Nygren: Value Managers Love Growth but Don't Overpay for It
The Oakmark manager discusses a value case for Google, his team's three-pronged investment approach, and why capacity is not a major issue for the Oakmark Fund.
Shannon Zimmerman: For Morningstar I’m Shannon Zimmerman here today with [Oakmark manager] Bill Nygren. We’re at the Morningstar Investment Conference, circa 2013. This is our 25th conference, so this is the Silver Jubilee. We’re here with an industry veteran, Bill Nygren. You’ve been in the industry for what, 30, 35 years,
Bill Nygren: 32 years.
Zimmerman: Wow. With Oakmark since 1991?
Nygren: I’ve been with Harris Associates since 1983, and we started the Oakmark Fund family in 1991.
Zimmerman: Today we’re going to talk primarily about the Oakmark Fund, which you’ve managed since March 2000, I believe. We’ve talked about this in the past, but I think it’s important to raise it now in the context of the conference. Oakmark is not a traditional value shop, in a way it doesn't have a focus on single-digit P/E companies, or those that just reside in certain sectors that people traditionally regard as being value-oriented. You’re looking for just a bit gap between what you think the company is worth and what the market has priced it at. So let’s start with a name that I think a lot of folks would not regard as a company that a value manager would hold, Google, which is in the lineup of the Oakmark Fund. From a value investor’s perspective, what’s the case for Google?
Nygren: To start with, Shannon, I think investors have a misperception that value managers don’t like growth. We love growth; we just don’t want to pay as much for it as most people will pay. The reason is because investors tend to stretch their time frames out too long. They think they see a company that’s growing at a high rate in the short term and they assume that can continue for a decade or two. We think Google is one of the exceptions to the mean reversion in the near term, where there is a very strong tailwind of advertising shifting from traditional media to online, and Google being the leader in the online-advertising category, likely to remain the leader for years, and online has a very small percentage of advertising dollars today. You talk to almost any consumer product company and their marketing department, and they will tell you that five years from now, 10 years from now they expect to spend substantially more of their advertising budget on the Internet than they do today. We think Google is very well-positioned to have an above-average growth rate for a very long time.
Now, with that advantage, if you look at Google's P/E after adjusting for the cash on their balance sheet, it’s maybe about 1.3 times the S&P 500 multiple. The low-interest-rate environment that we have today basically says the future is worth paying for, and when that happens, multiple spreads theoretically should be growing. What we are seeing instead is compressed multiples and some really great companies available like Google for not too much of a premium over what the rest of the market is selling for.
Zimmerman: So you mentioned the ad sales component of Google, which is almost all of Google in terms of where the revenue is derived from. About 98% of revenue, the last time I looked, is derived from ad sales. And, yes, there is a growing opportunity for that. I know you guys spend a lot of time thinking about the downside risk of any investment that you make. You're not really that concerned about volatility, but you are concerned about the possibility of permanent capital loss. So when you look at a company like Google--and it doesn’t just has to be Google, any company that has a fairly narrow focus in terms of where it derives its revenue from, which business line--how do you offset that concern, even relative to the growth you anticipate for ad sales online?
Nygren: We look at Google's dominance in the search position, where their market share went from nothing. They weren’t the first search engine out there. Back in the 1990s?
Nygren: AltaVista. I remember it well; it was the hidden asset inside all digital equipment. But Google came in with a better product. They’ve spent heavily on research and development, and they’ve had consistently growing market share. I believe they have grown to the point where a start-up search engine cannot displace them, the way they did with AltaVista. And the amount they spend on R&D is so high, that if there is going to be an innovation in search, they’re going to be leading it rather than responding to it. So we do pay a lot of attention to search market share, but there's not any bad data there relative to the Google investment.
Zimmerman: So one last pass at Google. They do have this other part of their company that is heavily spending in terms of R&D, but not yet monetized. I think of Google Glass, and maybe that’s a product that’s going to turn around; also the driverless car. How much of time at Harris is given over to discussing that part of the business relative to the possibility of growth in the online-ad space?
Nygren: As you know, we only want to invest with managements that we believe act in the shareholders' long-term interests. And I think there is a lot of attention to Google's R&D away from search because it is in such neat areas, and it's really interesting to think about Google, such as Google Glasses or some of the driverless-car features that we hear them working on. It's really pretty small dollars, and we believe the rate of return on those near term is not of interest. We believe that management has entered into those investments with the belief that the long-term rate of return will be attractive. So Google management passes our test of operating the business in the interest of the outside shareholders.
Zimmerman: So the conversation that we’re about to have as a general session here at the conference is focused on, among other things, active share in funds, such as yours, that have done quite well by deviating far from, in some cases, certainly the category average, the large-blend category here at Morningstar, and then the fund’s official benchmark, the S&P 500. We calculate over the last decade about a 85% active share, quite high, in the large-blend space in particular. So with that, with the willingness to have high tracking error and almost see that as a benefit, there come some substantial risks, as well. I know at Harris the process is not focused, hardly at all, in controlling volatility. You like to see volatility as opportunity. But on controlling the possibility of permanent capital loss. What is your approach to risk management, as you think about that question? You’re significantly invested in your funds. You don’t want to lose money either. How does the risk management conversation go?
Nygren: For starters, I think our definition of risk is quite a bit different than what has become popular today. I think tracking error has become a substitute for risk measurement for a lot of people that look at mutual funds or invest in mutual funds. Effectively, if the market was down 10% one year, up 10% the next, and we were flat both years, people would say, "That’s a risky fund. It was 1,000 basis points different than the market." We think of risk as how much money will you lose investing in the fund. The statistic I’m most proud of with the Oakmark Fund, and I think defines Oakmark Fund as a low-risk fund, is that in any year the S&P has been down, the Oakmark Fund has been down less. Now, it’s not an accident that that happens. It’s the investment approach that leads to that.
We look for three things in any company that we’re investing in: a big discount to value, value that grows with time, and management that’s aligned with the outside shareholders. Each one of those individually serves to lower the risk. When we buy at a discount to value, if something happens that’s worse than our forecast was, there’s not as far to fall. With business value growing over time, if things don’t work out quite as quickly or quite as well as we thought we would, as time goes by, the value is getting to a higher number every year. Most importantly, there's management alignment. When you take as long a time period as we do--we think about the next seven years; our average holding period has been five years. Over that length of time, managements have some important opportunities to change the character of their companies. They might sell a division, make an acquisition, or maybe even sell the entire company. We want to believe that as they approach those decisions, the only thing on their minds is what’s best for the long-term per-share value of the company. We don’t want them thinking like a traditional manager that might be more interested in climbing rungs on the Fortune 500 list.
Zimmerman: Last question for you, Bill. With around $10 billion, Oakmark doesn’t have a huge asset base for a large-cap-focused fund, yet given your pretty stringent valuation requirements--and it’s the most expansive portfolio that you run, but still not all that expansive with just 53 names--and money that you run in the strategy outside the context of the fund, what do you think the capacity for the Oakmark Fund is now?
Nygren: As you know, the Oakmark Fund is one of our most diversified products. We hold 50-60 names in the Oakmark Fund, and we invest only in big businesses. The way big businesses are valued, that’s almost always a very strong overlap with the large-cap universe. The year 2000 was the big exception to that when small tech companies invaded the large-cap universe. But because it’s so diversified and because it’s only purchasing large-caps, we really don’t believe that capacity is a major issue for the fund right now. We’ve been able to find attractive ideas with no problems. When we find those ideas, we’re able to purchase them in the size that we want to have them in the fund. If we believed otherwise, we would take steps to close the fund, as we have done at Oakmark with several others of our funds.
Zimmerman: Thank you, Bill, very much for being with us today. For Morningstar, I’m Shannon Zimmerman.
Shannon Zimmerman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.