William C. Nygren of Oakmark Funds shared his investment methodology in a chapter of a book “Investing under Fire: Winning Strategies from the Masters for Bulls, Bears, and the Bewildered” by Alan R. Ackerman.
A stock needs to meet 3 criteria before Oakmark will consider buying it
- The stock must sell at less than 60% of intrinsic business value
- Intrinsic value is the estimate of the price an all-cash buyer would be willing to pay today to own the entire company.
- Valuation isn’t an exercise in precision, a range can be very useful.
- Favourable future developments are discounted for time value, as well as for the possibility that they will not occur. [my note: assuming that they will not occur can set a lower figure for the range]
- Acquirers using stock can result in high prices for target companies because the acquirers know their stocks are incredibly overvalued. [my note: when looking at past transactions, should pay more attention to all-cash transactions and discount majority-stock-based transactions.]
- Oakmark analysts watch acquisitions of companies to determine what rules of thumb acquirers were using when purchases were made. The analysts then apply these rules to public companies to assess if they are inexpensive.
- A “60% of value” cutoff allows construction of well-diversified portfolios and to stay fully invested through most market environments.
- Oakmark considers the following factors
- Fundamental ability of the company to generate free cash flow for owners
- Private market values by examining comparable merger transactions, and reviewing trading values of similar publicly traded businesses.
- How secure is the current and expected competitive position?
- How does the balance sheet look, and how will it change over time?
- Estimates of the current per-share business value and how that will grow over the next 5 years.
- Sales and income growth, capital needs, and whether excess cash is generated or cash is consumed.
- Balance sheet changes are incorporated into the intrinsic value estimate.
- Value must grow as time passes
- Nothing is worse for a value investor than having declining estimates of value accompanied by a declining stock price. Oakmark demands that business value must grow as time passes so that it avoids stocks that are statistically very cheap, but whose value is likely to decline than grow.
- Look for companies where the (dividend yield + value growth) at least matches 8 to 9% (the long-run stock market return). This means that even if the undervaluation remains the same (e.g. 60%), the stock will return the same as the market return. If the valuation gap narrows, the stock will outperform the market.
- Management must be economically aligned with shareholders
- Read biographies of top management in its 10K
- Assess how managers are performing in their current company and how they performed at previous companies
- Talk to past business associates, current coworkers, customers, and suppliers to determine if the management team is smart and trustworthy.
- Management should own enough stock, or other incentives, so that management’s personal profit is maximized only if shareholder profit is also maximized. Look at the proxy statement to find out how much stock each manager owns, how many options, and how their bonus compensation is calculated.
Investing for the long-term: If a stock meets the 3 criteria above, Oakmark does not worry about whether the market will recognize the value.
- An extended period of undervaluation can be advantageous. The company can repurchase its own stock at a discount to fair value.
- The market takes 3 to 5 years to come to Oakmark’s estimate of the company’s business value. Such lengthy holding periods keep trading costs down, and also result in the gains being taxed at reduced long-term capital gains rate.
- Oakmark focuses on how a company is likely to change over the next 5 years (its potential for improving its operating results), and not on short-term events or macro forecasts.
- Oakmark portfolios generally hold around 50 stocks. Excessive diversification leads to average investment performance.
- Larger weightings in companies where analyst confidence and return potential are greatest.
- If the stock gets to 90% of its intrinsic value estimate, it is sold.
- If new information makes the manager believe that a mistake is made with the original buy (e.g. no value growth, bad management), the stock is sold.
- Oakmark’s holding period generally exceeds 1 year, so is taxed at only half the taxpayer’s marginal tax rate
- Oakmark identifies specific purchase lots from which its shares were sold, to minimize the tax consequence.
- When stocks declined in price, Oakmark often buys and sells partial positions with at least 31-day intervals to avoid violating IRS wash-sale rules and yet capture the tax loss (i.e. sell a partial position to capture the tax loss, and buy back after 31 days).