Bill Nygren Market Commentary | 3Q19

Theme and Background

This section is an excerpt from a Q&A session where two core investment managers of the Oakmark Fund (Bill Nygren and Win Murray) answered investor questions on GuruFocus.com, focusing on investment philosophy and process. The author emphasizes that Oakmark, as a long-term value investor, employs a core method of identifying growth-oriented companies, buying them when their stock prices are significantly below intrinsic value, and then patiently waiting for the price gap to converge.

Core Views

• Maintain an Open Mind; Avoiding Stubbornness Is Crucial for Value Investors: The author argues that even when firmly believing a stock is undervalued, investors must continuously seek "non-confirming information" to challenge their own investment logic. Otherwise, overconfidence can turn into stubbornness, leading to significant losses.
• Management Analysis Should Focus on "Track Record" Rather Than "Meetings": The author points out that CEOs are often charismatic and articulate, making it easy to be "impressed" during meetings. Therefore, analysis should primarily be based on their historical operational and capital allocation track records, not on impressions from meetings.
• The Core of Valuation Is Discounted Cash Flow (DCF): Asset-based and earnings-based approaches are merely simplified tools of DCF. They are useful in specific scenarios (e.g., cyclical industries), but ultimate value is still determined by cash flow.

Key Arguments and Data

• Emotion Control and Position Management:
• If fundamentals meet expectations but the stock price falls, the author views this as an opportunity to increase the position.
• If fundamentals do not meet expectations, no matter how cheap the stock price appears, the author believes "the investment thesis is broken" and chooses to exit.
• Key Points for Checking Management Compensation:
• The author opposes using "sales growth" or "profit growth" as compensation metrics.
• Prefers metrics with a "denominator," such as: sales per share, earnings per share, return on invested capital (ROIC), to ensure the cost of growth is properly accounted for.
• Comparison of Valuation Methods:

Valuation Method	Applicable Scenarios	Notes
Discounted Cash Flow (DCF)	All companies (most accurate)	Requires estimating normalized profit margins, tax rates, capital requirements, capital structure, growth rates, and discount rates
Earnings-Based Approach (P/E, etc.)	Mature industries, where earnings ≈ after-tax cash flow	Not suitable for industries with heavy R&D or amortization
Asset-Based Approach (Replacement Cost)	Strongly cyclical industries (e.g., deepwater drilling)	If industry conditions have changed, asset value models may overestimate company value (e.g., new drilling rigs cannot generate long-term returns)

• Case Study: Deepwater drilling companies. When oil prices were >$100/barrel, drilling rigs generated extremely high cash returns; after the oil price crash, rigs became idle, generating no cash flow and even requiring maintenance expenses. In this scenario, the asset replacement cost method can serve as a valuation basis, but one must be cautious of structural changes in the industry.

Companies/Assets Involved

• Warren Buffett: The author recommends reading Buffett but suggests not limiting oneself to books about him; one should also read works by growth investors or commodity traders.
• Deepwater Drilling Company (unnamed): Used as a typical example of asset-based valuation, illustrating how asset value and cash flow value can diverge significantly during extreme cycles.

Investment Insights

• On Investment Process: Investors should establish a "fundamentals roadmap" and strictly adhere to it. A falling stock price is not a reason to buy; fundamentals meeting expectations are.
• On Management Analysis: Do not be fooled by a CEO's personal charisma. Focus on verifying their historical capital allocation track record (e.g., whether they used cheap stock for expensive acquisitions) and compensation structure (whether it aligns with shareholder interests).
• On Valuation Methods: DCF is fundamental, but earnings-based or asset-based approaches can be flexibly used as shortcuts. During cyclical industry troughs, the asset replacement cost method may provide a margin of safety, but one must confirm that the industry's long-term return prospects have not changed.
• On Learning Resources: Avoid the "not invented here" syndrome. Actively study competitors' holdings and the thinking of investors with different styles, and even draw methodologies from commodity traders.

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Theme and Background

This chapter uses firsthand experiences from two seasoned investment managers—one from his pre-Oakmark career and the other being Bill Nygren—to reveal the flaws in Wall Street’s mainstream “short-term catalyst-driven” investment model, as well as Oakmark’s steadfast long-term value investing philosophy: buying companies at prices far below their intrinsic value and holding patiently.

Core Insights

• The mainstream market model chases short-term news and psychology, not true investing: Many “investment” institutions tie analyst evaluations to 12-month stock performance, shifting their focus to predicting news flow and market expectations over the next few quarters rather than the true value of the business.
• True long-term returns come from “deep value”: Nearly all investors with outstanding track records spanning over 25 years make money the same way—buying when a company is deeply unpopular, at a price well below its value, and holding until cash flows drive the stock price back to fair value.
• Qualitative factors (management quality, business quality) matter more than quantitative models: Nygren points out that Oakmark has never gained an edge by “out-modeling” others; its most successful investments often involve differentiated judgments about management or business quality.

Key Arguments and Data

• Case 1: FedEx (End of 2012)
• An analyst, after extensive work, calculated FedEx’s value at approximately $160 per share (with the stock at $90), but hesitated to recommend it due to a lack of a “catalyst” (no improvement in trans-Pacific trade data), fearing career risk.
• Outcome: One year later, FedEx’s stock rose to $130 (+44%), and two years later it doubled to $180.
• Conclusion: Waiting for a catalyst can cause investors to miss value-recovery opportunities when no catalyst is present.

• Case 2: Consolidated Papers (Author’s Early Experience)
• Analysts were told to “pick stocks that will go up,” even though the company’s value to a strategic buyer was twice its current stock price; if the industry cycle was downward, short-term performance would still be dismissed.
• Conclusion: Short-term evaluation mechanisms perpetuate market inefficiencies, creating opportunities for long-term value investors.

• Methodology Comparison

Dimension	Mainstream Short-Term Model	Oakmark Long-Term Model
Core Task	Predict news flow and market expectations over the next few quarters	Assess the present value of future cash flows and seek significant discounts
Evaluation Horizon	12-month stock performance	5-7 year holding period
Key Skills	Quantitative modeling, short-term catalyst judgment	Qualitative analysis (management, business quality) + valuation
Attitude Toward Management	Look at valuation first, then reluctantly accept management	Find excellent management first, then wait for an attractive valuation

• Nygren’s Process Reversal
• Traditional approach: First find cheap stocks, then try to convince oneself that management and the business are “not too bad.”
• Oakmark approach: First find management and a business that excite you, then check if the valuation is attractive; if not, keep tracking the stock price and be ready to act when it becomes cheaper.

Companies/Assets Involved

• FedEx (Oakmark Fund holds 1.0%): Used as a case study to illustrate value investment opportunities without a catalyst.
• Consolidated Papers: Serves as a negative example, showing how short-term evaluations distort investment decisions.
• Other Holdings (as of 09/30/2019):
• Oakmark Fund Top Holdings: Alphabet Cl C (3.8%), Ally Financial (3.3%), Bank of America (3.3%), Capital One Financial (3.2%), Citigroup (3.6%), Netflix (2.7%), Fiat Chrysler (2.2%), General Motors (2.2%), Wells Fargo (2.2%), Apple (2.0%).
• Oakmark Select Fund Top Holdings: Alphabet Cl C (10.7%), Ally Financial (7.8%), Citigroup (7.3%), Bank of America (5.0%), Capital One Financial (4.7%), Fiat Chrysler (4.7%), Netflix (3.5%).

Investment Takeaways

• Avoid chasing short-term catalysts: Market inefficiencies arise because many participants are driven by short-term evaluations; investors should exploit this by buying deeply discounted quality companies when no catalyst is present.
• Prioritize evaluating management and business quality: Start with qualitative analysis, then quantitative; seek management teams that can create long-term value, and wait for the right valuation to enter.
• Beware of the “modeling trap”: Quantitative models cannot capture qualitative factors like management capability and corporate culture, which are precisely the key sources of long-term excess returns.
• Hold patiently for 5-7 years: Excellent management often creates value beyond model predictions during the holding period, while poor management can destroy value.