholder unfriendly management, where the directors seemed to be saying, okay, we haven't done a good job in our role here and we're going to see if we can't change that.
We actually got in too early. I think I started buying the stock at $15, we bought it all the way down to $9, and by the middle of last year it was $28.
There are two answers to that question. The easy one is that we'll sell when it hits our sell price target. Our targets are set at basically 90% of what we think is intrinsic value. That enables us to have a margin for error. And of course, that intrinsic value will be growing over time.
By the same token, if the stock erodes back down again to 60% of its then-intrinsic value, we're willing to look at it again, to go back into it.
Frankly, the way that we prefer to sell a stock is when we get a takeover offer, which was part of the reason why we had a good year last year. We had our two largest companies receive takeover offers. We also maintain a long list of reasons to own the particular securities that we hold. And when the reasons that support our understanding of the intrinsic value of the stock begin to be eroded away, we sell.
A good example of the reasons to own getting violated happens to be Ford Motor Company. We made a lot of money for our clients in Ford in the 1980s and got out in 1989 when our list of reasons to own began to shrink. The list went from six original reasons down to three. We saw that and sold the stock and it worked out very well.
Our turnover rate is not very high. But the portfolio turnover ratio in a balanced fund is a bit different than in a straight equity fund. In our case, whenever our Treasuries get to a loss position, which hasn't happened much recently because of the strong bond market, but when they do, we turn them over in order to use the losses to offset any short-term gains we may have on the stock side. So we do tend to be surprisingly active on the bond side, but to no real end, if you will. It's just to produce some losses.
No, because we didn't understand why the stock was doing so well. That was the way we evaluated Enron all along, when it went from $10 to $90.
And in situations where we just don't have a good handle as to what's going on, we don't want to spend our time there.
On the fixed-income side, you mentioned that you like the inflation-indexed Treasuries. Why do you like those better than regular Treasuries?
At a 1.15% inflation expectation over the next seven to 10 years, depending on which issue you pick, we think that that is a prediction that the United States is going tohave an economic future more akin to Japan in the last 10 years than has been the norm for the U.S.
But inflation has never been at this 1% level in our country's history outside of the Depression, where it was deflation.
Is it impossible that that will be the outcome? No. I just think it's highly unlikely. On the other hand, I think that there is far more risk that rates could go higher than the market is saying.
Now, where I'm going to be wrong is if we are in a permanent low growth or deflationary depression here over the next five years. But I don't buy it.
I think that the United States' reaction to September 11 is meaningfully different from what you have seen in Japan-particularly, for example in terms of wrestling with economic problems. For instance, when Japan's economy got bad, their federal reserve actually increased rates for the first year and a half going into their depression. Our Fed has been lowering rates drastically, providing liquidity and keeping the financial system whole. I guess you could say Enron was part of the financial system. But Enron and Argentina don't seem to be having any real impact on our financial picture.
Ten years ago, if South America sneezed or had real problems, our banks were in peril. Today, our banks as a rule look great except for the oddball small ones.
So, I don't see the kind of risk in the environment that the market seems to be predicting.
And if you look at the securities, the downside of owning the inflation-protected Treasuries is, basically, that you earn your three or three-and-a-quarter coupon, and the upside relative to all other bonds, is that it really provides a margin of safety if all of this money that the Fed is pumping into the economy eventually has an inflationary impact.
On the other side of it, I have a promise to my shareholders that we will have a truly balanced portfolio and in our case a portfolio that is heavily weighted toward Treasuries. Treasury yields are quite low, but they are more susceptible if interest rates rise. With the inflation-protected Treasuries, if it turns out that rates go much higher over the next three years, our shareholders will be less injured than would be the case with a straight 10-year bond.