Bill Nygren Market Commentary | 2Q18

Theme and Background

This chapter explores how GAAP accounting rules obscure the true economic value of businesses and how value investing has evolved from relying on tangible assets to identifying intangible assets. Using Gartner as an example, the author illustrates that traditional book value metrics can no longer effectively measure the intrinsic value of modern asset-light enterprises.

Core Views

• The core of value investing remains unchanged: Buying intrinsic value at a discount, but it requires looking beyond GAAP and adjusting accounting treatments to reflect the economic substance of intangible assets.
• Counterintuitive judgment: Gartner has a P/E ratio of 31x and a book value of only $2 per share, appearing to be a growth stock. However, after adjustments, its valuation reverts to that of an ordinary company, meeting value investing criteria.
• Contrarian to market consensus: The decoupling of price from book value is not irrational but a rational reflection of intangible assets generating returns; relying solely on a low price-to-book strategy will continue to underperform.

Key Arguments and Data

1. Gartner Case:

• The stock price fell from $142 to $119, with a P/E ratio still at 31x and a book value of only $2 per share.
• Average client retention exceeds six years, and sales and marketing expenses should be treated as long-term investments (adjusted EPS increases by nearly $3).
• Adjusted valuation shows Gartner as an "ordinary company," aligning with the value investing principle of "buying excellent companies at ordinary prices."

2. Historical Comparison: Tangible vs. Intangible Assets:

Metric	1975	Current
Tangible book value as % of market cap	83%	<20% (intangible assets account for 80%+)
Correlation between stock price and book value	71% (25 years ago)	14% (current)
P/E ratio distribution	More dispersed	More concentrated

3. Evolution of Graham's "Margin of Safety":

• 1934: Liquidation value formula (cash + accounts receivable discounted 10-25% + inventory discounted 25-50% + other assets discounted 50-100% - liabilities).
• Current: Intangible assets (brands, customer relationships, R&D, patents) become the primary source of value, but GAAP does not value them.

4. Buffett's Shift in Thinking:

• Berkshire Hathaway's 1983 annual report noted that intangible assets like brands are not on the balance sheet but constitute the core value of a business.
• Early investments (General Foods, RJ Reynolds, etc.) had already deviated from the low price-to-book strategy.

Companies/Assets Involved

• Gartner: A leading global IT research and consulting firm, asset-light and database-driven. Oakmark holds a long position, bullish (adjusted valuation is reasonable).
• Berkshire Hathaway: Cited for Buffett's 1983 views, representing the evolution of value investing philosophy.
• Packaged Food Companies: Oakmark historically bought these because brand advertising expenses were expensed, understating earnings (the opposite is now true: cutting advertising boosts GAAP earnings).
• Cable TV Distributors: Reported net losses and negative book value but rapid customer growth (customer acquisition costs are expensed immediately, yet customer lifetimes are long).
• High-Growth Biotech Companies: After capitalizing R&D expenses as long-term investments, their P/E ratios are lower than those of mature pharmaceutical companies.

Investment Implications

• Abandon the pure low price-to-book strategy: The current correlation between stock price and book value is only 14%; this strategy has underperformed over the past decade and may continue to do so.
• Adjust the GAAP perspective: Capitalize sales/marketing expenses and R&D expenditures based on their economic life to identify undervalued earnings.
• Focus on the ability of intangible assets to generate returns: The narrowing of the P/E ratio distribution indicates that intangible assets have been effectively converted into earnings; investors should focus on adjusted earnings rather than book value.
• Industry applicability: Banks, utilities, etc., can still reference book value, but most companies need to shift to economic value assessment.

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Theme and Background

This chapter continues to explore the evolution of value investing in the intangible asset era. The author notes that as the importance of intangible assets rises, Oakmark has increasingly invested in companies typically held by growth investors (e.g., Alphabet, Facebook, Netflix). The core question is: In a context where traditional valuation metrics (such as price-to-book) have become ineffective, how can investors identify funds that truly adhere to a disciplined value investing process?

Core Thesis

The author argues that the core principles of value investing (margin of safety, divergence between price and intrinsic value, contrarian investing) have remained unchanged for 84 years, but the metrics used to measure value must evolve. Counterintuitive judgment: Companies with seemingly expensive GAAP P/E ratios (e.g., Alphabet at 26x P/E) may still be value investments, as their intrinsic value is far from fully reflected in accounting earnings. True value investors should be able to clearly explain the source of their margin of safety—i.e., "what they believe they are getting for free."

Key Arguments and Data

1. Unchanged Value Investing Principles: The author cites Graham's Security Analysis and its core concepts over 84 years—investors still follow trends, act emotionally, and overreact, causing stock prices to diverge from intrinsic value, allowing patient investors to buy below value and create a margin of safety.

2. Failure of Traditional Metrics: Price-to-book is nearly useless for estimating intrinsic value; low P/E is often, but not always, an indicator of value. While Oakmark's portfolio still generally trades below the market P/E, it increasingly invests in "exceptions"—companies with seemingly expensive GAAP P/E ratios.

3. Alphabet Case Study:

• In 2018, consensus expected P/E was 26x, which the author considers reasonable (given expected growth in the search business).
• However, the company held $115 billion in cash, YouTube, and other bets (including Waymo), which contributed zero to current earnings but had significant value.
• Conclusion: These assets were "obtained for free," constituting a margin of safety.

Companies/Assets Involved

Company/Asset	Role	Key Data	Bullish/Bearish
Alphabet	Core case, top holding in Oakmark and Oakmark Select	2018 P/E 26x; cash $115B; YouTube, Waymo, etc., not in earnings	Bullish (margin of safety from free assets)
Gartner	Intangible asset adjustment case (analyzed in Part 1)	P/E 31x, book value $2/share	Bullish (adjusted earnings increase)
Facebook	One of the holdings	Oakmark Fund holding 1.1%	Bullish (intangible asset logic)
Netflix	One of the holdings	Oakmark Fund holding 2.5%	Bullish (intangible asset logic)
Regeneron	One of the holdings	Oakmark Fund holding 2.1%; Oakmark Select holding 3.4%	Bullish (intangible asset logic)
Berkshire Hathaway	Mentioned but not held	0% holding	Neutral (only as background)

Investment Implications

1. Abandon Price-to-Book: Investors should no longer rely on price-to-book as a value criterion, especially in an intangible-asset-dominated economy.

2. Redefine "Cheap": A high GAAP P/E does not necessarily exclude value investing; the key is to identify assets with significant value not reflected in earnings (e.g., cash, platforms, R&D pipelines).

3. Focus on the Source of Margin of Safety: A true value fund should be able to clearly explain how its margin of safety is calculated—i.e., assets or businesses "obtained for free."

4. Look Beyond Style Boxes: Traditional growth/value style boxes are no longer sufficient to understand a fund's true investment approach; investors should read fund commentaries or watch interviews to grasp its investment philosophy.