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R E P R I N T E D F R O M D E C E M B E R 2 1 , 2 0 2 0
Identifying Intrinsic Value Key to Stock Selection
MICHAEL NICOLAS has been a co-manager of the Oakmark Fund since 2020.
He is also an investment analyst at Harris Associates and a VP of the Oakmark
Funds. He started at Harris Associates in 2013 after serving as a managing
director at Lakeview Investment Group. Prior to that, he was a senior analyst at
Stratford Advisory Group. Mr. Nicolas earned a B.B.A. from the University of
Wisconsin-Madison (2002).
SECTOR — GENERAL INVESTING in this role, you must stay informed on almost every investment candidate
TWST: Could you please introduce the Oakmark Fund that on our approved list of securities. This list is comprised of stocks that have
you co-manage? And tell us about your continuing work at Harris gone through our investment process and have been approved for purchase
Associates and the dual roles of being a portfolio manager and an by our Stock Selection Group members. I’m fortunate to be surrounded and
investment analyst? supported by an incredibly talented research team.
Mr. Nicolas: Harris Associates, the adviser to the Oakmark TWST: What is your team’s investment philosophy and
mutual fund family, is a Chicago-based investment management firm guiding strategy? How has it evolved over the recent past, and over
with approximately $100 billion in assets under management. The the course of your career?
significant majority of our firm’s assets are invested in the public equity Mr. Nicolas: At Oakmark, we adhere to a proven, bottom-up
markets, both domestically and overseas, but we also manage balanced investment process. We look to identify individual companies trading for
portfolios as well as a standalone bond fund. The fund that I co-manage meaningful discounts to our estimate of intrinsic value, and where we
alongside Bill Nygren and Kevin Grant is the Oakmark Fund. expect per-share value to grow over time. Furthermore, we want to make
The Oakmark Fund specifically focuses on bigger domestic sure that the management teams that run our companies are properly
companies and is typically comprised of 50 individual stocks. Our aligned with us, and that they think and act like owners of the business.
portfolio often looks very different than broader market indices and tends We spend an awful lot of time studying the track records and the
to be more focused than other diversified mutual funds. We’re proud of capital allocation history of the management teams we’re considering
the fact that had you invested in the Oakmark Fund at its inception in investing with, which is critically important given our willingness and ability
1991, you would have made more than 25 times your original investment, to own a company for a long time. In terms of my own evolution relative to
which compares to the 16 times you would have received by passively earlier in my career, I’ve gained a much greater appreciation for how
investing in the S&P 500 index. important management quality can be in affecting investment outcomes.
You mentioned the dual roles of being a portfolio manager and TWST: Tell us about your investment process and how that
an investment analyst. This is common at Harris Associates. Many of our might be reflected in your current sector allocations? Has it changed
portfolio managers also serve as investment analysts. A typical analyst at over this past year in view of COVID?
Harris will be responsible for closely following roughly 10 individual Mr. Nicolas: We define value differently than many of our
companies and will usually present three or four new investment ideas per peers. By that I mean we don’t believe value and growth are opposing
year to our investment committee. forces as so many market strategists seem to suggest. Rather, we consider
As a portfolio manager, I have the added responsibility of growth as one of many inputs that we incorporate into our calculation of
assisting Bill and Kevin with portfolio construction. In order to be effective intrinsic value.
M O N E Y M A N A G E R I N T E R V I E W
MONEY MANAGER INTERVIEW ——————— IDENTIFYING INTRINSIC VALUE KEY TO STOCK SELECTION
For us, a value investment is simply a business that trades That being said, we regularly incorporate devil’s advocate
below our estimate of intrinsic value, which we calculate by making a reviews into our process, whereby one of our analysts will be tasked with
number of predictions regarding a company’s future growth rate, profit presenting the bear case on a position within our Fund. The purpose of
margins and capital requirements, among others. We perform a discounted these devil’s advocate reviews is to ensure that we’ve properly surfaced
cash flow analysis, whereby we project all the future cash flow of a and sized the most important risks in any given idea. In a sense, our
business and discount it back to the present using a discount rate that’s devil’s advocate reviews are internally written short reports on our
based on the risk levels of a given business. existing long positions.
But even when we appraise the value of a company to be far in We’ll debate the merit of these reviews during our weekly
excess of its current stock price and see what we think is a clear path to investment committee meetings. As you might imagine, this can be an
per-share value growth, we won’t uncomfortable and challenging
buy the stock unless we have process for those involved, but
conviction that the management Highlights one that we believe bolsters our
team in charge of the business will risk mitigation efforts. The only
think and act like an owner. The Michael Nicolas discusses the Oakmark Fund, which focuses way this process works is to have
stocks that meet these criteria on bigger domestic companies. Mr. Nicolas explains that analysts who operate as generalists
become candidates for ownership using a bottom-up investment process, fund managers and are capable of analyzing a
in the Oakmark Fund. identify companies trading for meaningful discounts to their variety of different industries and
I mentioned that the way estimate of intrinsic value and where they expect per-share business models.
we define value is different than value to grow over time. The quality of a company’s TWST: How often do
many of our peers. We don’t require management is also an important consideration. Sell targets you reposition your fund; that
a current or prospective portfolio are typically set around 90% to 95% of their estimate of value. is, add or sell different
company to trade for a low multiple Rather than considering value and growth to be opposing holdings?
of the earnings or book value they dynamics, Mr. Nicolas views growth as one of many factors Mr. Nicolas: It really
publish in their audited financial to incorporate into a calculation of intrinsic value. He seeks depends on the opportunity set
statements. Our CIO–U.S. Equities, companies that are well capitalized with ample liquidity so and the relative attractiveness of
Bill Nygren, has written at length that they’re positioned to take advantage of the rebound in our current holdings that are in
about the flaws of solely relying on economic activity as the coronavirus subsides. Rather than the portfolio. On average, our
generally accepted accounting speculate on short-term stock price movements, Mr. Nicolas portfolio turnover tends to be
principles — or GAAP — to advises Millennials to allocate a significant percentage of their about 25% to 30% per year.
determine how profitable or funds to the equity markets with a buy-and-hold mentality. TWST: And what is
valuable a company is. At Given increased life expectancies, he believes Baby Boomers your sell discipline?
Oakmark, we often go to should have a healthy allocation to equities as well. When a new idea is
painstaking lengths to recast a Companies discussed: Alphabet (NASDAQ:GOOG); Comcast presented, the analyst
company’s financial statements in Corporation (NASDAQ:CMCSA); CBRE Group (NYSE:CBRE); recommending the company
order to reflect what we believe its Keurig Dr Pepper (NASDAQ:KDP); Wells Fargo & Co. will set an estimate of its fair
true economic earnings power to (NYSE:WFC); JPMorgan Chase & Co. (NYSE:JPM); Visa value. From there, we’ll always
be, which can sometimes look (NYSE:V) and Bank of New York Mellon Corp. (NYSE:BK). set buy and sell targets, with the
quite different than how GAAP latter typically set around 90%
would define it. to 95% of our estimate of value.
For these reasons, you’ll see a mix of what I would call traditional As our estimates of value change over time, so, too, will our buy and
value names in our portfolio, like many of our financial holdings, and non- sell targets. Additionally, we are constantly evaluating what we
traditional value names, like Alphabet (NASDAQ:GOOG), which I can currently own against our internal opportunity set, which is our
discuss later in more detail if you’d like. approved list of investable companies.
“I believe that shorting is a difficult way to make a living, given that markets go up
over long periods of time and the risk/reward is inherently unfavorable, as you have
limited upside potential and an unlimited downside risk.”
We’ve incorporated some other unique attributes into our process During certain periods, such as the violent downturn we witnessed
that are worth noting. Oakmark is a long-only fund, which means that we earlier this year, we found ourselves in the unusual position of selling stocks that
don’t actively bet against or short companies in our portfolio. I believe that were trading at the buy target, roughly $0.60 on the dollar, for those that were
shorting is a difficult way to make a living, given that markets go up over trading well below their buy target, call it $0.40 on the dollar. It’s a dynamic,
long periods of time and the risk/reward is inherently unfavorable, as you opportunistic process that’s based on both a stock’s distance to its sell target as
have limited upside potential and an unlimited downside risk. well as the relative cheapness of the opportunity set we can consider owning.MONEY MANAGER INTERVIEW ——————— IDENTIFYING INTRINSIC VALUE KEY TO STOCK SELECTION
TWST: Do expect to reposition once we see a COVID But what this type of simplistic analysis tends to overlook is
vaccine rollout, and/or a Democratic administration? that Alphabet has several money-losing or under-earning assets in
Mr. Nicolas: I wouldn’t say we’re attempting to reposition the various stages of maturity that we believe are worth significantly more
portfolio in anticipation of a vaccine rollout or a new administration. than what is being captured in consensus earnings estimates. If we begin
Given our investment approach, we’re much more concerned about what to disentangle these various assets, the multiple we’re paying for
a business will look like seven years from now than we are over the Alphabet’s core search business, Google, is unusually attractive for such
coming quarters — or even a few years — as a vaccine is rolled out and a dominant, high-quality, high-growth business.
a new administration comes in. So let me get into some specifics. We expect Alphabet to have
roughly $250 a share of net cash and investments on its balance sheet by
1-Year Daily Chart of Alphabet Inc. the end of 2022. This cash is earning very little today, given where
interest rates sit. Furthermore, we estimate that YouTube, which is under-
earning relative to its ultimate monetization potential, is conservatively
worth another $200 a share to Alphabet and potentially much more if
one were to value an hour of viewership on YouTube in a similar fashion
to how the public cable networks are being valued. So simply by
adjusting our valuation for these two assets and backing out our estimate
of their respective contribution to consensus EPS forecasts, the multiple
on Alphabet grinds down from 24 times to 19 times.
There’s more. Alphabet has been investing heavily within its
“Other Bets” segment, which includes a collection of venture capital-like
investments, such as Waymo, the world’s leading autonomous driving
technology. These investments are highly valuable, but currently lose
Chart provided by www.BigCharts.com
money, further weighing on reported earnings and inflating the stated p/e
ratio of the company. For context, some sell-side analysts have appraised
Waymo alone to be worth more than $200 per Alphabet share.
The market has certainly presented us with opportunities to So, making a further adjustment to back-out the losses coming
add to our existing positions and uncover new ones that are facing from Alphabet’s “Other Bets” and instead treating them as though they
transitory headwinds from COVID. But given that we’re valuing were invested through a venture capital fund, we believe we’re paying a
businesses based on the total amount of cash flow we expect them to below-market multiple for Alphabet’s core search business. We love
generate throughout their life, it’s usually the case that a few years’ worth buying terrific businesses at below-average prices, and we believe
of impaired or above-trend cash flow won’t have an overly material Alphabet represents a compelling opportunity to do that.
impact on our estimated value. We try not to trick ourselves into thinking Another name that we like today is Comcast
we can accurately time market inflections. (NASDAQ:CMCSA). Comcast is the largest broadband provider in
“The delivery of traditional linear television can be provided by cable, satellite, DSL or
fiber (where available), but high-definition on-demand video can only be delivered by
cable and fiber. Cable is the only infrastructure capable of delivering broadband
speeds to greater than two-thirds of American households.”
TWST: Can you share with us a few of the stocks that did the U.S. and it owns several other iconic assets, including a large
best so far over 2020? And on the other side of that, which may have theme park portfolio and the NBC family of broadcast and cable
disappointed? networks, among others.
Mr. Nicolas: I’ll talk about our biggest position, which is We’ve long believed that concerns about the demise of the pay
Alphabet, the parent company of Google. I think Alphabet is a great TV bundle on Comcast’s cable business were misplaced. In fact, we
example of how relying purely on reported financial results can distort believe the opposite is true. The delivery of traditional linear television
the magnitude of undervaluation that we see at the company. Given how can be provided by cable, satellite, DSL or fiber (where available), but
familiar everybody is with the company’s products, I’ll skip right to the high-definition on-demand video can only be delivered by cable and
source of inefficiency. fiber. Cable is the only infrastructure capable of delivering broadband
Alphabet’s consensus forward earnings estimate, looking out speeds to greater than two-thirds of American households.
two years, is $72 a share. Today, the stock trades for $1,750. Simply We believe that investors should increasingly view Comcast’s
evaluating the business on this metric, the company trades for about 24 broadband business as an infrastructure asset. It is an unregulated,
times 2022’s expected earnings, which is a healthy premium to the hyperlocal natural monopoly. New competitors have to pay today’s labor
market and an optically high multiple of forward earnings. costs and are only competing for fractional market share. WhileMONEY MANAGER INTERVIEW ——————— IDENTIFYING INTRINSIC VALUE KEY TO STOCK SELECTION
Comcast trades at a multiple that’s comparable to traditional media should deliver steady growth, consistent market share gains and
companies, we believe its economic characteristics are more similar to significant excess cash flow. It’s an above-average business trading at
the wireless tower and data center operators. These companies trade for a meaningful discount to the market, its beverage peers and historical
significantly higher multiples than Comcast does today. private market transactions.
The increasing utility and cost to replicate Comcast’s cable TWST: Where have you been disappointed over the past
plant bodes well for future pricing power. While the company is by no year? And what worries you most looking ahead into 2021?
means a hyper-growth business, we believe that it will grow its operating Mr. Nicolas: The most disappointing stock price performance
income at a mid-single-digit rate on average over time. has come from our financial holdings. More specifically, we own several
Furthermore, Comcast’s more cyclical business segments — banks that have performed poorly in the current environment given
in particular its theme park portfolio — should benefit from an eventual concerns about credit costs, interest rates and the ability to grow fees in
snapback in demand post-COVID. Today, we believe investors are the current environment. We continue to find the space to be attractive as
paying very little for this asset, as well as the NBC family of networks, many of the companies that we own today are trading for mid- to high-
its film studios and its European satellite TV business. single-digit multiples of our estimate of normalized earnings, and in
Making some adjustments for the cyclical impact that many instances at or below their tangible net asset value.
COVID has had on some of these other assets, we estimate that In terms of general concerns about the market looking into
Comcast is trading at just 12 times our estimate of normal earnings 2021, I would say that most of those would be centered around the
looking out a few years. That’s far too cheap for such a high-quality health, economic and social implications of COVID. This will ultimately
collection of assets, many of which would be incredibly difficult and influence the duration of the recession that we find ourselves in today, as
cost prohibitive to recreate. well as the pace of the economic recovery. We continue to focus on
“In terms of general concerns about the market looking into 2021, I would say that
most of those would be centered around the health, economic and social implications
of COVID. This will ultimately influence the duration of the recession that we find
ourselves in today, as well as the pace of the economic recovery.”
TWST: Beyond what you’ve already discussed, can you ensuring that the companies that we own are well capitalized with ample
share your most recent ideas that you may have added to the liquidity, such that they’re positioned to take advantage of the inevitable
portfolio? rebound in economic activity as the virus subsides.
Mr. Nicolas: The two most recent positions that we’ve added TWST: As we face a very big turning point with the
to the portfolio were CBRE Group (NYSE:CBRE) and Keurig Dr hopeful rollout of the COVID vaccine, are you looking at any stocks
Pepper (NASDAQ:KDP). CBRE is the largest commercial real estate that might benefit? Is this upcoming turning point something that
services firm in the U.S. The company has significant scale across its you are taking into account?
various service lines and geographies, which enables it to consistently Mr. Nicolas: As I mentioned earlier, we pay close attention to
invest more than smaller peers into the research, tools and technology anything that we believe could impact long-term business value for our
that customers value. This industry-leading value proposition has driven companies. But we’re not repositioning the portfolio specifically in
consistent share gains for CBRE in recent years, as large clients have anticipation of a vaccine rollout, nor are we speculating on potential
been attracted to the company’s differentiated capabilities and the best winners or losers in that environment.
brokers have been attracted by the steady stream of clients. TWST: What are the biggest mistakes you see most
We expect CBRE to continue to gain market share in the investors making? And how might the mistakes made by Millennials
highly fragmented brokerage industry for many years to come while differ from that of aging Baby Boomers?
it further transitions away from transaction-driven commissions and Mr. Nicolas: For the Millennial generation, there seems to be
toward more contractual fee revenues. There’ve been some outsized this tendency to treat the stock market as though it’s a casino, whereby
fears around “work from home” that have caused the company to sell younger investors attempt to speculate on short-term stock price
for less than 13 times our estimate of mid-cycle earnings. We think movements and are seemingly investing more for entertainment value
this is an attractive price for a high-quality and well-managed than they are for financial security.
business like CBRE. My advice to this generation, given their long investment
The other name that we recently acquired was Keurig Dr horizon and presumably higher risk tolerance, is to allocate a significant
Pepper. Keurig Dr Pepper is one of North America’s leading percentage of their excess funds into the equity markets. I’d argue that
beverage companies and commands a strong market position in single- this generation doesn’t need to be actively trading their portfolio on a
serve coffee and flavored sodas. Keurig’s competitive advantages are day-to-day basis and would stand to benefit from investing in a
many. It has a low-cost production footprint, the largest installed base diversified portfolio of stocks with a long-term buy-and-hold mentality.
of brewers and exclusive brand partnerships, which allow it to collect This type of mentality aligns well with our own value-oriented, long-
a toll on most pods sold in America today. We believe Keurig’s brands term investment approach at Oakmark.MONEY MANAGER INTERVIEW ——————— IDENTIFYING INTRINSIC VALUE KEY TO STOCK SELECTION
I’d say for the Baby Boomer generation, one thing to keep in institutions in the country. It had consistently posted some of the highest
mind is that life expectancies have increased. While the historical rule of returns on tangible equity of its big bank peer group and it regularly
thumb for older retirees was to invest the significant majority of their net traded for north of two times its tangible book value.
worth into bonds, I believe it’s still appropriate for many in this generation But regulators have not been kind to Wells Fargo over the
to have a healthy allocation to equities as well. Doing so, especially in past four years. The company is still attempting to address a number of
today’s historically low interest rate environment, allows for both income consent orders outstanding and it’s currently operating under an asset
generation and the growth of capital. It’s possible to construct a portfolio cap, which limits its ability to grow. As a result of these issues, Wells
of value stocks today that offer higher yields while also allowing you to Fargo has become a bloated and highly inefficient bank, as the
participate in future earnings and business value growth. company has had to spend considerable sums on correcting historical
Given where rates currently sit, we believe it’ll be difficult to faults by hiring outside consultants, paying large legal settlements and
replicate the strong performance that many retirees have been accustomed restructuring the company.
to earning in fixed income over the last several decades. To illustrate the point, Wells Fargo today has more employees
TWST: It sounds like Oakmark Fund is relatively low risk. than JPMorgan (NYSE:JPM), despite the fact that its revenue base is
That said, do you have any strategies for mitigating risk? some $35 billion smaller. When coupled with the challenging operating
Mr. Nicolas: I wouldn’t define investing in the equity market environment that all banks find themselves in as a result of COVID,
as low risk. That said, we have a number of tools in place to help mitigate Wells Fargo’s income statement looks like a mess. The stock has fallen
the risk of permanent capital impairment. The best tool is making sure precipitously as a result.
that we appraise the value of our businesses as accurately as possible and We see the potential for Wells Fargo to look more similar to
that we’re buying into a healthy margin of safety (i.e., a steep discount its former self in a few years. New management is now in place, led by
to intrinsic value). As mentioned earlier, we incorporate various other a world-class CEO, Charlie Scharf. Scharf has a strong record as an
tools, including our devil’s advocate program, industry and position executive and is well equipped to transform the bank. He was a former
sizing limits, and an intense focus on balance sheet and management top lieutenant to Jamie Dimon at JPMorgan and was also the former
quality. CEO at Visa (NYSE:V) and Bank of New York (NYSE:BK).
TWST: Tell us about the cyclical valuation trends that Scharf has talked regularly about the enormous cost opportunity
you’re seeing and how that may have influenced your choices? he believes exists at the bank. More specifically, if Wells Fargo simply
Mr. Nicolas: Cyclical trends in general are quite weak right operated at a similar ratio of non-interest expense to total revenue as its
now across many end markets, and any p/e-based valuation metric is peers, or its former self, it would generate over $4 per share in EPS,
going to make the market as a whole look quite expensive on current assuming a normal credit environment. Today, the stock trades for $25 a
earnings. But this is not a normal year by any stretch of the imagination. share or just over six times this normal estimate.
Therefore, many companies are not earning what they would in a normal Furthermore, we believe our downside is reasonably well
economic environment. We price businesses based on our estimate of protected as the stock trades for just 75% of its tangible book value,
normal earnings power, or in the case of a highly cyclical business, on and its capital levels remain strong. In theory, the company could sell
mid-cycle earnings. This estimate will incorporate both good times and all of its assets, pay back all of its liabilities, and you could still get
bad times. more than your money back. In fact, the last time Wells Fargo’s stock
But from a market perspective, using next year’s projected price was in the $25 range was in 2014. At that time, the company had
EPS for the S&P 500, the market is trading around 19 times p/e. While just $18 a share in tangible equity. This year, the bank is expected to
this forward multiple is a few turns above its long-term average, I’d finish the year with $33 a share in tangible equity, but trades for the
contend that next year’s EPS will still be below trend for many same price as it did back then.
companies in the index. And the lower interest rate environment should We like the unique opportunity that Wells Fargo has in front
further support a higher valuation multiple relative to historical averages. of it, whereby streamlining the cost structure could enable the business
We’re still uncovering plenty of attractive investment opportunities in to achieve our estimates without the need to rely heavily on a rising
this environment. interest rate environment. Of course, if interest rates move off their
TWST: Any other compelling ideas that you would like to historically low levels and the yield curve steepens, this would likely be
discuss in greater detail before we conclude? an added bonus.
Mr. Nicolas: I mentioned before that a handful of our TWST: Thank you. (VSB)
financials have been disappointing performers this year, so it probably
makes sense to discuss one of them in more detail. I’ll speak specifically
to Wells Fargo (NYSE:WFC), which owns one of the largest consumer MICHAEL NICOLAS
banking franchises in the country. The company has fallen on hard times Co-Manager & VP
due to a number of missteps by former management, most notably the The Oakmark Funds
sales practices scandal that was exposed during 2016. Prior to these www.oakmark.com
issues, Wells Fargo was one of the highest-performing banking
© 2020 T h e Wa l l S t r e e t Tr a n s c r i p t , 6 2 2 3 r d Ave n u e , N ew Yo r k , N Y 10 017
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