Looking for Large Caps on Sale

By Josh Lipton  FEB 01, 2010 10:00 AM

Oakmark fund manager Bill Nygren explains his market outlook and his top picks.


Growing up in Minnesota, Bill Nygren loved baseball but quickly figured out that his talent didn’t match his interest. Still, even now, the professional stock picker remains a dedicated fan of the game.

“I think us nerdy types tend to love baseball because of the statistics,” he says. “Baseball statistical analysis is much more robust than other sports. That draws in the analytic types.”

Fortunately for his investors, Nygren, who is a die-hard but frustrated Chicago Cubs fan, has proven much more skilled at picking stocks than batting homeruns as the longtime manager of the Oakmark Fund (OAKMX).

There, he hunts the indexes for large and mid-cap companies that trade at a significant discount to what he considers to be their true business value and have strong free cash flows and high levels of manager ownership.

Through January 28, the fund’s total 10-year annualized return of 6.50% beats the S&P 500 by 6.95 percentage points and leads its Morningstar rivals by 5.84 percentage points, or 98% of its competitors.

The fund, with $3.5 billion in assets, has an expense ratio of 1.23%, and requires a minimum investment of $1,000.

Recently, we caught up with the 51-year-old Nygren at his office in Chicago. We chatted about the market as well as some of his top picks right now, including DIRECTV (DTV), Medtronic (MDT), and Intel (INTC), and what he and his team learned from a bad bet in the financials.

Minyanville: The public has been AWOL on this stock market rally. What will it take to convince Ma & Pa investor to jump back in?

Nygren: I don’t know. Investors have aggressively pulled money out of domestic equity funds, and there have been very large flows into bonds funds. Frankly, if there is a bubble out there today then it is in the very safe part of the fixed income market, like the Treasury market. Investors grossly overpaid for safety last March. And we saw the penalty for that in the negative returns that Treasury bills had in the second half of the year relative to the returns in the corporate bond and equity markets.

So what is your advice for investors today?

Nygren: The thoughtful investor today, rather than thinking about how they missed the rally or remaining afraid of another lost decade, needs to get back to basics. They need to think about what target equity allocation makes sense for them. For most investors, equities are still the asset class of choice. They should still have long-term returns exceeding fixed-income returns. Most investors today are still beneath their target allocations.

Minyanville: What is the biggest risk for equity investors, as we move into 2010?

Let’s start with where we see positives: Corporate earnings are already coming back. We see the end of inventory de-stocking and we’ve seen significant cost cuts. We are not starting at an unusually high P/E multiple. The big risk isn’t with the company-specific fundamentals we’re used to analyzing.

Minyanville: So what is it?

It’s the political backdrop we see today. It’s an administration that feels like it gains points by bashing business and whipping up anti-business populism that in the long run could be destructive to our economy. But, over the history of the United States, we have seen that politics swings like a pendulum. When it swings too far in one direction, natural pressures bring it back to a more moderate position. Hopefully, that is what we’re seeing now.

Minyanville: Walk us through the fund’s investment process.

Nygren: We focus on three factors that we believe are risk reducers and return enhancers. The first of those is the price we pay. Ballpark, we like to pay $0.60 on the dollar for what we think a business is worth today. When the price gets to $0.90, we sell it. Buying at a discount lowers the cost of your mistakes and it increases the returns, when you analyze the fundamentals correctly.

Minyanville: What’s the second factor?

We want businesses that are growing per share value at least as rapidly as the market is. Third, we look for management teams that are incentivized to maximize long-term per share business value. We like to avoid situations where management incentive packages are based on growing the sales or income of the company. We like the metrics that are tied more to per share value or return on capital.

Minyanville: How long will you hold a stock?

Nygren: The typical holding for us is at least three to five years. Over that time, a management team can have the opportunity to make transforming transactions, maybe buying or selling a business. We want them focused on how they are changing the per share value of this company. If we have all three of these things -- a management team on our side, a value that is growing at least as rapidly as the market, and a significant discount from value for our entry point -- then we can be extremely patient. Minyanville: Let’s do some stock picking. DIRECTV, the largest satellite television provider in the US, is the fund’s biggest holding. Why?

Nygren: As we look at where DIRECTV is valued today, it is selling at a small price to cash flow premium to Comcast (CMCSA), which we also like a lot. On our estimate of a discounted cash flow value, two years from now, DIRECTV would have a business value 50% higher than where the stock price is. But, even more attractively, and a theme through many of our holdings, we think there are other potential owners for the DIRECTV to whom synergy would accrue.

Minyanville: Such as?

Nygren: Telephone companies are the obvious example. If they owned DIRECTV, they would have significant savings on their satellite costs and billing costs. They could sell multiple products to the same customer, making those customers stickier. So we think DIRECTV is undervalued as a stand-alone, managed to maximize long term growth of business value, has a great balance sheet, and this free option that, over a multi-year time period, it would make sense that the company gets taken over.

Why is Medtronic a buy?

Nygren: It has been a great growth company for a long time. The stock sells at 13 times expected forward earnings. Over most of the last 20 years, the multiple has been substantially higher than that. We think its growth rate and quality deserves a higher multiple.

What does the company do that its rivals don’t?

They were among the early adopters of combining economic and scientific analysis. Medtronic can show how utilization of their devices actually lowers medical costs. So we have here a very good cash-generating company with a strong balance sheet selling at a slight discount to the market multiple when we think it deserves to be selling at a significant premium.

Minyanville: Explain why you like Intel.

Nygren: It’s one of those great companies in an industry where long-term growth is likely to be significantly higher than the overall economic growth rate. It usually sells at such a high P/E premium that a value investor can’t get excited about it. But today, the stock sells for just under $20 per share, about 13 times forecasted next year’s earnings. Its dividend yield is just under 3%. So I can own the leading semiconductor company in the world, get a dividend yield exceeding what I could get on a 5-year government bond, and pay a P/E less than the market. That is a compelling package.

Minyanville: How are you playing the consumer right now?

Nygren: Consumer discretionary is a large part of our portfolio. We own media companies like DIRECTV, Comcast, Time Warner (TWX), Discovery Communications (DISCA), and Viacom (VIA). The market has punished these stocks on the concern that the Internet will take viewers away from TV.

What do you think?

We think device proliferation is basically leading to video being available to people almost 24 hours per day. Device proliferation will accelerate the move away from print to video. The providers of that video will be compensated regardless of what device people use.

Minyanville: You also like retailers.

Yes, we own Best Buy (BBY), Walmart (WMT), and eBay (EBAY). Importantly, as you go down that list, it’s not the economic sensitivity people expect. These products are discretionary but the stickiness of cable TV matches that of almost any product. We are heavy in consumer discretionary, but we don’t need an unusually strong economic recovery to justify the positions we have in that sector. In a gradual recovery, these names would all perform just fine.

Minyanville: Switching to financials, you’re a fan of State Street (STT).

Nygren: Investors were overly concerned about mark-to-market losses on a lot of the securitized investments State Street held. The company alleged, and we agreed with their analysis, that the market was what was crazy. The fundamental value of their assets was likely to prove that they were worth par. Bears thought that the company would be swamped by markdowns on their assets. We did not share that view and didn’t think future capital issuance would be as dilutive as the market feared.

Minyanville: The stock is up 78% in the past 12 months.

We have seen a very significant recovery in the stock. The mark-to-market issue has disappeared as most of those securities have come back to trade close to par. We view State Street as a very high quality financial services provider. It used to sell at a premium to the market. And we think it can return to that kind of pricing.

Do you agree with our President, that we should limit the size and scope of the banks? And restrain the kinds of risks they can shoulder?

Nygren: There should be some limit, or price to be paid, for institutions offering insured deposits to their customers. We shouldn’t just have a blind eye to the risks an institution takes when we are backing that with a federal government guarantee. But there is a lot of populism in the proposal.

Such as?

The companies they’re penalizing are the ones the government made a significant profit lending TARP funds to. It’s Fannie Mae (FNM), Freddie Mac (FRE), and the autoworkers that are the beneficiaries of the TARP lending where we might not get our money back. Taxing the banks to get that back violates a sense of fairness.

Minyanville: Analysts mention that the fund faltered starting in the second half of 2007, with a bad bet on financials, and with Washington Mutual in particular.

The mistakes we made in financials became apparent, and impacted performance, earlier than our peer group. Washington Mutual was an important negative to our performance in 2007 and early 2008. We underestimated the severity of losses on the book of loans they decided to keep on their balance sheet.

Minyanville: What did you learn from that experience?

Nygren: We are now much more skeptical of the GAAP valuation of various assets on the books of financial companies. That doesn’t necessarily make us more negative. It makes us consider the possibility of a much broader array of potential values relative to GAAP value on financial service company assets.

Minyanville: Thanks for your time.

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