Here is an old speech(2002) by noted value investor Bill Nygren who has over the years built a terrific track record at Oakmark funds.To improve our game,it does help to learn from some of the best in the field.Hope you can glean some nuggets of wisdoms as he does go into great detail on how to identify undervalued companies.Enjoy!
Bill Nygren on Searching for Value
3/10/02 A speech from the Louis Rukeyser Investment Conference
Sunday, March 10
"Searching For Value"
"Thank you and good morning. I'd like to start by thanking all the people at the Louis Rukeyser Investment Conference -- by paying such careful attention to the logistics, they've made this an amazingly hassle-free trip. I'd also like to thank Lou Rukeyser, not just for giving me the opportunity to speak to this great audience, but also because when I was in high-school and was becoming interested in the stock market, and the financial media barely existed, there was a brand new show on PBS called Wall Street Week that quickly became a highpoint in my week, and over time, an important and ongoing part of my stock market education. Thank you, Lou.
It seems a little ironic to be in Las Vegas and be giving a speech about value investing. Value investing requires following a discipline of placing bets only when the odds are favorable and here we are in a city that's been built on bets placed when the odds were not favorable. Perhaps even more ironic, my own interest in investing started when a family vacation to Disneyland had a stopover in Las Vegas. I was ten years old and my father decided it was time for me to learn about the dangers of gambling. We walked from our motel across the street to a Kroger grocery store that had a slot machine in the entryway. Dad reached in his pocket, took out five nickels and told me that even though he knew he would lose those nickels, he was going to put them in the slot machine so that I could see just how much the game was stacked against us. He smiled, put the first nickel in, pulled the handle, then frowned. As seven nickels came jingling down, my eyes were as big as saucers. After the next nickel went in, five more nickels came out and I was begging Dad to stop while he was ahead. But he was determined to prove his point.
It took half an hour, then the smile finally returned to his face when he succeeded in losing his 25�. The lesson he had hoped to teach me wasn't quite the one I learned. I knew my father was smart and he was telling me that gambling was a loser's game but I had just witnessed this machine shooting out free money. The seed was planted for a lifelong fascination -- I wanted to learn everything there was to know about the risk and return of all different forms of speculation. I learned that if you "invested," and I use that word in quotes, 100 dollars in a typical lottery, you would get back on average, 50 dollars. At the racetrack or in slot machines, 100 dollars in bets returns about 85 dollars. 100 dollars at craps or blackjack returns 98 dollars. And most importantly, 100 dollars invested in stocks, on average, a year later was worth about 109 dollars. The stock market is very different from gambling because in any form of gambling, average results lead to losing money. I believe, in the stock market, results that are simply average lead to higher returns than almost any other form of investing.
To demonstrate just how powerful market returns can be, allow me to share another anecdote. When I lived in suburban Chicago, I rode a commuter train to the office and I often used the trip home for a relaxing game of bridge. One day when we couldn't find a fourth for a game, one of the older players shared his investment story with me. He was an engineer who had a hobby interest in the stock market. He was anxious to prove his ability, so in 1979 he set up an experiment to test his stock selection skill. He took half of his investible funds and invested in a mutual fund, and with the other half he made his own stock picks. He defined the mutual fund results as average, a result he could achieve without investing any of his own time. His success, the reward for his hard work, could be measured by the amount his stock picks exceeded the value of the fund. After thirteen years he was severely humbled as the mutual fund investment had become 25 percent larger than the individual stocks he managed. His own assets had grown eighteen fold but the mutual fund, which when he bought it had a relatively new manager by the name of Peter Lynch, had grown by twenty-three fold. He not only concluded that he had no special talent for stock picking, but felt he had wasted a great deal of time.
I spent yesterday afternoon trying to prove I have some ability at my hobby -- handicapping horses. Were I an average handicapper, I would have lost 15% of what I bet. Given that I actually lost only 5%, I proved I have some skill. So I lost money and succeeded at proving my ability, while my bridge partner grew his capital substantially and felt he had failed. That's why, for me, handicapping is just a hobby! That story shows just how powerful the stock market is -- average returns compounded over long time periods have produced amazing growth of capital. And that's exactly the point that industry professionals like John Bogle make when they promote index funds -- average returns are so good, maybe it's not worth the battle to try and do better than average. The academics say that the only way to get higher returns is to take higher risk and if you reduce your risk, you are destined to get below average returns.
But at The Oakmark Family, we've built a business that is based on our ability to achieve superior long-term returns through superior stock selection. We have seven mutual funds with a total of 12 billion dollars in assets that cover all market capitalizations both domestically and internationally, all using the same approach to value investing. Utilizing a mixture of quantitative and qualitative analysis, we identify attractive investment opportunities. Across all seven of the Oakmark funds, we look for stocks that meet each of three criteria, which we believe each simultaneously reduce risk and increase return.
Our first criteria at Oakmark is that we want to buy stocks when they are selling at a large discount to intrinsic value. Our estimate of intrinsic value is the price a buyer would be willing to pay today, in cash, to own the whole company. Then we only buy the stock if it is selling at less than 60% of that number.
Each phrase in that sentence is important:
"Estimate" -- this isn't an exercise in precision. The reality is an estimate that business value is somewhere between $50 and $60 per share is very useful if a stock trades at $30. Frequently, overly precise value estimates get published in research reports. A value estimate like 54 dollars and 62 cents always makes me laugh. That degree of precision is simply unattainable.
"Today" -- we want a best guess of what the business is worth now. That means any favorable developments need to be discounted not only for time value, but also for the possibility that they do not occur.
"In cash" -- when a buyer pays cash, you know they believe what they are buying is worth at least what they pay for it. Acquirors using stock, however, may believe an acquisition makes sense because they know that the stock they are issuing is overvalued. A couple of years ago, my daughter thought she had entered the world of high finance when she and her girlfriend traded their Beanie Babies. They would look up prices on the Internet and exchange Beanie Baby investments they thought were "worth", 500 dollars. In the end, they were just swapping 5 dollar stuffed animals. In hindsight, the parallels to some technology company mergers seem obvious! The high prices only made sense because the acquiror's stocks were so overvalued.
"The whole company" -- stocks are partial interests in a business, not just pieces of paper. We are interested in the price someone would logically pay to own that business. We don't have use for forecasts with squiggly lines that suggest where a stock price might be headed in the next few days. Because in the long run, the value of a company and its market price must converge.
"We try to buy below 60% of value" -- obviously cheaper is better. The bigger the discount we demand, the greater the potential return, but the fewer stocks that will qualify. Over time, we have found that using a 60% of value cutoff allows us the opportunity to construct well diversified portfolios and to stay fully invested through most market environments.
But the majority of stocks fail on this criteria. Most are priced significantly above 60% of estimated value. Generally, to fall below 60% of value requires an over-reaction to short-term negative news. Merck falling from $90 to $60 when 2002 earnings guidance was cut by 10%, Honeywell falling from $35 to $25 in late September when expectations for air travel declined, or McDonalds falling from $50 to $25 as mad cow disease reduced European income. All are examples of the market treating short-term problems as if they were long-term problems. All these stocks are currently owned in The Oakmark Fund. Finally, before I move on to the next criteria, a stock price being down a lot from its high is not sufficient to make a stock meet our value criteria. Today, many technology stocks are down 50-80% from their highs yet still look expensive to us. Relative to current earnings, expected earnings or even sales, most technology stocks are still priced at very high multiples relative to their historical averages, so we own almost nothing in that sector.
Our second criteria at Oakmark is that business value must grow as time passes. One of the most frequently experienced problems of a value investing approach is that it leads many value managers to own the statistically cheapest companies which are often also the most structurally disadvantaged companies. Effectively, these are stocks that trade at low prices but deserve to trade there. These companies may be worth, say, 100 dollars today, but because of market share loss or declining profitability, they will be worth 90 dollars in a year, then 80 dollars and so on. Nothing is worse for a value investor than having declining estimates of value accompanied by a declining stock price. That makes it very difficult to sell the stock -- because all the way down, it just looks too cheap to sell.
When I think of examples of companies that fail to pass the growing value criteria, I am taken back to June of 1981. I had just completed my Masters degree and started a job as an equity research analyst -- my conviction in value investing was already firmly established. I was taking part one of the CFA exam and was excited to see that the essay section asked us to compare and contrast Wal-Mart and K-Mart, and to write a buy recommendation for one of those companies. The question couldn't have been any easier. Wal-Mart was growing faster than K-Mart, but K-Mart sold at a lower P/E, K-Mart had a 5% dividend yield compared to Wal-Mart's 1%, and K-Mart was priced below book value, while Wal-Mart traded at more than three times book. Of course I wrote my buy report on K-Mart and highlighted just how cheap it was relative to a similar competitor. Fortunately I passed the test, but twenty years later, I'm not sure I deserved to! Wal-Mart stock has increased in price by two hundred fold while K-Mart has slowly gone out of business.
The statistically cheapest stocks aren't always values. What I had missed in my analysis was that Wal-Mart had much better computer systems and had a corporate culture obsessed with expense control. Being the low-cost operator, Wal-Mart had the ability to enter any city K-Mart was in and significantly underprice them. K-Mart faced two choices -- cut their prices and earn an inadequate return, or lose market share. Effectively, their choice was sudden death or slow death. They elected for a slow death. K-Mart was a structurally disadvantaged competitor that experienced a steady decline in its business value. And, its stock was held primarily by value investors for the last twenty years.
So how do we avoid the K-Marts? Over long time periods, the stock market has returned a few percentage points per year above the government bond yield, say a total return of around 8 or 9%. To achieve that return, we look for companies where the sum of dividend yield plus value growth at least matches the market. That way, if our stocks start out at 60% of value and stay at 60% of value, we should still produce a return similar to the market. If, as we expect, the valuation gap narrows, we will outperform. So with each investment under consideration, we estimate the current per-share business value, and we also project how that value will change over the next five years. We of course look at sales and income growth, but we also look at capital needs and whether excess cash is generated or cash is consumed. We incorporate those balance sheet changes into our value estimate. Consider an example we own that is especially appropriate this time of year -- H&R Block. What could be more boring than a tax preparation business? Its pretty easy to project that as population grows, the number of tax returns will continue to grow each year. The percentage of filers needing professional help has consistently risen and we expect that to continue, and H&R Block has been the market leader for years and will probably keep slowly gaining market share.
In most any economic environment, H&R Block should see good revenue growth because it prepares more tax returns each year. Small price increases will add to revenue growth, and as revenues grow, operating margins also improve slightly. Because of these higher margins, net income should grow even faster than revenues. Another great feature of the tax preparation business is that very little capital is needed to support growth. There is no inventory. Customers pay at the time of service, so there are no receivables; and capital spending is pretty much limited to new desks and chairs to expand capacity. Therefore, H&R Block should generate a large amount of cash that isn't needed to support its revenue growth. Management has recently been using their excess cash primarily for share repurchases. So five years from now, H&R Block's net income will likely be divided across fewer shares than are outstanding today. Per-share value growth should therefore be even greater than net income growth. Add in the dividend, and we conclude that value growth at H&R Block is likely to be much greater than value growth for the overall market. A superior business at a below average price, H&R Block continues to be one of our favorite stocks. This is the process we go through on any stock that we think looks undervalued.
Our third and final investment criteria at Oakmark is that we invest only in companies where we believe management is smart, honest, and economically aligned with shareholders. If, today, I was offering you the opportunity to invest in a private partnership, I have no doubt there would be many questions about the management of that partnership. Who is running it? Are they trustworthy? What is their track record? How do they get paid? All are very appropriate questions. For some reason, however, investors often neglect those same questions when they are purchasing publicly traded stocks. Our goal is to invest in companies where we are so comfortable that management is smart, honest, and acting in our interest, that even if the investment was in a limited liquidity partnership, we would still be anxious to invest. How do we learn about management? Every public company is required to present brief biographies of top management in their 10K annual report filed with the SEC. These are now all available free on the Internet.
We look at how management is performing in their current company, and also at how they performed at previous companies. A year-and-a-half ago, some shareholders thought we were crazy to be buying JC Penney stock. In the two years prior to our purchase, the stock fell from a high of 78 dollars down to 12 dollars as Penney's lost market share to discounters like Kohl's and Target and to department stores like Macy's. We hadn't had confidence in JC Penney management. But, then they hired a new CEO, Allen Questrom. Anyone reading Penney's SEC document could have learned of Questrom's success turning around Neiman Marcus, Federated Department Stores, Macy's, and Barney�s. Since we had previously been an investor in Federated, we were already very familiar with his track record. Did we think the new management made a turnaround a sure bet? Of course not -- but it sure changed the odds.
We also want company management to be honest. We talk to past business associates, current co-workers, customers, and suppliers to see if they feel this particular management has been honest with them and is trustworthy. We expect to hold a stock for several years -- during our holding period many important decisions will get made that will never be disclosed. Being able to trust management is really important. Our firm is located in Chicago so our Midwestern roots and common sense are an important part of our investment approach. As I was growing up, my dad used to say that he would rather have the word of an honest man than the signature of a dishonest man. That's the thought we try to bring to judging the character of our managements.
The last point about management is that we want their economic interest aligned with ours. Over the several years we own a stock, the company will face a handful of major decisions that will strongly influence whether or not our investment is successful. Perhaps management will consider making a large acquisition, or even consider selling our company. We want to make sure that they own enough stock or have other incentives so that their own personal profit is maximized only if our profit is also maximized. We want management to think like owners, not hired hands. We want them to get rich only if we do. And again, all of this information is in the annual proxy filed with the SEC and available free on the Internet. It will tell you how much stock the managers each own, how many options, how their bonus compensation is calculated -- everything you want to know.
Our most successful stock in Oakmark's history was Liberty Media. One of the reasons we were comfortable taking a large position in Liberty back in 1991 was that the proxy disclosed the CEO had asked to have his entire compensation over the next five years in the form of stock options. He knew the company far better than we ever would and we liked the fact that he was working for free unless the stock went up. We still own Liberty Media. Despite the strong stock price performance, business value has grown rapidly and we still believe the stock is inexpensive.
When all three of Oakmark's investment criteria are met : 1) the stock sells below 60% of value, 2) the value grows as time passes, and 3) the company is managed by people who behave like owners, we create our greatest competitive advantage -- the luxury of a long time horizon. We don't worry about when the market will recognize value, because the longer it takes, the greater our return will be.
In fact, for companies that generate excess cash, as most of our investments do, an extended period of undervaluation can be used to our advantage. A company that repurchases its own stock at a discount to fair value ends up increasing the value of all the remaining shares. At Oakmark, we have found that on average, it takes three to five years for the market's view on value to converge with our own view. Such lengthy holding periods keep our trading costs down and also are beneficial at tax time, as almost all of our gains end up qualifying for the reduced long-term capital gains rate.
I can't state strongly enough the importance of our long time frame. Most of the financial media, as well as individual and professional investors, obsess over monthly economic data and minor deviations from quarterly earnings expectations. There are seemingly endless debates about whether an economic recovery has already begun or will not happen until the second half of the year. When you think, instead, about how a company is likely to change over the next five years, the short-term issues that others focus on become trivial.
Last March, I was in Dallas for an analyst meeting with JC Penney management. This was the first time their new management spoke to analysts about their turnaround plan. During the presentations, Penney executives walked us through their five-year plan -- sales expectations, margin goals, capital needs, and so on. Plugging those targets into an earnings model suggested that earnings per share in 2005 could reach nearly 5 dollars. That was especially interesting to me because the stock price was 15 dollars at the time. I was so impressed with what I had heard that I called our trading desk from the meeting and I asked them to increase our JC Penney position before the market closed. My thinking was that many of the analysts would do the same math I had done and they would write reports about how cheap Penney was, based on expected earnings.
The next morning, I read all the analyst reports. Not one analyst mentioned how cheap the stock was based on 2005 goals. Instead, the typical report said JC Penney will earn only 60� this year, so at 15 dollars per share, the turnaround already seems to be reflected in the stock price. In the end, the rush I put on our buy orders was unnecessary because our five year time horizon had lead to an entirely different conclusion than our competitors arrived at when they focused solely on the coming year. And, while the one day result of that purchase wasn't so great, JC Penney did finish 2001 as one of the top performers in the S&P 500. The stock now at $21, in our opinion, is still inexpensive relative to its earnings potential.
I would like to use one more example, and show how our largest holding, Washington Mutual, affectionately known as WaMu, meets all of our buy criteria:
� � WaMu is the largest savings and loan in the United States. Many retail financial companies focus only on the wealthiest clients. WaMu, however, primarily serves the middle market customer. We view that as a good thing, because there is less competition, and because we believe there is less risk. Finally, their loan portfolio is composed mostly of mortgages on owner-occupied middle-market homes, again one of the lowest risk category of loans. � � Relative to our investment criteria, is the price of WaMu less than 60% of value? WaMu sells at about eight times expected earnings for this year, putting it at about one third of the S&P 500 multiple, and less than two-thirds the multiples given to other leading financial services companies. In addition, acquisitions of financial services companies that we believe were significantly inferior to WaMu, have occurred at P/E's in the teens. � � How will the value of WaMu grow over time? The current dividend yield is 3% and has been raised not each year, but each quarter for the last five years. Over the last decade, earnings per share have grown at a 17% compound rate, and we concur with management's forecast of annual double digit growth going forward. � � What about management quality? CEO, Kerry Killenger, has been CEO for over a decade, and most of his personal net worth is invested in the stock. He treats the company's capital with the same care he does his own, including a willingness to use cash to repurchase shares when they are undervalued.
Washington Mutual stock fits each of our three criteria and has a lower than average risk profile -- that's why we have made it our largest position. Unless we get lucky, and the market quickly recognizes the value we see in WaMu, we are likely to own WaMu for several years. Given the yield and earnings growth, it is easy to be patient -- the longer it takes, the more the value grows, and thus the more money we will make.
Now that we have so thoroughly covered our approach to buying stocks, I would like to spend a few minutes on the decision most investors find infinitely more difficult -- selling. I believe the reason many investors have such a struggle with selling is because they don't really know why they owned a stock in the first place. At Oakmark, our buy criteria is so explicit that our sell decisions are very straight-forward. We buy stocks that are inexpensive, selling at less than 60% of value. We sell them when they exceed 90% of value. During the time we own the stock, we are constantly evaluating fundamental changes to make sure our targets reflect the most current information.
Because most of our companies have values that are growing, this generally leads to increases in buy and sell targets. But, when the stock price rises to 90% of value, we sell it. We don't worry that it might go higher, we simply sell it and start the process over again. We have found that by reinvesting the proceeds of those sales in new stocks that are selling at less than 60% of our value estimate, we will grow our capital more rapidly and we will assume less risk than if we continued to hold a stock that had already reached 90% of our target.
That describes the sell process for our successful investments. Unfortunately, there is another reason we need to sell -- we make mistakes. Minimizing the cost of your mistakes is just as important as maximizing your successes. We are often asked if we would automatically sell a stock that fell 10 or 20%. The answer is no -- to us, short-term stock price movement is not a useful tool in defining mistakes. In fact, often times stocks keep going down after we begin buying, and our typical response is to buy more. To us, the reason a stock should be sold is that it no longer meets our investment criteria. In addition to selling our successes that increase to 90% of value, we will sell a stock if we lose confidence that the business value will grow, or if we no longer believe we invested with smart, honest, owner-oriented management.
USG Corporation, the largest wallboard manufacturer in the world, is an example of one of the biggest mistakes I've made as both analyst and portfolio manager. The stock sold at a very low multiple of cashflow, the company was the low-cost producer in a commodity industry, and it had a great management team that wisely reinvested the cash the business generated. During the time we owned USG, their asbestos liabilities were growing but seemed pretty well contained. What I had missed in the analysis was that as some poorly-financed building-supply companies went bankrupt, USG would have to pay an increasing share of asbestos judgements. When we sold USG, we still liked the management and still thought they ran a great wallboard company. But we lost confidence that any of the value growth would end up going to the shareholders -- instead, it would go to asbestos claimants. Some time after we sold our stock, USG eventually filed for bankruptcy protection to handle the growing asbestos lawsuits. We lost money on our USG position, but we would have lost far more had we continued to hold the stock.
So that's how we buy and sell stocks. If you truly have a passion for stock-picking, I encourage you to hear many successful investors give explanations of how they invest. There are many different ways to profitably buy and sell stocks. Value investing works for us because our personalities are suited to it. For me, I buy stocks the same way my mother taught me to buy groceries -- when things are on sale, I stock up. Applying our investing discipline is just a natural extension of how I think as a consumer. Whatever investment philosophy you develop, it is vital that you have total confidence in it, and that you are behaving naturally when you execute it. The stock market has an amazing ability to make you abandon your discipline just when it proves most costly! Only by picking an investment approach that is consistent with your personality, can you stick with it when it is most important.
If you're like most people, and you can think of dozens of things you would rather do than spend time researching stocks, then mutual funds provide a great opportunity for outsourcing. To most people, investing is a chore, and hiring someone to perform it for then is just as logical as hiring a cleaning service, or paying someone to cut their lawn. If you do invest in funds, I would suggest you select your funds by using a mixture of quantitative and qualitative analysis, just like we do when we select stocks.
Just as we look for good track records in our management teams, look at the long-term performance of any fund you are considering, also look at the results of other funds that manager previously managed, and look at the long-term performance record of the whole fund family. Good managers and good firms have a history of success. Select smart, honest managers who are economically aligned with their shareholders. I continue to be amazed at how many funds are run by managers who have very small percentages of their personal net-worth invested in the funds they manage. At Oakmark, each of our fund managers has more of their personal assets invested in funds they manage than in any other investment. And finally, just as we invest in a stock using a 3- to 5-year time frame, we find that mutual fund investors who invest with longer time frames tend to achieve better investment results than those who trade more frequently.
Whether you elect to invest in individual stocks or mutual funds or both, it is a great time to be an investor. When I started in this business, professional investors had much better access to information than did individual investors. Today, it's a level playing field. It is amazing how much information is available to anyone who has access to the Internet. From financial statements, to research analysis, to management conference calls -- the information is quickly and easily accessible. And the best part, to a value investor like me -- it's almost all free!
I wish you all the best of luck in reaching your investment goals and remind you of the words of Thomas Jefferson -- ' I am a great believer in luck, and I find the harder I work, the more I have of it. '
Thank you."
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