William “Bill” Nygren is a partner with Harris Associates and co-manages the Oakmark Fund, the Oakmark Select Fund and the Oakmark Global Select Fund. He and I spoke about following a disciplined long-term, low-turnover approach to investing in stocks.
—Charles Rotblut

Charles Rotblut (CR): Your management style is a lot different than that of many other mutual fund managers in that you have a five- to seven-year time horizon and a pretty low turnover ratio. Could you explain the rationale?

Bill Nygren (BN): Sure. At Oakmark, when we assess what a business is worth, we’re projecting out for a five- to seven-year time horizon. I think that length of time is important because it allows us to focus on things that today’s short-term-oriented investor is typically not focused on: industry fundamentals and whether the industry is facing headwinds or is benefiting from tailwinds. It forces us to ask, “Is the business a cash generator or a cash user?” If it’s a generator, how might that capital be put to work and what kind of incremental return might the company get from it? If the company is a cash user, what does that mean for either a balance sheet that’s becoming more levered or a company that will need to raise equity capital in the future? Effectively, it’s the difference between reacting to news, like most investors do today, versus thinking as if you were buying a whole business.

I like to say that the way we manage money at Oakmark is that we’re bringing a private equity perspective to public equity investing. Obviously private equity has been very popular lately. You think about the things they do—they are trying to identify a company that might be worth significantly more in, say, five to seven years than it’s currently being valued by investors.

A couple of the biggest differences between how we do it and how private equity firms do it is that we try to identify the companies that already have the management teams in place that will get us to that higher valuation five to seven years from now. Private equity firms have to take control of the company and install their own management; we don’t need to get involved in the management of companies whose stocks we end up purchasing. The second big difference is that private equity firms tend to achieve their returns with leverage; we don’t. We never lever up our portfolio. And then, obviously, there’s a major difference in fees. The typical private equity firm has an incentive fee structure of about 2% of assets plus 20% of the profit; we at Oakmark charge just a fraction of 1% as an asset management fee.

I think that by taking that long-term time frame, we are lessening the pool of investors that compete with us. Lots of people might have the same view of the company five to seven years from now, but since they aren’t willing to invest for that time horizon, they don’t act on the information that gets us interested in a company.

One other thing I should say is that the time frame we use for analyzing the business doesn’t necessarily correlate to our holding period. After we go through the process of identifying companies we think are attractive, we will set a price target, and if a stock achieves that level today, we would sell it. Over the time we hold the stock, we will adjust our price target for changes in business fundamentals, but when our target gets hit, we sell it. If that happens within a year of our purchase, then our holding period on that stock is only one year. If it takes 10 years, then it’s 10 years. The five-year average holding period we have equates to something like 20% turnover of names in the portfolio annually. This level of turnover is just a fallout of how long it usually takes the market to reach the same point of view on a company that we had when we purchased it.

CR: If you bought a stock as a long-term holding, how do you recognize if a mistake was made? In other words, how do you determine that something changed about the business in a negative way versus just realizing that more patience is required?

BN: If a business is achieving the fundamental targets that we had set for it, we will have almost infinite patience. We’ll even have infinite patience with dealing with a stock that has gone down in price. If the fundamentals aren’t unfolding the way we had anticipated, that’s potentially us being wrong in our assessment of the business. A much higher level of scrutiny on the stock occurs when the business fundamentals are differing from what our analysts had projected.

I think a mistake investors often make is reacting to stock price change rather than to a change in the business fundamentals. If the business fundamentals are performing the way you thought they would, and the stock happens to go down in price, then that’s just a better opportunity than it was when you first purchased the stock. If the stock is going down because the business isn’t performing the way you thought it would, that’s probably a mistake—an analytic mistake—and something that you’d be better off selling and moving on to a business that you understand better.

CR: Are there particular metrics you use to judge the fundamental attractiveness of a stock?

BN: There are three things that we look for, that we require before we would call a stock attractive. I guess the simplistic version is that we want a good business run by good people and we want to buy it at a good price. The “good business” to us means that we anticipate the growth in business value per share plus dividends to at least match what we’re expecting from the S&P 500 index. So, today’s expectation, as we talk in July 2015, is probably S&P 500 earnings growth of something like 4% or 5% per year with dividend yields of a little over 2%. So it gets you a combination of about a 7% return that you’d expect from the S&P 500 if the price-earnings ratio doesn’t change. What we’re looking for is per share business value growth and dividends to be at least 7%. That could be a business that isn’t growing, but pays out a 7% or higher yield, or a business that’s growing by at least 7% a year and doesn’t pay a dividend, or anywhere in between. We don’t have a preference between dividends and business value appreciation.

Most importantly, when we think about business value growth, we think about it on a per share basis. That means giving consideration to whether the company is a cash generator or a cash user and how the balance sheet is likely to change. It’s not just looking at how earnings are projected to change.

The second thing that we look for is a good price. To us, the value of a business is the highest price that an all-cash acquirer could pay to buy the entire business and still expect to earn a reasonable return on their investment. We call that intrinsic value. We want to purchase a stock at less than two-thirds of that intrinsic value.

To try to define that number, we look at acquisitions of similar companies and the multiples that were paid by acquirers—price to book, price to sales, price to earnings, price to pretax cash flow, or whatever we think was the most important metric to the acquirer of that business—and then we use that metric to get an estimate of the intrinsic value of a company we’re considering investing in. For a lot of companies that are relatively straightforward, we will look at an enterprise value divided by EBITA—earnings before interest, taxes and amortization—and look at how that compares both to similar public companies and similar companies that have been acquired.

Third, we look for capable managements that are economically incentivized—through stock ownership, options, and bonus compensation—to maximize the long-term per share value of the company. Effectively, we want them to maximize their personal gain by maximizing per share value.

CR: I guess would it be fair to say that you don’t have a single valuation metric you look at, but that it depends on the industry or the sector that a company is in.

BN: Absolutely. I don’t think there is one metric that works well across lots of different industries. If you’re looking at a bank, you’re probably focused on a price-to-book-value ratio. If you’re looking at an industrial company, enterprise value to EBITA might be the right metric. If you’re looking at a cable TV company, it might be enterprise value divided by number of subscribers. For a retailer, it might be price-to-sales-ratio. I think the artistry is in understanding which metric best defines value for each specific industry.

CR: And that comes down to just understanding the industry you are investing in and then looking at acquisitions and how they are valued?

BN: Right. I mean, you might look at examples of retailer acquisitions and see that one’s at 60% of book value and one’s at 500% of book value. You observe that the price-to-book ratios are all over the map. In terms of the price-earnings ratio: Some companies might be valued at 30 times earnings, some might be 10 times earnings. Then you look at price-to-sales ratios and you notice that they have clustered around a consistent number and that the distribution on the price-to-sales ratio is much tighter than it is on the other metrics. That’s a good indicator that price-to-sales ratio was the number that was more important to the acquirers than the other metrics.

I think a lot of times in acquisitions—to stick with retail as an example—the acquirer is not looking so much at what the business is currently earning, but what they anticipate it can earn several years down the road. It’s the sales base that is the strongest determinant of what the earnings power is years down the road, much more so than what the business is currently earning or the book value that’s invested in the company today.

CR: Switching to allocation, your firm is pretty unique in terms of not holding many stocks and also not particularly overweighting any particular stock. Could you explain the rationale?

BN: At Oakmark, we believe the skill that we can apply to create the most value is stock selection. Therefore, we want our stock selection to have as large an impact on the portfolio as it prudently can.

A typical mutual fund today owns well over 100 stocks. I think the average is up into the 120s now. Our most diversified fund, the Oakmark fund (OAKMX), generally holds somewhere between 50 and 60 stocks, or less than half the average mutual fund. So we’re clearly structuring our portfolio to maximize the impact of our stock selection. When it comes to position sizing in our portfolio, our largest positions are typically about twice the weighting of our smallest positions. There, you’re looking at a trade-off between maximizing the impact your best ideas have on the portfolio, while still trying to control the amount of capital that you would lose if it turns out you’re wrong on one of those investments that you thought was among your best ideas. Taking the example to the extreme, if you think you’re a great stock picker, why not have a one-stock portfolio? Well, if you’re wrong, you potentially take your capital down to nothing. When you take your capital down to near nothing, it’s game over—you don’t have a base large enough to recoup your losses. We try to make sure that our portfolios are structured such that if we’re wrong on a couple of our large positions, we’ve still got enough capital left in the portfolio to recoup those losses.

Table 1. Mutual Funds Co-Managed by Bill Nygren

			Avg Ann’l Ret (%)		Yield (%)	Expense Ratio (%)
	Total Return (%)		Last 3 Yrs	Last 5 Yrs
Fund (Ticker)	YTD	2014
Oakmark I (OAKMX)	-0.3	11.5	18.6	17.4	0.6	0.87
Oakmark Select I (OAKLX)	-1.1	15.3	20.1	17.8	0.0	0.95
Large-Cap Stock Funds Category Average	1.6	10.8	16.9	16.4	0.9	0.93
Oakmark Global Select I (OAKWX)	3.6	2.5	17.6	14.8	0.8	1.13
Global Stock Funds Category Average	3.6	3.2	14.1	12.8	1.3	1.20
Source: AAII’s Quarterly Low-Load Mutual Fund Update and “Individual Investor’s Guide to the Top Mutual Funds 2015.” Data as of June 30, 2015. Bold returns are in the top 25% of all funds within in the investment category.

CR: Finally, I want to ask you about the process. You’ve mentioned it in several of your commentaries, and even at the recent Morningstar Investment Conference you talked about the importance of just having a process for investing. Why do you think it’s important, and could you elaborate on the Oakmark process?

BN: I think it’s important for any investor to understand what it is they think they are doing that is bringing value to their stock selection, and then be disciplined about sticking to those things that add value. Investing in stocks is the kind of business—or perhaps hobby for a lot of your members—where somebody’s always got an idea for you that sounds exciting. They talk about a company that might grow tremendously or change an industry, and it’s easy to fall for all these new, hot ideas if there isn’t any framework for how to think about investing in them.

I think one of the problems a lot of people have is they don’t really understand why they own particular stocks, and that makes selling them very difficult. If you don’t understand why you own it, you don’t know what to monitor to see if your reasons for owning the stock have lapsed. That basically means that the only reason for selling a stock would be that it’s going down in price and it’s disappointing you. That’s just not a process that can be repeated successfully.

At Oakmark, as I said, we concentrate our investments more than other investors, because we believe stock selection is our skill that adds the most value. We believe that our long-term investing horizon is our most important competitive advantage. For everything we look at, we’re projecting out five to seven years from now what we think the business could be worth. We then monitor the fundamentals of those names extensively, paying great attention whenever results deviate—either positively or negatively—from our forecasts and adjusting our price targets of where we would buy or sell the stock based on new fundamental information. We try to buy stocks at 60%, or two-thirds, of intrinsic value. When they get to 90% to 95% of what we think they’re worth, we sell them.

If you don’t have a disciplined process like this, it becomes too easy to increase the risk level of your portfolio by not selling names that have worked well. One thing that’s always hard for investors to do is to recognize that the risk level has increased because the price of something has gone up. If you don’t act by reducing that position, you’re inadvertently allowing your portfolio’s risk level to rise.

The other thing we look for are companies that are run by good people with management teams that are aligned with their outside shareholders. We watch the activities of management. How are they investing their personal money? Are they buying or selling shares in the company that they’re managing? We consider whether the company is repurchasing shares, if management thinks the shares are undervalued, or if management is just trying to grow the top line of the business so that their own jobs become more important. If we lose conviction that the management team is acting in our interest, that’s also a reason we would sell the stock.

The third thing we talked about is how we want the combination of growth in value and dividends to at least match the market. If the company performs in a way that we no longer believe is true to our assumptions and we think the business has become an inferior business, then it’s not a business we want to own, even if it’s run by a good management team and it’s available at a below-market valuation multiple. If it’s a bad business, it probably deserves to be at a below-market multiple.

The process is very defined: It creates a structure to our portfolios, it creates a method for monitoring all of our holdings to know when they should be sold, and it creates a way of looking at any new investment idea to see if it’s appropriate to consider for inclusion in the portfolio. I just can’t stress enough how important discipline is for investors, especially because at important turning points in the market, the market has a way of tricking you into abandoning your discipline. An investor who has a well-defined process has a much greater chance of getting through market tops and bottoms, having taken actions that enhance his or her portfolio rather than actions that are detrimental.

If you look back six years ago, there were many investors who sold stocks because they went down so much and they never got back in the market. That was the result of an undisciplined way of thinking and a lack of process. Because anyone who tied their investments to fundamental definitions of value would have viewed stocks as becoming more attractive, rather than less attractive.

Bonus Audio

Hear from Charles’ interview with Bill Nygren about who influenced Oakmark’s investment style and the biggest investing lessons Bill has learned throughout his career.

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