Excerpts from Value Investor Insight Interview (paraphrased)
Assuming you are looking for stocks trading at discounts to your estimate of value, management teams aligned with shareholders, and value that grows over time – true?
Bill Nygren: If the name isn’t cheap, it doesn’t even qualify as a value investment. If the value isn’t growing, then you’ve got a clock that’s ticking against you. And if management isn’t focused on maximizing long-term per-share value, then no matter how good your analysis is of the business, decisions being made can disrupt the path of value you’d otherwise see in the static business. PE firms generally look for companies they believe investors will perceive differently 5-7 years from now because of changes they can put in place. Investors today might be ignoring hidden assets or are overly focusing on a temporary problem, but a PE approach focuses on how values could change over several years. That’s very different from investors who are trying to outguess each other on next quarter’s earnings.
You invest in some of the best-known and most-followed companies. What can make them mispriced?
Bill Nygren: Easiest thing for investors is to extrapolate historical trends. Opportunities we find usually arise when that extrapolation leads to something that is very different than what we think is likely. That could come from new management and believing future margins are going to be different than in the past. It could come from non-earning assets turning profitable and from overreaction to a short-term problem.
Win Murray: We’re coming to companies that haven’t been run well and investor perception is that the business itself is not good. With Baxter International, for example, we saw a company with an operating margin of roughly half the 20% we thought was possible, with a new CEO, taking over at the beginning of last year after a very successful stint at Covidien. That type of situation is interesting, combining a stale company perception with an executive who has a record success.
It’s more difficult than ever to distinguish between permanent and temporary issues facing companies and their industries. How do you deal with investments that aren’t working out as expected?
Bill Nygren: When we get to a point where fundamental results have deviated from our plan, say by a double-digit % that triggers a process where we revisit our assumptions to see if we’d have enough confidence to buy it today. Value investors take great pride in their patience, but for patience to be a good thing, your thesis has to be right. At some point, you have to recognize when new information presents a challenge to your thesis that you should revisit whether this is an investment you would make today.
How do you generally arrive at estimates of fair value?
Win Murray: For most of our companies, we estimate a normal cash-flow level – EBITDA as a short cut – and then ascribe to that a multiple that makes sense in the framework of a discounted-cash-flow model and relative to valuations on other names we look at. If we’re making our best estimates in every case and arriving at those estimates in a disciplined and consistent manner, we should be surfacing attractive relative ideas for each portfolio. We want our analysts to be torn and not know if they’d bet the over or the under on their cash flow estimates. When it comes to making portfolio-management decisions, it’s the absolute value of the error that is going to cause the investment mistake.
What do you think the market is missing about General Electric (GE)?
Win Murray: We like to look for management catalysts in companies that have a stale perception in the marketplace. We have always admired GE’s businesses – like businesses where you sell big OEM equipment at a low margin and then collect a 40-year stream of high-margin service revenues that the customer is essentially locked into.
Problem we had with GE is they bought expensive healthcare, Amersham, when oil and gas was really cheap – then they bought expensive oil and gas – Lufkin Industries, Vetco Gray, Dresser, and others – when healthcare was really cheap. They expanded financial services at the worst possible time. They sold NBC at the bottom of its ratings cycle.
When Jeff Bornstein took over as GE’s CFO in mid-2013, you can draw a line when capital stewardship changed. Bought power-equipment business for a single-digit multiple of cash flows, sold Synchrony Financial in a tax-efficient spinout, sold appliance business for a high multiple, combined the oil and gas business with Baker Hughes at the bottom of an oil cycle, dismantled GE Capital swiftly at a good multiple.
Bornstein drove a change in how GE’s top 6,000 or so executives are paid – new incentive system was a complete revamp of a 1950s-era plan that was almost union-shop in construction, based more on seniority and your bonus last year than how you actually performed. New plan pays out based on a scorecard of factors under managers’ direct control and tracked in real time.
How well positioned do you consider GE’s key operating divisions?
Win Murray: Aviation is a powerhouse that has been taking market share and the medical equipment business is well positioned in its core ultrasound and imaging markets. In power, significant cost synergies and cross-selling after the Alstom purchase. In oil and gas, Baker Hughes transaction filled holes in both companies’ portfolios with little overlap and merged company has access to GE’s balance sheet. As oil market recovers, the new Baker Hughes has the potential to gain share as a result.
Some analysts have questioned GE’s earnings quality. Is that a concern?
Win Murray: We don’t believe so. GE has been preparing for big product launches and has by design been less efficient with working capital. That is explainable by where they are in the launch cycles and cash flows they’re going to produce from those launches are well worth any short-term mismatch between GAAP earnings and cash flow.
Harley-Davidson (HOG) has been on value investors’ radar for some time now. What upside do you see from here?
Win Murray: Prior management had spent a decade trying to optimize capacity for demand and improving manufacturing efficiencies. That was all well and good but the challenge now has been to correct for years of underinvestment in new products, marketing and geographic expansion. Today they’re investing more than 200 bps of margin into marketing and new product development.
Is all that enough to compensate for traditional baby-boomer customers aging out of the market?
Win Murray: What’s important is how many motorcycles 25-to-50-years-olds around the world will be buying in 10 to 15 years. We think that’s going to be a surprisingly high number. According to industry data, current 25-to-50-years-olds are more likely to own a motorcycle than baby-boomers were when they were that age. Internationally, it’s not a question of demand for motorcycles but the extent to which rising disposable incomes support the purchase of Harley. International now represents 36-37% of the company’s unit volumes.
How do you handicap the competition?
Win Murray: The most buzz is around Indian which is Polaris’ relaunched brand – but Indian is a drop in the bucket relative to Harley and its volumes are a long way from being large enough to incent Polaris to invest the large dollar amounts required to build significant additional capacity. We’re arguing that the company is navigating a customer-base transition, but that the strength of the core brand underneath will win the day with a long-enough time horizon. If the brand isn’t resonating with new customers, that will clearly be an issue.
Are you finding it hard to find sufficiently discounted share prices?
Bill Nygren: It’s always hard – when prices get to a level where they look really cheap, it’s usually in the midst of a new environment that makes investors reluctant to commit long-term capital. I used to think it must have been easy to be an equity investor back in the 1950s when dividend yield exceeded the yield on 10-year Treasuries. When we experienced that environment in just the past few years, didn’t seem so easy. I think it’s dangerous to draw lines in the sand after which you’ll just sit it out – once you do, temptation is to spend all your time trying to defend why now is not the time. When you look at the list of things investors had to deal with over the last 25 years – wars, hurricanes, global financial crisis, oil-price collapse – it’s amazing the market returned 10-fold. You could look at the market today and say trailing P/E is 15-20% above historical averages, which could be enough to give one pause. On the other hand, dividend yields as a % of corporate bond yields are higher than normal. Economic growth outlook is positive, retained earnings are higher than average and are being put to use to delever balance sheets, increase dividends and repurchase shares – there are always reasons to be bearish and there are always reasons to be bullish.
2Q17 Bill Nygren Market Commentary, June 30, 2017