#39 – The Optimizer

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Transcript

STEPHEN CLAPHAM: Hi, welcome to the Behind The Balance Sheet podcast where we meet leading investors and commentators and educate ourselves about the world of investing and the world. Our mission is to remove some of the mystique around investing and improve our understanding of what makes a successful investment or indeed an unsuccessful one. Our goal is to inform, educate and entertain. We hope you enjoy this and every episode.

STEPHEN CLAPHAM: Behind The Balance Sheet and affiliates and podcast guests may own shares or have an economic interest in securities discussed in this podcast, which is aired for your education and entertainment only. Nothing in this podcast should be construed as investment advice or relied upon for investment decisions. Always do your own research.

STEPHEN CLAPHAM: This episode is brought to you by Alphasense, the number one rated financial research solution by G2. I’ve started using the platform and now I can access all the company documents, the earnings call transcripts and the expert network call transcripts in one place. With generative AI-powered summarization and chat features, AlphaSense delivers instant, accurate insights into what’s driving your investment universe.

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STEPHEN CLAPHAM: Most of my listeners are fundamental investors and one thing I’ve learned about them is they take real pride in their research. Great investors use significant discipline and process. To get to the truth. But many investors don’t apply the same level of discipline to position sizing as they do in their research process.

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STEPHEN CLAPHAM: I was very excited to talk to this month’s guest, and boy, he didn’t disappoint. I had the most stressful connection at O’Hare to make my flight to Omaha back in May to get to dinner in time to hear Bill Nygren speak. It was worth the sweat, and even more so when Bill, who runs the Oakmark Fund for Harris Associates, agreed to come on the podcast.

STEPHEN CLAPHAM: In this fascinating conversation, Bill explains why accounting is central to his analytical approach, why Oakmark uses a seven-year time horizon to value companies, why index funds are risky, how he and his colleagues can have real fights about stocks, but A bit like brothers sit down afterwards and have an amiable lunch.

STEPHEN CLAPHAM: Most importantly, Bill explains why he’s a value investor, yet Alphabet is his biggest position, and in the last couple of years he’s owned Netflix, Meta, and Amazon. Not your typical value investor names. Bill is a really thoughtful investor, and Harris Associates is organized in a very particular way, which is designed to make the best investment decision the default.

STEPHEN CLAPHAM: I know professional investor listeners will take a lot away, but everyone will find this a fascinating conversation. Stay until then, because Bill also has some interesting observations on which books investors should read. I know you’re going to enjoy my conversation with Bill Nygren.

STEPHEN CLAPHAM: So Bill, listen, I’m really excited to talk to you. I’ve been looking forward to this. It was great to meet you in… Omaha a few months ago, I always start by asking the same question. Did you always want to be an investor?

BILL NYGREN: Well, always is obviously a really long time, but from a pretty young age, I would say I knew I wanted to be in the investment business. When I was in middle school, we were on a family vacation that took us driving through Las Vegas. We met up with a cousin of mine who’d been in the Vietnam War. And before we met with him, my Dad took my older brother and me to the Kroger grocery store across from the motel we were staying in.

BILL NYGREN: And they had a slot machine in the entryway. And he wanted to teach us how stupid it was to gamble. And so Dad took five nickels out of his pocket. And he puts the first one in and seven nickels fall down. Puts the next one in, three more come down. And my father, who is normally a very, very calm person, you could see he was getting more and more agitated. As he’s trying to feed nickels in to prove that gambling didn’t work. And, you know, as a 12-year-old boy, I was like, Dad, you’re winning. Stop. Stop playing this.

BILL NYGREN: And I was confronted with this. My father, who I very much revered for his logic and intelligence, was telling me gambling was stupid, but I’d just watched this machine spit out nickel after nickel. And…

BILL NYGREN: For me, it ignited a passion in all forms of putting Capital at risk, whether that’s in a casino, a racetrack, lottery, or kind of that line where the expected return gets above one, where you start calling it an investment, you know, bonds and stocks. And I learned that, you know, if you wanted to do well at the racetrack, you had to overcome like a 20% take. And that was almost impossible to do.

BILL NYGREN: Sports gambling, it was better. It was only a 5% edge. Blackjack, if you could count cards, and that’s a lifelong goal of mine I haven’t met yet, that’s about a half a percent. But then you get to these things called stocks, where if you did average, you were making several hundred basis points a year more than inflation.

BILL NYGREN: And there was a big spread. That was always important to me. I grew up with an accounting education. I thought if I wanted to be in the investment business, it was important to speak the language of investing, which to me is accounting.

BILL NYGREN: But as an accountant, if you’re 10% better than the guy who’s sitting next to you, maybe you get paid 10% more than that person does. I wanted a career that more levered my bet on myself. And the equity market provided a really interesting way to do that. If you are average, you can…

BILL NYGREN: You could earn decent returns on your investment, but to get paid as a professional investor, you needed to be better than that. And if you did, then the rewards were potentially quite large. So that to me was the fascination with investments. Through high school, I read almost every book on investing in our public library.

BILL NYGREN: I went on to college, got an accounting degree, followed that up with a master’s in finance. Was part of the Applied Securities Program at the University Of Wisconsin. And from all that reading, I knew that I wanted to be a value investor. It clicked with me. It was consistent with the way my parents had taught me to behave as a consumer.

BILL NYGREN: I’d get dragged along to the grocery store as a kid with my mom. We’d go into one store and buy extra grapes because they were on sale in that store. And then we’d go to another one and buy cherries there because they were on sale. So we’d pick off the specials.

BILL NYGREN: So the idea that when things got cheap, you buy more of them was something that was drummed into me, not in an investment class, but growing up just the way I dealt with everyday life. And I think it’s one of the most important things for people who consider this business is to make sure they have an investment approach that isn’t fighting with their basic psychology.

STEPHEN CLAPHAM: And what led you to Harris Associates?

BILL NYGREN: Well, after I got my master’s degree, I worked for an insurance company for two years. And that’s kind of where I learned two things that I thought were really important for me to succeed in my career.

BILL NYGREN: One was I wanted investing results to be what drove the success or failure of the business. At the insurance company, their success or failure was driven by. How much insurance they sold. And the investment results, as long as they weren’t too bad, would support the need of the insurance company. I’d been there about a year and a half.

BILL NYGREN: Got a call one day from the CFO of the company, which never happened, and he said he wanted me to come to his office. And he said, I’ve got really exciting news for you. You’ve been selected to be part of our management training program. We’re going to move you out of equity research and into all these other areas of the insurance company to try and teach you how to be an insurance executive.

BILL NYGREN: And I tilted my head and with… A zero political savvy that you might expect for a 23-year-old who grew up in a middle-class family in St. Paul, Minnesota. I said, I think you might be misunderstanding something. I’m an investment guy who happens to work at an insurance company, not an insurance executive who happens to work in a common stock department.

BILL NYGREN: And then realizing my days were numbered there, I started thinking about what were the other reasons that this company wasn’t a great fit for me. And I was a value investor from the time I graduated my program at Madison.

BILL NYGREN: So I’d do all this work to identify companies I thought were really cheap, and then I’d present those to my bosses, and they’d say, well, where are the buy reports from the sell-side research that says this stock is a buy? Like, well, there aren’t any. They all say it is either a hold or sell it.

BILL NYGREN: And they’re like, well, it’s an interesting idea, but we want to have at least two reports in the file that say, you know, these firms thought they were buys. So, you know, I’d recommend something at this price. It would go up. You’d get the buy reports. The portfolio managers would get excited about it. And I’d say, well, the opportunity that I thought was there is gone now.

BILL NYGREN: And I learned it. It wasn’t about who was smarter than the other person. It was, are you on the same page with investment style?

BILL NYGREN: And it was important to me that in my next job, I got to affiliate with other people that thought as value investors. So I called up the professor of the Applied Securities Program, Steve Hawk, and said, I don’t think this is working out for me at the insurance company.

BILL NYGREN: And… I’d really like to find an opportunity with people that are convinced they’re value investors and where investment success drives the success or failure of the business. And maybe a month later, my phone rings and I pick it up, say hello, and I get…

BILL NYGREN: Hey Bill, this is Steve Hawk from Wisconsin. You’re going to get a call in a minute from an alumni you don’t know, Clyde McGregor, from a firm you’ve never heard of, Harris Associates. You should take the job. I’ve got to go now because I told Clyde to call you. Click. And I’m like, okay.

BILL NYGREN: And then my phone started ringing and it was Clyde on the phone. Clyde and I have worked together for 40 years. He just retired at the end of last year. I was portfolio manager of Oakmark Equity And Income Fund. But Clyde and I talked. We set up a dinner with other partners of the firm.

BILL NYGREN: And it felt like any stock they asked about was something I’d been working on. Anything I brought up that I’d been working on, one of them had worked on. And you could just feel that meeting of the minds. And I knew instantly that this was a place that I was going to be able to learn a lot from. From the people that I worked with.

BILL NYGREN: And my thought was, I know it’s going to work for at least three to five years. And that was 41 years ago.

STEPHEN CLAPHAM: So 41 years at the same firms, quite unusual, but you must have seen enormous changes in markets. So 41 years ago, when you arrived, you wouldn’t have had a PC in your desk. You wouldn’t have been using a spreadsheet. You wouldn’t have had access to instant information.

STEPHEN CLAPHAM: Many of our listeners will be younger and can’t imagine that world, a world without spreadsheets. So talk us through the changes and how have you had to adapt your investing style? What have been the big changes you’ve seen?

BILL NYGREN: When I started, once a month, we paid for a printout from the value line investor database that would rank order 1,500 companies by what PE they were selling at. And we all eagerly awaited getting the hard copy of this so that we could see which stocks were at the lowest PE. And that would help inform the companies that we wanted to do our research work on.

BILL NYGREN: I was covering the retail space when I was at the insurance company.

BILL NYGREN: And coming from an accounting background, I was frustrated by… The differences in accounting and businesses that weren’t really reflected in P-E ratios. So like some companies were on LIFO, some were on FIFO. Some had their own credit card, some didn’t. Some leased all their stores, some purchased all the real estate. So I put together this monster spreadsheet that basically put all of these companies on common accounting.

BILL NYGREN: So I made the adjustments as if they were all on LIFO, as if they all owned all their properties, as if they didn’t have credit card operations. And it was an enormous undertaking. Because it was enormous, very few people were willing to do that amount of work. And because of that, the outcome was highly useful because it was data that other people didn’t bother to create.

BILL NYGREN: Now my assistant can run that screen on FactSet in less than five minutes. But the result is, since everybody’s got easy accessibility to that data, it’s not very valuable anymore. So I think 40 years ago, identifying which companies were cheap based on similar accounting, that was half the battle. Today, that’s kind of a starting point.

BILL NYGREN: So I think we have had to become more creative in finding the pieces of value that were kind of falling through the cracks. And maybe that would be a company that has two divisions. One’s doing really well. One’s losing money. So it looks like it’s selling at a high P. E. But if you looked at just the good business, the P. E.

BILL NYGREN: Is pretty reasonable. And you could probably give away the other business or sell it for a small amount if you wanted to. Or we look at companies where gap accounting doesn’t do justice to the value creation. But a simple screen today to show you which companies are expensive and which are cheap has basically become useless.

STEPHEN CLAPHAM: And what about sort of actors in the market and the growth of passive? I was listening to David Einhorn talking about… How he felt that in the old days, he used to find a stock, buy it, and was six months ahead of Fidelity. And he could kind of rely on Fidelity or Capital or one of these very good, big, research-driven houses to come in and identify that stock and buy it and push the stock price up.

STEPHEN CLAPHAM: He said, those people have gone. And the sort of traditional value investors aren’t there. So now, He doesn’t buy the stock unless he knows the company will buy it back. I mean, how would you categorize or how would you think about sort of changes in the market structure? And how has that affected your approach?

BILL NYGREN: Well, I think when I started this more than 40 years ago, there was an element of you could just buy low P stocks and patiently wait for reversion to the mean. And I don’t think that’s as effective anymore. It’s also not enough to earn an active management fee.

BILL NYGREN: 40 years ago, when we would go to a potential new client, the whole pitch would be to sell them on why value investing made sense. And if we could convince them of that, there’s a pretty good chance they’d select us as the value investor. The alternative for them was usually an index hugging mutual fund or something like that.

BILL NYGREN: And just being a value investor was enough to earn a fee. I mean, today there are any number of ETFs that will buy low price to book, low PEE funds, charge an investor basically nothing to do that. So to earn an active management fee, you have to do something more creative. And I think…

BILL NYGREN: The index fund consistently became a better competitor for us, in addition to us having to make value more creative. Today, it’s important for us to show that the active share in our portfolio is extremely high. I think the growth of the index fund has been one of the biggest trends in the business. And again, if you look back 40 years ago.

BILL NYGREN: You start with stocks were an interesting asset class and the neighborhood stockbroker was a very expensive way to access them. But that was the typical way people got into the equity market. Then you started to have mutual funds available.

BILL NYGREN: Were pretty much index hugging, but their 1% fee was less expensive than the stockbroker was. So it was a better deal. Then along comes an index fund that says, hey, if you’re just going to hug the index, we can do that for you at almost no price.

BILL NYGREN: And there’s been this constant pressure on active management to kind of force out closet indexing and really get down to… Only what you’re doing that’s active as being worthy of earning a fee on.

BILL NYGREN: First index funds came out, then it was, well, we’re not an index fund, we’re value. And then it’s like, well, if we buy the value manager and the growth manager and put them together, we pretty much recreated an index fund and you’re just doing it at active management fees. So our process has always had to stay a step ahead. Of what could be mechanized and basically given to investors for free.

STEPHEN CLAPHAM: Your process is incredibly simple in the way you express it. You say you look for three factors in a stock. You buy a discount intrinsic value. You buy companies that can grow per share value. And you invest with management that think and act like owners. I imagine it’s taken a bit of time to develop that. Just talk a bit about how you arrived at this philosophy.

BILL NYGREN: When I started 40 years ago… I worked for one of our partners, Peter Foreman, who said, just remember that every time you make an investment, you’re buying the balance sheet of the company, but also the person that’s running it. We’ve evolved a little bit, but the guts of our current process were there 40 years ago.

BILL NYGREN: It wasn’t just identifying cheap companies. It was identifying cheap companies that had managements. That we wanted to have in control of our investment. And I think as catalyst-based investing became so popular 20, 30 years ago, we added that third criteria of saying, we’re looking for companies that can give us a combination of business value growth and dividend income that at least matches what we expect from the market.

BILL NYGREN: Because that’s really what it takes to put time on our side and give us the luxury of being incredibly patient.

BILL NYGREN: And you had a lot of value investors back then that’s kind of moved away from just an accounting-based value investing model and said, we still do that, but we wait for a catalyst to be in place. Because they were often looking at these structurally disadvantaged companies that their best days were behind them. And… And the longer you waited for something to happen, the worse your annualized return became.

BILL NYGREN: And we said, we’re not looking for catalysts, but we’re looking for companies that can grow and that they generate Capital and they return Capital to shareholders. And even though they’re cheap, we still expect them to grow and return Capital at least as fast as the rest of the market does.

BILL NYGREN: When you think about buying at a discount, getting a company that grows as fast as the rest of the market and getting a management that’s aligned with the outside shareholders, then you’ve really got everything in place for kind of waiting as long as it takes for the market to recognize the value.

BILL NYGREN: And I think one of the biggest lessons learned over being the 23-year-old kid who started in this business to the other end of 40 plus years doing it today. Is realizing how important the people are.

BILL NYGREN: You know, you come into this business, you’ve got spreadsheet skills that run circles around the more senior people, but they’ve got the nuance of being able to understand the importance of qualitative and the importance of assessing the people you’re investing with. You know, a lot of our holdings, we probably average five years for a typical holding.

BILL NYGREN: During that period, a management team has got some big decisions to make with how do they deal with excess Capital? Are they willing to give it back to us? Do they just try and reinvest maybe in areas that they aren’t experts in?

BILL NYGREN: What do they do with tangential businesses that might be worth more to somebody else than they’re worth to them? Are they willing to sell it off and maybe shrink their Capital base? In a value at per share value additive way. What happens if somebody comes along and realizes the company is worth more to their company as part of their company than it is as a standalone? Are they open to the idea?

BILL NYGREN: Of selling out the business when they can get a good price. Those things often matter more over a five-year period than whether your initial price was 60% of the market multiple or 75% of the market multiple.

STEPHEN CLAPHAM: Sure. If you’re holding it for five years, you might see more than one CEO, right? And I just wonder, how do you handle that? When the CEO changes, what do you do?

BILL NYGREN: We do end up in that situation very frequently. But when we go in, we are hopeful that the current CEO has a time frame that’s long enough for the market to recognize the value. And our belief is that they are likely to do a good job. So they aren’t getting fired and they aren’t retiring.

BILL NYGREN: But we make a lot of mistakes and we misjudge people. And it doesn’t mean that our philosophy doesn’t work. Our philosophy gives you a lot of room to make mistakes.

STEPHEN CLAPHAM: You talked about making mistakes. You said you make quite a few. What do you do when you make a mistake? I read that you do a postmortem.

BILL NYGREN: We do. We have a whole thing we call mistake management protocol. And it starts when a company’s results start to fall short of what our thesis was at the point we originally purchased the stock.

BILL NYGREN: Our goal is to kind of increase the pressure to make sure that we are treating this the same as we would if it was presented as a new idea today. Sometimes value managers are so proud of their patients that they’re unwilling to acknowledge they made a mistake and exit a position.

BILL NYGREN: We all believe if we identify something that’s cheap, and we’re patient enough to wait for it to appreciate to its fair value, this is a can’t-lose philosophy. The problem comes in when we’re wrong. And there’s that fine line between are you being patient or are you being stubborn?

BILL NYGREN: And the difference to me is stubborn is when you aren’t reacting to new information and you aren’t reassessing your position based on that information. So when we fall short, fundamentally, we increase the review cycle that the analyst is required to present new information.

BILL NYGREN: If they fall short, like a second quarter of falling significantly below our estimates, we’ll go out and have another meeting with the management team. But again, the goal is to resist that value investor urge to say. The stock’s down, it’s even cheaper than when we first bought it.

BILL NYGREN: And to instead kind of look at it with blinders on is, if this was a new idea today, would I be excited enough about it to put it into our portfolio? And we’ll reassess. You talked about our three criteria. We reassess when any of those three is violated. Ideally, stock price goes up so much that it’s no longer cheap.

BILL NYGREN: We’ll revisit. Has there been new information that we should be increasing our targets? But if there isn’t, then we sell it.

BILL NYGREN: Thankfully, those aren’t mistakes. Those are great outcomes. But then you have fundamental results falling short of expectations. And we increase the pressure. Eventually, we’ll shift it to a new analyst to see if that analyst is as excited about the ideas the prior analyst was. But Again, the goal is to treat it like a new idea through any disappointment that they have.

BILL NYGREN: And then finally, management might engage in a transaction that we think dilutes value per share. A big drug company that we think is undervalued buys what looks to us like a very expensive drug company and uses their stock in the acquisition. And we look at it and say, if we thought the value was $100 a share before the transaction, now you’ve got a bigger numerator, bigger denominator, but maybe it’s 98 after.

BILL NYGREN: We will sell a stock if we think management is not behaving in the interest of the outside shareholders.

STEPHEN CLAPHAM: When you change the analyst, how does the original analyst feel about that? I mean, I imagine it must be quite upsetting. How do you cope with that?

BILL NYGREN: Well, I think something we’ve done well over the 40 years that I’ve been a part of it and witnessed change at Harris is we’ve got a very collaborative culture.

BILL NYGREN: I explain it almost like siblings, where I could go into somebody’s office and we fight like two brothers fight, and someone witnessing it might think it was an awkward battle, but the two of us would do that all the time.

BILL NYGREN: But if you said those same things to him, you’re picking a fight with me. So we’re like family that way. And we all know that our goal is to get the best results we can get for our clients. And if we achieve that goal, everyone does well.

BILL NYGREN: And I think what prevents the analyst, the original analyst from feeling really bad about it is what usually happens is that analyst still feels strongly that this is a good idea.

BILL NYGREN: But they’ve been saying that as the stock’s been going down and we use the term they’ve kind of lost their voice. That, you know, they’re talking, but to us, it’s just it’s almost becoming noise and it goes in one ear and out the other. So that analyst is kind of excited that a new analyst comes to the same conclusion and the audience is more receptive to a new voice.

BILL NYGREN: We don’t want these ideas that might still be very good ideas to become unowned in our client portfolios because of a fatigue factor. And we think changing analysts helps prevent that. And everybody’s on board that it’s not a punishment.

BILL NYGREN: It’s a chance to revive an idea that you feel strongly about.

STEPHEN CLAPHAM: I’ve never heard of anybody doing that before because I suppose your structure lends itself to that because you’ve got generalist analysts.

BILL NYGREN: I will argue all day long about the advantages of being generalists, especially given that we have access to career specialists on Wall Street that can kind of help fill in our knowledge gaps. But generalist makes us more flexible on the analytic team. It makes it easier to swap coverage responsibilities.

BILL NYGREN: I think it’s also better training. For portfolio management, because our analysts are all used to the idea of, you know, is GM more attractive than Citibank right now? And at specialist shops, that’s something that most of their analysts just aren’t equipped to even engage in that thought process.

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STEPHEN CLAPHAM: One of the reasons I was so keen to listen to you at the dinner in Omaha and so delighted that you agreed to come on the podcast was I’ve been very interested in reading your letters about how you’ve adjusted the gap numbers to come up with different conclusions about different stocks. And you alluded to this earlier.

STEPHEN CLAPHAM: And I just wonder if you wouldn’t mind sharing some examples of things that you’ve looked at. I was quite struck because you talked about Netflix at the Omaha dinner and how you’d looked at it on a per subscriber basis. So you just talk about a few of those examples, because that’s my sweet spot as well.

BILL NYGREN: Sure.

BILL NYGREN: Coming from an accounting background, my first real job after bussing tables at IHOP and bagging groceries, my first real job was an internship at Pete Marwick and Mitchell.

BILL NYGREN: Most of the kids today have never even heard of that name.

STEPHEN CLAPHAM: PPMG now, right?

BILL NYGREN: Yes. But back then it was the big eight accounting firms and now it’s down to a big three maybe.

BILL NYGREN: But I was always interested in areas where gap accounting deviated from business valuation. And as you know, gap accounting was really based on an industrial world where…

BILL NYGREN: If you’re trying to grow as an industrial company, you build a big new plant, that plant’s going to last for 20 years. So you take 5% of the cost of that plant through the income statement each year for the next 20 years.

BILL NYGREN: And that works pretty well for most companies if you’re not in a crazy inflation environment where your depreciation numbers are changing from replacement cost. But there are some industries where investment spending went through the income statement because gap accounting, if it’s not something you can touch and feel, it’s called an intangible. And if you spent money to create an intangible, it’s an expense immediately.

BILL NYGREN: So one of my first exposures to this as an analyst was in the cable TV industry where it was a new industry. Back in the old days, you had like three three channels in a moderate-sized city. You get it for free over the air. And then this wonderful thing came along called cable television that gave you about 40 channels to choose from. You paid a monthly Bill.

BILL NYGREN: And the companies spent a lot of money acquiring permitting to allow them to service a community, a lot of money advertising to create customers. And Because of that, they all reported losses every year, negative book value.

BILL NYGREN: But there was an active private market that was purchasing these businesses. And I was attracted by that disconnect.

BILL NYGREN: Why did private Capital think these companies were worth 11 times EBITDA?

BILL NYGREN: And the public market value investors said these businesses are worthless because they lose money all the time. Well, a big part of it was non-economic depreciation going through the income statement. You put a wire in the ground, it might last for 40 years, but it was getting depreciated over five. Or you spend a lot of money trying to attract customers.

BILL NYGREN: A customer, once they’re with you, stays for seven to 10 years, maybe longer, but it’s immediately expensed. Well, we tried to adjust the accounting to match the economics. And when we did that, the stocks went from looking like they lost money to looking like they were selling at a market P. E. Multiple with unusually high growth rates.

BILL NYGREN: Fast forward 30 years and the thought process wasn’t much different on Netflix. It was a company that was scaling up, spending a lot of money on customer acquisition.

BILL NYGREN: And we had owned Time Warner at a time when HBO was one of their biggest assets. And if you looked at a reasonable multiple on HBO’s income stream, say 13 times operating income, it would get you to the idea that a subscriber was worth about $1,000.

BILL NYGREN: We thought, you know, if HBO had 40% margins at one time, they were charging $18 a month for subscriptions. So $7 a month of profits, of operating income a little over $80 a year. That’s how you get to $1,000. We said, what if Netflix did the same thing?

BILL NYGREN: Most consumers thought Netflix was more valuable than HBO, even though they weren’t paying that much for it. And. Our belief was they could scale to earn margins similar to what HBO did.

BILL NYGREN: Then if their subs were worth $1,000 and they were growing subs by $25 million a year, that means they were creating $25 billion of value. Even though the income statement said.

BILL NYGREN: There was zero income or effectively no increase in value. And we looked at the market cap of the company, somewhere around $125 billion back then, say there’s an alternate way to think about this. This isn’t some crazy high price for a company that’s worthless. It’s selling at about five times the value it’s creating in a given year.

BILL NYGREN: And it looks like they can continue to do that for multiple years. And then… They’ll hit a transition point where the growth in subs won’t be as much. But when that happens, the operating margin will start to build up. And then it’ll become a mature traditional company that accounting does a better job of realizing the value.

BILL NYGREN: So we were one of the few value managers that bought Netflix, and it ended up being a wonderful stock for us.

STEPHEN CLAPHAM: Do you wish you still owned it?

BILL NYGREN: Do I wish we still owned it? Well, I mean, that’s a tough answer. I mean, the obvious answer, yes, it’s higher than when we sold it. So in a way, we always regret that. But I think a deeper look at that says, basically, should we have become momentum-based owners to anything that’s going up and exceeds our sell targets?

BILL NYGREN: And we can certainly find examples where our shareholders would have been much better off had we held on. But when we look at the totality of all the companies that we’ve sold because we thought they hit their sell targets, and what would have happened if we continued owning that portfolio versus recycling into another set of names that we thought was cheap and met our initial buy criteria.

BILL NYGREN: It always ends up that we’re better off making that transition as a portfolio, even though Netflix is one of the exceptions that, at least at the moment, looks like we shouldn’t have sold it.

STEPHEN CLAPHAM: It’s very unusual for a value investor to be owning all these tech stocks because you’ve owned Netflix, Amazon, Meta.

BILL NYGREN: Yeah, I think maybe career risk is one of the reasons a lot of portfolio managers shy away from that thinking. Or maybe they’re too wed to a process that a computer can spit out value ideas for them. But I mean, we love the challenge of explaining to our clients why Netflix was a value.

BILL NYGREN: They’ll typically start by saying, wait a minute, you guys say you’re value investors, but you own Netflix. What’s going on here? And it gives us an opportunity to tell that same story that I just told you. And at the end of it, they’re usually nodding, saying, yeah, that does sound like a pretty good value, and we’re glad you think that way.

BILL NYGREN: Amazon, when it was selling at an insanely high P. E., we looked at it as, well, first time we owned it, when it was around $200 a share before it had the large stock split, it was selling at a price-to-sales ratio cheaper than the BRICS.

BILL NYGREN: And mortar retailers that it was putting out of business. So the question to us was at scale, was this a business that if they weren’t investing so much in growth could earn margins typical of typical of average retailers? We concluded yes. So we bought it as a cheap retailer.

BILL NYGREN: We sold it when it became to us a fully valued retailer. That had this interesting AWS business that we didn’t really understand and the market was starting to get excited about. In hindsight, again, another bad early sale, but the stock went up a lot, but then it came down.

BILL NYGREN: And a couple of years ago, we were able to look at it and say, this is really two separate businesses here. And we can argue that either of these businesses is worth about a hundred dollars a share. The retail business based on a price to sales multiple, AWS based on price to sales of similar businesses like Microsoft’s Azure.

BILL NYGREN: And market was asking us to pay 90 for it. We’re like a little bit cheap, not cheap enough as a pure retailer or as a pure cloud company. But we’re kind of getting one of the two businesses for free. We own the stock until fairly recently when it got up to 90 percent. Of our estimate of the combined value, a little bit more than a double in the stock.

BILL NYGREN: We’ve owned a company like Salesforce, where they are making heavy investment spending through their income statement for customer acquisition. It looks expensive on a PE basis, but it sells at about two-thirds the price-to-sales ratio of what good software companies have been getting acquired at.

BILL NYGREN: We owned Meta for a long time when we thought blue Facebook and Instagram were worth significantly more than we were paying for the entire company. And we were getting a pile of cash, WhatsApp, as well as a lot of artificial reality investments for free. We’ve owned Alphabet when the market looked at it as a fully priced company at 30 times earnings.

BILL NYGREN: And we said, wait a minute, they’re doing a ton of venture cap investing that looks like they’re pretty good at. And if we add that back to earnings and then treat the venture cap investment as another asset that we thought we were paying. Significantly less than a market multiple for search.

BILL NYGREN: So that’s the kind of portfolio you can get in an Oakmark Fund that’s got a more open-minded approach to how you think about business value than just a pure statistically cheap on gap numbers. And then people will say, well, isn’t this just an excuse for saying the market’s really high?

BILL NYGREN: And you’re making all these companies look cheaper. And we’ll say, no, you know, there are lots of companies that pull way back on income statement investment spending. You know, the 3G group that kind of transformed Anheuser-Busch and then tried to apply that same thought process to the food industry.

BILL NYGREN: They dramatically cut R&D spending. They dramatically cut advertising. And these companies demonstrated fantastic improvement in EPS. A lot of value managers got sucked in thinking these are decent businesses selling at really low PE multiples.

BILL NYGREN: But when you adjusted the accounting like we did and continued to charge them for the past R&D and advertising spending, they were still benefiting from. The stocks looked much more expensive than the stated PE multiple. And that helped us steer clear of that industry at a time that they really pulled back on how much they reinvested. It’s funny.

STEPHEN CLAPHAM: Kraft Heinz makes an appearance in my Forensic Accounting course, because they were talking about zero-based budgeting as if it was like this brand new thing. And I remember when I was studying at university, I studied zero-based budgeting. I mean, it’s been around forever. But I just wanted to pick you up on Alphabet because we’re recording this on the day that NVIDIA is going to be reporting results.

STEPHEN CLAPHAM: And I’ve been puzzled. I mean, I’ve started to sell my Alphabet, you know, my personal portfolio, because I’m concerned about AI. And not that I have any idea whether ChatGPT is any better than the Google AI. And I’m sure Google are very, very good at AI. And they bought DeepMind, the British company. But I’ve been concerned for…

STEPHEN CLAPHAM: For some time that the stock market didn’t seem to be worrying about it. And I’ve also been concerned about the regulatory threats. I mean, you still own the stock. How do you factor those things into the valuation? Because you’re taking a seven-year view. I mean, a seven-year view is, I mean, it’s a long time to look at, right?

BILL NYGREN: No, it is. And clearly, even though Alphabet has a lot of assets, by far, the biggest piece of the value is search and specifically Google. So I think there are a few things.

BILL NYGREN: One, the market had gotten quite concerned that in the European Union, Alphabet was not going to be able to pay Apple to be the default search engine on iPhones. And we took great comfort in six months in and now more than a year into that experiment, if you will. Google hasn’t lost any market share.

STEPHEN CLAPHAM: And they save themselves a lot of money.

BILL NYGREN: Well, a little bit, but they still pay a percentage of their revenues to Apple to be on that list of possible default search engines. So our belief is that it’s not the massive payment that goes to Apple. That’s putting Google in the lead on search, that customers actually prefer it.

BILL NYGREN: Then when ChatGPT first came out, there was this fear that Google had been leapfrogged or Alphabet had been leapfrogged, despite the fact that they’d been spending on artificial intelligence much longer and much heavier. Than any other company had. And I think what we’ve seen since then, it’s not that Alphabet is behind on search, but they had more to lose.

BILL NYGREN: Microsoft has Bing and they’ve got something like one or 2% of the search market. It’s much less costly for them to experiment with incorporating AI in their main Bing product than it is for. Google to risk offending its customer base if the AI is giving them wrong search results.

BILL NYGREN: So I think they do have to be more cautious because they have more to lose. But that doesn’t mean that they aren’t spending enough, that when someone does find a breakthrough for artificial intelligence in search, I think Google can be an extremely fast follower or simultaneous.

BILL NYGREN: Introduction of that same kind of technology. So, I mean, the company continues to grow revenues at a very rapid pace, much faster than the market. And, you know, we look at it as a 15% grower for some time. And I think one of the areas where I think value and growth investors do differ a lot is We say at seven years, our crystal ball gets too cloudy to say anything is more than an average business at that point in time.

BILL NYGREN: So if it takes longer than seven years to grow a company’s way into a market multiple, or if you have to believe that years seven through 15 are also super normal growth, we won’t get involved. But I think a seven-year timeframe for search is pretty reasonable. We’re up to what, almost 30 years now that… That Google has been the lead search engine.

BILL NYGREN: I am old enough to go back to AltaVista, owned by Digital Equipment Company, being something that looked like a really interesting investment opportunity. And Google put that out of business within about a year. This industry isn’t one that two high school kids in a garage can change the course of the industry anymore.

STEPHEN CLAPHAM: Just turning back to Amazon, I know you’ve sold it. I’ve been slightly puzzled because they’ve put a huge amount of money into heavy assets. So in order to improve their competitive position and deliver faster, I know in London, all the Amazon vans are owned by Amazon. They’re all electric.

STEPHEN CLAPHAM: And there’s a huge amount of assets on the balance sheet. And there’s also a huge amount of labor. They’ve increased the number of staff. Very, very significantly. So the revenue per employee has fallen by, I think, 60% in the last 10 years. I just wonder, why do you think the market isn’t more worried about that?

BILL NYGREN: I guess one way of looking at it is they’re diversifying into worse businesses than what basic Amazon website is. The other way of looking at it is the Amazon website has become so incredibly valuable. That they don’t want to risk bad customer experience by leaving that up to a third party.

BILL NYGREN: And I think they’re getting reasonable returns on those investments, even though they are much, much lower than what they get on the basic Amazon business. And it’s making Amazon more impenetrable. Yeah.

STEPHEN CLAPHAM: You talked in your last quarterly about how Morningstar is a growth value score for every stock and determined portfolio scores. And a portfolio with a score under 125 is value, over 175 is growth. And you said then S&P 500 score was 192 and the Oakmark score was at 73. I mean, there’s no misprint there. What’s going on?

BILL NYGREN: Well, I think, Steve, the S&P 500 index. Because of which stocks have performed so well, both fundamentally, and then because of that fundamental performance have been given what we would call excessive valuations. The character of the index has changed dramatically.

BILL NYGREN: The person who thinks the S&P is like the least risky portfolio out there, and I can put all my assets in it, and it’s divided across 500 companies. Two-tenths of one percent of my assets are in each business. They’re getting something very, very different than that today. The top, I think it’s top 23 companies are half of the portfolio. That’s almost as concentrated as we are in Oakmark Fund. And most people think if you’re going to buy Oakmark as one of your mutual funds, you probably need that in a portfolio of four or five funds. They’re very comfortable owning the S&P as their only equity asset.

BILL NYGREN: We think you should own 50 to 55 names in a portfolio. That’s half of what the typical mutual fund owns. We want less because we want our stock selection skills to have more of an impact on our return. And we’ve thought that’s 2% for an average position, probably should cap it off at twice that.

BILL NYGREN: So if something appreciates to more than 4%, not really appropriate for an individual to keep that kind of concentration in their investment. Well, the S&P, I think now has four or five names that we would consider imprudent. To have weightings as high as they are in the S&P. We have 40% of our portfolio today in financials.

BILL NYGREN: That’s the first question we get in any client meeting is, how can you get comfortable with that? And the answer is financials is a really broad universe. It doesn’t mean banks. Well, the S&P has got almost that kind of concentration in technology. And those companies are much more similar than you know, say Fiserv is to Bank Of America.

BILL NYGREN: You know, one’s a data business, one’s a traditional banking business. But, you know, the technology stocks move more monolithically than do the varied financial names. So I think, you know, the index fund sellers have done a phenomenal job of convincing all of us investors that…

BILL NYGREN: Risk isn’t about losing money. Risk is about performing differently than the S&P 500 does. And this whole industry has grown up measuring tracking error. How much do you differ from the S&P? And that’s a primary measure that institutions use to grade us on risk levels.

BILL NYGREN: I say, if you… Tracked the S&P 500 by how much different it looks than Oakmark Fund, it would look like the really risky index. And the much better measure is when things go down, who goes down more? And in the time Oakmark Fund has been around, there have been six down markets, down years. And in five of those, we’ve lost less money than the S&P 500 has.

BILL NYGREN: Yet we are graded as a much riskier investment than the S&P 500, because knowing what the S&P 500 does doesn’t inform you very well as to how Oakmark will perform. So I think investors have a lot of catching up to do with rethinking this portfolio that’s become a growth portfolio, that’s become hyper-concentrated.

BILL NYGREN: Such a heavy investment in mega cap businesses. How does that risk profile really square with what you thought you were buying 10 or 20 years ago when you bought your index fund investment?

BILL NYGREN: We’ve for years encouraged clients to rebalance portfolios. We’re not market timers. We know we can’t do it. We don’t think anybody’s very good at it, but we’ll say like, If you’ve got 60% in stocks and 40% in bonds and stocks do really well so it becomes a 70-30 mix, rebalance. It takes the risk down and might even improve your returns. If your growth stocks do really well and your value stocks don’t, rebalance or vice versa.

BILL NYGREN: They are measures that can both reduce risk and potentially increase return. The S&P 500 doesn’t rebalance. It just, you know, it becomes a momentum index that the names that have done well become heavier weighted. And I think investors need to revisit, is that really this nice diversified core portfolio that they thought it was? Or has it become a growth fund?

STEPHEN CLAPHAM: Well, that’s a massive, massive question. And of course, the people will be afterwards, will be talking about this after NVIDIA has blown up. And.

STEPHEN CLAPHAM: They can’t make any more chips or somebody else to come up with a better chip or tsmc is under the Chinese control and the Chinese won’t let NVIDIA have any of its chips we’ll see what happens, but I suspect that people will be telling this story in some years down the road and saying, oh, that was mad, that growth fund, the S&P 500.

STEPHEN CLAPHAM: So very good that you brought that up. I always finish by asking people to suggest a book to a young person entering the industry. Do you have any favorite investing books?

BILL NYGREN: I’ve got a few thoughts on this. I love reading books about… People who have become exceptional at whatever they do. And in the investment side of the business, as a value investor, Warren Buffett is the king of value investing. And I would definitely suggest reading a book about Warren Buffett. But I think what a lot of value managers do or value investors do, books about Buffett become like comfort food.

BILL NYGREN: I find after you’ve read a couple books about him, diversifying is useful and learning more what made other people great or what people who follow investment philosophies different than you follow, what made them great. So, I mean, I’d suggest a book like Richer, Wiser, Happier by William Green, a chapter dedicated to each of, I don’t know how many it is, 20 or 30 very successful investors.

BILL NYGREN: You know, a book I’m reading right now, Out of the Darkness, Ian O’Connor, about Aaron Rodgers, someone who’s clearly achieved greatness in their career and learning what they did differently at young ages, the sacrifices they made to achieve greatness.

BILL NYGREN: Aaron Rodgers was getting in trouble in grade school. Because during lectures, he was doing the X’s and O’s of plays from his favorite quarterback, Joe Montana.

BILL NYGREN: I think there’s a lot that can be learned from studying greatness. So people who’ve built great businesses, read Hastings’book, No Rules, Rules.

BILL NYGREN: You learn. The single-minded focus that there was on achieving success.

BILL NYGREN: I love sports. I still love sports gambling.

BILL NYGREN: There’s a book, Talking to Goats, Greatest of All Time, by Jim Gray, that kind of has that same approach as Richer, Wiser, Happier, but a chapter on each of highly, highly successful athletes. And I think what you learn from all of them.

BILL NYGREN: Is you really do have to sacrifice to achieve greatness. One of my pet peeves is talking to kids that are graduating from school today, and one of the first things you hear them say is they want a job that lets them achieve a great work-life balance.

BILL NYGREN: And nobody ever says that, meaning that they want work to take up a bigger part of their life. It’s always they want to find a way to, like, chisel down the amount of time they give to work. And I think if you spend time reading about people that have achieved greatness, you find out that rather than trying to limit the time that they spend on work, they learn to love that time.

BILL NYGREN: And, you know, like Buffett talks about skipping to work every day and none of it feels like work. I mean, I think when you achieve a high level of success at something, then what you’re doing to further that success becomes really enjoyable. You know, I hate the advice to kids of follow your passion. You know, that’s how you get 30 year olds still trying to succeed in garage bands.

BILL NYGREN: But I think I think it’s more find what you what. What you are competitively advantaged in, where you’re really good, that’s something someone will pay you to do and become great at it, and it will become enjoyable.

STEPHEN CLAPHAM: That is a brilliant way to end it. Bill, thank you so much. I really enjoyed talking to you. Before we go, where can people find you?

BILL NYGREN: Best spot to find information on us is at our website, Oakmark.com. We intentionally keep up years worth of commentary. And we tell people the best way to get to know us is to go back, start reading our reports from three or four years ago. And you’ll see we use a process that gets tweaked. But it’s never really had an overhaul or big change to it.

STEPHEN CLAPHAM: And the letters are really good. So I really, I recommend them. Bill Nygren, thank you. Well, you can see why I was so keen to get Bill in the podcast. I would love to be a fly on the wall at one of their investment meetings. I was really impressed with their culture, particularly the ability to challenge each other in search for the truth and the idea that everyone has an equal voice.

STEPHEN CLAPHAM: I am unlikely to build an investment firm, but if I did, these are principles which I would be sure to copy. Similarly, there are earnest exploration of mistakes down to even switching the analyst, which is something I’ve never come across before. And the way Bill approaches valuation, normalizing the accounting is really, really important and gives them a real analytical edge.

STEPHEN CLAPHAM: If you want to pick up similar skills. I’m running my Forensic Accounting course in New York in mid-November. One version for professional investors, one for private investors. Email me at info at behindthebalancecheat.com for more details, letting me know which one you’re interested in. Thanks, as ever, for your support.