Interview With Bill Nygren of Oakmark

Funds
The Motley Fool sits down with a wise investor.
This interview originally appeared in Motley Fool Inside Value.
Value investor William Nygren has 34 years of investment experience, including eight years as
director of research at Harris Associates. Now a partner at Harris, he is also portfolio manager
at the Oakmark Fund, Oakmark Select Fund, and Oakmark Global Select Fund. As of
December 31, assets under management at Harris Associates were about $123 billion, and the
Oakmark fund family had about $75 billion. Nygren's many accolades include being named
Morningstar's domestic stock manager of the year in 2001.
Fool analyst John Rotonti recently interviewed him about the qualities he looks for in companies
and management teams, the best indicators of stock outperformance, and how he likes to value
businesses.

John Rotonti: What's your definition of a high-quality business?

Bill Nygren: Oakmark would consider a business to be high-quality if it had many of the following
attributes:

high return on incremental invested capital

high free cash generation

above-average growth opportunities

competitive advantage not subject to replication

low cyclicality

low risk of obsolescence

I'm no doubt missing other important characteristics, but you get the idea. More importantly,
however, is that there is a big difference between a high-quality business and a great stock, and

that difference is stock price. Just as consumers do, we are always making trade-offs between
price and quality.
John Rotonti: What's your definition of a high-quality management team?
Bill Nygren: I think all investors would agree that a very important measure of a management
team is its ability to maximize long-term returns for the business. It is rare that we disagree with
the consensus on how well management runs the business. The issue we spend a great deal of
time analyzing that many other investors gloss over is how a manager allocates capital.
If you buy a stock expecting to sell it after the next earnings release, capital allocation barely
matters. But if you buy a stock expecting to hold it for five years, like we do, capital allocation
becomes critically important. We define good capital allocators as always searching for the
option that maximizes long-term risk-adjusted return. That means thinking like an owner, not a
professional manager. A professional manager is almost always focused on making the
company bigger effectively focusing on the numerator. An owner pays just as much attention
to the denominator, meaning maximizing per-share values.
John Rotonti: Warren Buffett has often defined a good business as one that generates a
high return on tangible equity, and Joel Greenblatt uses tangible capital to
calculate return on invested capital (ROIC) in The Little Book That Beats the
Market. When you calculate ROIC or return on equity (ROE), do you prefer to keep the
intangibles in or take them out?
Bill Nygren: I don't see it as an either/or selection. If you are assessing how well the company
allocated its capital when it made acquisitions, of course you want the denominator to include
the full cost of those acquisitions, not just the tangible assets that were acquired. If, however,
you are making projections about returns from future investment for organic growth, then you
would not want the denominator to include the acquisition premium.
John Rotonti: Do you think there's one source of competitive advantage that's stronger
and more enduring than others?
Bill Nygren: As soon as it is obvious that a business is successful (meaning it earns a higher
return than its cost of capital), other businesses begin trying to replicate that success. The most
obvious enduring protection is a patent that can't be bypassed (think pharmaceuticals), which
gives relative certainty to monopoly status until expiration. Unfortunately, most investors
recognize and are willing to pay for that advantage. Other competitive advantages we like are
brand names, high switching costs, and scale. The longer I've been at this, the more respect I
gain for corporate culture being a sustainable advantage. One would think that Liberty
Media's (NASDAQ:LMCA) singular focus on per-share value, 3G's focus on cost reduction,
or Goldman Sachs's (NYSE:GS) focus on hiring the best and brightest ought to be easily

copied, but it isn't. I think that an advantaged corporate culture is the "moat" that is most often
available for free.
John Rotonti: Now a few questions on valuation. In a previous conversation, you told me
that your preferred method for estimating intrinsic value is to look at recent acquisition
multiples for comparable businesses and that you use discounted cash flow analysis just
as a sanity check. For businesses that don't have comparable acquisition multiples (such
as Apple (NASDAQ:AAPL), Google holding company
Alphabet(NASDAQ:GOOG) (NASDAQ:GOOGL), or Amazon (NASDAQ:AMZN)), what's your
next preferred method?
Bill Nygren: Our preferred method is not encompassed by one summary statistic. We want to
apply the statistic(s) that best captures each company's unique value. We owned Amazon most
of last year an odd holding for a value manager given a P/E ratio of several hundred. The
metric that gave us confidence that Amazon was cheaper than other retailers was enterprise
value divided by sales. It seemed odd to us that Amazon, growing sales at 20%-plus annually,
was priced at a smaller percentage of sales than were average brick-and-mortar stores. Other
investors were focused on Amazon's low margin; we believed forfeiting a year of earnings was a
small price to pay to grow more than 2000 basis points faster than competitors.
In the case of Google, now Alphabet, we use a sum-of-the-parts approach explicitly valuing
cash, cumulative investments in venture cap-like projects, and YouTube valued at a similar
price-to-hours-watched ratio as other media companies. We then apply an appropriate multiple
to search EBITA considering its low incremental capital needs, high market share, and strong
industry tailwind.
John Rotonti: You have sometimes supplemented your analysis with the price-to-sales
ratio comparing companies in the same industry. What are your thoughts on using the
P/S ratio when looking at cyclical companies in some of the heavier industries? Does the
P/S multiple eliminate some of the operating leverage component inherent in cyclical
industries?
Bill Nygren: I think price-to-sales is most useful when comparing very similar companies. If you
told me Wal-Mart (NYSE:WMT) was selling at a lower price-to-sales than GM (NYSE:GM), that
doesn't shout to me that one is mispriced relative to the other. However, if you said GM is much
lower than Ford (NYSE:F) that starts to sound interesting. Underlying a price-to-sales
comparison is the implicit statement that margins will trend toward the same number for both
companies.
Using price-to-sales to claim that a cyclical is cheap is really no different than using a price-toearnings ratio, but substituting "normal" margins for those currently earned. We try to smooth

the earnings peaks and valleys in our valuations but tend more often to use price-to-normalizedearnings because it can also be used to compare across industries.
John Rotonti: For companies with high ROIC, do you think it's useful to incorporate
enterprise value/invested capital as a valuation metric? I have sometimes found that
companies that have high ROIC and are trading at lower multiples of invested capital
(let's say EV/invested capital less than 3) tend to also look attractive using other
valuation methodologies.
Bill Nygren: That's a metric we haven't used. The value of a high ROIC really comes from high
incremental returns, which can be quite different than the base returns. Back when I was taking
finance courses, they taught that a quick way to forecast a company's growth rate was to take its
ROE and multiply by the earnings retention rate (one less the dividend payout ratio). So a
company that had a 25% ROE and paid out 20% of earnings would be expected to grow at a
20% rate. The problem with that, of course, is that a company might have no ability to invest
new capital in projects that are as attractive as the base. For example, think of how much
cash Apple (NASDAQ:AAPL) generates versus its reinvestment opportunities.
The ideal situation for a value investor would be a company that was priced appropriately for its
mediocre return on existing capital but had a very high return on incremental capital and had
ample opportunities to invest for organic growth. An example could be a company that has
market-share growth opportunities in an industry with large economies of scale.
John Rotonti: In your experience, which factors lead to share outperformance over a long
period of time?
Bill Nygren: Your first question asked what defined a high-quality business, and I answered by
listing a number of characteristics such as high return on capital, high growth, high free cash
flow, and so on. A company that can enjoy those characteristics for a long time will perform
significantly better than the average company. But to also be a significantly above-average
stock, it has to benefit from those characteristics for a longer time than is implied by the current
stock price. I don't think you can separate the positive fundamental attributes from the stock
price when trying to predict returns. A great company purchased at too high of a price will be a
lousy investment, and a mediocre company purchased at a very cheap price can be a great
investment.
John Rotonti: Are there ways of identifying what I'll call non-GAAP compounders, and is
this something you try to do? These are fast-growth companies that are investing heavily
today so they may not be generating a GAAP profit. I think some metrics to focus on may
be customer retention and market share.

Bill Nygren: Any time you can identify a measure of value that isn't earnings-based, you have the
potential to see value compounding where investors focused on reported earnings don't see it.
Examples we have profited from include using price-to-sales to identify value growth at Amazon,
using price-to-subscriber to value cable TV or programming companies, price-to- EBITDA plus
R&D for drug companies. All can be examples of businesses where growth capital is invested
through the income statement rather than being capitalized.
John Rotonti: From what I can tell, you have tended to sell once a stock price approaches
your estimate of fair value. Is this always the case, or are there some companies that you
consider of such high quality that you would consider holding as long as the valuation
does not balloon outside a zone of reasonableness?
Bill Nygren: When we purchase a stock at Oakmark, we set a sell target that is based on our
best estimate of the value of that company. Our value estimate incorporates our belief about
how the business quality compares to other businesses higher-quality companies would
benefit from higher multiples used to set sell targets. While we own a stock, the analyst's job is
to constantly refine and update our estimate of fundamental value, and thus the sell target.
When that target is reached, unless we are delaying the sale to allow a gain to benefit from
lower long-term capital gain tax rates, we sell.
Investing is always about opportunity cost by definition, having your assets invested in a
specific portfolio of stocks means you have no capital remaining for the stocks not in the
portfolio. One of the all-time great investors, Charlie Munger, is constantly reminding us that
some conclusions are easier to reach if we invert our thinking. So let's assume we want to hold
stocks of great businesses when they appear fully valued. The capital used to make room for
holding those stocks means you no longer have as much capital to buy all the stocks you have
identified as undervalued. You would effectively be saying that a fully valued stock is a superior
investment to an undervalued stock. The only way that could be true is if you didn't build in an
appropriate multiple premium for a great business when setting your sell target. I think it is a
very risky game for a value investor to become a momentum investor once a stock has reached
its sell target.
John Rotonti: How do you approach diversification?
Bill Nygren: The goal of diversification in a portfolio is to take advantage of the fact that risk is
reduced by adding a stock that is not perfectly correlated with the other stocks owned. If we
make an extreme example by assuming that Apple and Samsung will share the smartphone
market, but we don't know what their relative shares will be, an investor could eliminate the
company-specific market-share risk by owning both stocks, but would still have the smartphone
industry risk. But real-world examples are never that precise; there is always the risk of a new
competitor.

We think about portfolio risk across industry lines. The portfolio risks we want to consciously
consider are those where a certain macro event would require revisions to our value estimates
for multiple portfolio holdings. For example, MasterCard (NYSE:MA)
(technology), QVC (NASDAQ:QVCA) (media or retailing) and Fiat Chrysler (NYSE:FCAU)(auto)
are all owned in the Oakmark Select Fund and all are considered to be in different industries.
But all three will react negatively if consumer spending is expected to decline. So instead of just
looking at our industry weightings, we think about the percentage of the portfolio that is exposed
to consumer spending, or interest rates, or housing, or changing currency rates and so on.
When we consider which stock should be added to the portfolio when we sell an existing
holding, we look at how it changes the risk to the total portfolio. If we already own stocks
exposed to the same macro risks, we set a higher hurdle for adding to that risk. For example,
Oakmark Select today is very heavily invested in financials that are deemed to be systemically
important and therefore are subject to additional regulation. Despite believing that some
systemically important financials we don't own are also very attractively valued, if the
undervaluation is even close, we'd prefer to add a stock that had a different risk profile. Industry
classification can give a quick indication of overlapping risks, but we believe a more careful look
across industry lines is also necessary. And remember, the goal isn't to eliminate all companyspecific or industry-specific risk from the portfolio. That would basically turn it into an index fund.
The goal is to stay in the game even when you are wrong and make sure you are getting paid
adequately for the risks you are taking.
John Rotonti: Can you discuss the research process at Oakmark?
Bill Nygren: Our analysts are all generalists. They will only be hired at Oakmark if they are value
investors. We tell them the same thing we put at the start of each of our quarterly reports:
"At Oakmark, we are long-term investors. We attempt to identify growing businesses that are
managed to benefit their shareholders. We will purchase stock in those businesses only when
priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for
the gap between stock price and intrinsic value to close."
So the analyst's job is to find stocks that are cheap and well-managed, with growing per-share
values. Analysts can look in whatever industries they want to find those stocks. By requiring
such discipline for the type of stocks we will buy, we believe we can give the analysts a great
deal of freedom and creativity for where they find such stocks. Further, we believe we attract
better analysts to Oakmark than we would if we had a specialist structure.
We have a weekly meeting attended by the entire investment team. Reports of about four pages
plus attachments are prepared a day ahead and distributed to everyone. Sometimes reports on
new ideas are a little longer, while most updates on existing holdings are a little shorter. We
don't use PowerPoint. Everyone at the meeting tries to identify flaws in the analyst's work, and

additionally, one person is charged with constructing the bear case for any stock we consider
investing in. At the end of the discussion, our three most experienced investment professionals
vote as to whether or not the stock meets our criteria. If two or three say yes, the stock is added
to our approved list and available for portfolio managers to purchase. Research is centrally
stored and accessible to all investment professionals. I describe our process as being much like
sibling rivalry: We can bitterly fight with each other, and then after it is over, enjoy going out to
lunch together. For this process to work, attacks have to be made on ideas, not on individuals.
John Rotonti: Do you meet with management?
Bill Nygren: Yes, we meet with almost every management we invest with.
When I joined Harris Associates (the advisor to the Oakmark Funds) in 1983, my boss asked me
to go to a due diligence meeting for an IPO and report back. Upon returning, I told him the CEO
was extremely impressive. He leaned back in his chair, took a big puff of his cigar, and then said,
"I don't want you giving your opinion on a CEO until you've seen 100 of them. Only then can you
start to tell the top from the bottom decile. Of course they are impressive, how do you think they
get to be CEOs?"
Though I didn't appreciate his comment at the time, the more years that have passed, the more I
see the wisdom in what he said. It is too easy to complete all your work on a company, then
meet management and convince yourself they are exceptional. Rating managements effectively
requires just as much rigor as does a valuation model.
We have specific goals of what we want to learn from management meetings. As long-term
holders, our questions are never about next quarter or the outlook for the year. We are trying to
learn how they think, what their long-term goals are, how they are incentivized, and how they will
judge their own success or failure. It is a very different conversation than we would have if we
were trying to refine our earnings estimate. Think about the questions you would ask someone
you didn't know personally who wanted you to become their business partner that is the
direction our conversations normally go.
Just like our valuation models aren't always perfect, neither are our qualitative assessments of
managements. But if you judge our success against a goal of being directionally right more often
than not, I believe getting to know management teams has been very additive to our process.
John Rotonti: Do you have any performance metrics that you prefer management
compensation be based on?
Bill Nygren: We have one objective when looking at management compensation: We want to
believe that they will maximize their personal economics by maximizing the long-term return on
the stock. For that reason, we prefer performance metrics that drive fundamental value and that
they be measured on a per-share basis. It is easy to make a company bigger by diluting the

shareholders. Every management team says they want to maximize shareholder value; the elite
management teams maximize per-share value.
John Rotonti: Are there any industries you tend to prefer? Or avoid?
Bill Nygren: Part of being a value investor is that very few investments are defined as off-limits.
Instead, almost everything is a trade-off between price and quality. We won't invest in a business
if we don't believe per-share value growth plus dividend yield can match the same for the S&P
500. To do so makes time your enemy. But that eliminates fewer companies than you might
think because even stagnant or slowly declining businesses can be good cash-generators and
decapitalize rapidly enough to meet our goal. We also won't invest with a management team
that is content destroying per-share value.
Some less exciting industries rarely get priced at levels we find attractive like utilities. But
other industries that share commodity-like negatives are frequently priced low enough to merit
our interest. Industries with strong growth and exciting new products typically attract enough
interest from investors that we won't think they are cheap. But over the years, industries go in
and out of favor. Back in the late 1990s, people thought Oakmark would never own tech stocks
because we had deemed them too expensive for so long. Today, tech is one of our largest
commitments. I think it is important for value investors to remember that the term "value" is not
synonymous with "below-average." Companies don't get tagged as "value" companies. Value is
never independent of price. Based on price, sometimes a company represents value and
sometimes it doesn't. A value investor has to look at a wide array of possible investments and
be comfortable saying "no" most of the time.
John Rotonti: When we experience a broad market sell-off (say 20% or 30% or more),
what are you looking to buy first? Do you buy more of your core holdings? Do you look
to purchase shares of businesses that may have been on your watch list but the
valuation never made sense? Do you go first to the companies offering the largest
margin of safety?
Bill Nygren: People who own the Oakmark Funds expect us to be reasonably fully invested most
of the time. They are hiring us to find stocks that are better than the average stock, not to guess
future stock market direction. In an ideal world, our investors would respond to a 20% correction
by giving us more money to capitalize on the price decline. But unfortunately, very few investors
behave that way. The result is that when the market corrects, we rarely have much new cash to
invest. So our process is the same whether stocks are down 20% or up 20%. We want our
assets invested in the stocks that have the best risk-adjusted expected returns. We are always
looking for opportunities to sell stocks at or near our estimate of value and reinvest those funds
in stocks selling well below our value estimate. Large market moves often create more pricing
variations one stock to the next, so we tend to be more active after bigger market moves.

In a June 2015 email exchange, Rotonti asked how Nygren calculates the discount rate
that his team uses for DCF valuation models. Here was his answer:
Bill Nygren: So the first challenge is identifying the right benchmark. In finance class, we all
learned that stocks are very long-duration assets, so one would be inclined to consider a longterm bond as the appropriate risk-free benchmark. But the real (as opposed to nominal) return
on a long bond is highly exposed to the risk that inflation differs from current expectations.
Though businesses don't perfectly pass through inflation, they do at least lessen the risk of high
inflation by having the ability to increase prices. So we conclude that rather than comparing an
equity to a long-term bond, the more appropriate comparison is an intermediate-term bond, and
we use a seven-year maturity. Historically, investors have earned a little more than inflation on a
seven-year government, so we set a floor for that benchmark of 100 basis points above inflation
expectations. If the bond drops below that yield, we would not lower our discount rate.
Since we are investing in corporations, our next step is to examine the yield premium for A-rated
industrials. We add that historical average premium to the Treasury yield (or if higher, our floor
yield). If the current A vs Treasury premium is higher than the historical average, we use that
premium instead. (That prevents the possibility of having an equity-required return that is less
than a current bond yield not even close to an issue today, but was an issue six years ago
during the credit crunch.) Finally, we add the historical average premium that equities have
achieved relative to A-rated bonds. That becomes our discount rate for an average equity. Then
we adjust from -100bp to +500 bp for the relative riskiness of a specific stock versus the market.
(The main reason it isn't symmetrical is leverage.)
In ballpark terms, inflation expectations today are about 2%; adding 100bp premium puts our
seven-year government floor at 3%. Since the current yield on a seven-year is less than 3%, we
use the floor. To that 3% we add the historical average A-rated bond premium, and then the
historical average premium equities have achieved versus A-rated bonds. All in, that gives us
about a 7% discount rate for the S&P 500. (Note that since the S&P has yielded a little over 2%
and we believe it can grow earnings 5% to 6% including share repurchase, for a long-term total
return of 7% to 8%, prices today appear to be at or slightly below a fair-value level.) So our DCF
discount rates today range from 6% for what we believe are the least-risky equities up to 12%
for the most risky.
Having said all that, our preferred model for estimating intrinsic value is one that uses recent
acquisition multiples for comparable businesses, and our DCFs are used just as a sanity check
on what we believe is a more reliable model.