Looking For Intrinsic Value - Clyde McGregor of Oakmark Funds

And this is a relatively recent occurrence, right? Relatively. We did well in 1997. Almost all strategies worked then. But in mid-1998, the wheels didn't come off value in the sense we lost money; we just stopped making money. Other people using different approaches were making a lot of money, and people were pretty quick to leave us. By the middle of 1999, it had become an absolute torrent, particularly in our all-equity products, most notably the Oakmark Fund. This fund peaked at $9.1 billion and bottomed at $2 billion. Now it's back around $2.8 billion. It's definitely taking in money more days than it is losing money, but it has still not returned anything like what we saw in 1997.

So value investing is clearly back? Yes, I think that value is definitely the place to be for the intermediate term. We have had a significant rally in the value sector over the last 12 months. Last year, the Russell Mid-Cap Value index was up 19%. That just doesn't seem to be understood by anybody outside of the value circle. In 1999, for example, a year that was supposedly a great bull market, only a third of the stocks were up for the year on the New York Stock Exchange. But in 2000, the year that was considered to be the start of a bear market, 57% of the stocks were up. It's the opposite of what you'd expect.

Why is that, do you think? I think it's because the big caps move the averages around. All the averages are market cap-weighted now, with the exception of the Dow Jones Industrial Average (DJIA), which is in a very peculiar form. You have to get down to something like the Value Line to get one that is more equally weighted.

The outcome of the average stock has been more disparate from the big caps, particularly the tech-sector big caps, over the last few years than has ever before been the case. So value has had a stealth bear market and a stealth bull market in the last three years. The time for value is still here, but it is less compelling than it was a year ago.

What goes through the minds of managers when they have clients asking, "Why aren't you guys doing as well as the others?" How do you explain your approach in the middle of irrational exuberance? It's highly problematic. On the mutual fund side, we lost a lot of clients who didn't like our answers. I've been blessed because my fund is a more conservative product, at least in terms of asset allocation. I never got caught up in the feeding frenzy when value was hot in the mid-1990s, and I didn't suffer near as much. I think the grand total that left my fund was only about $11 million or $12 million from the peak. But since September, the fund has tripled in size as we've received some favorable press and made it to the top of the list in balanced funds.

You deal with this situation a little more with individual clients who keep pushing. It's the newer clients who haven't seen the value of value over long periods who end up leaving. It's important that individual investors understand what value is. Unfortunately, people lost contact with the power of negative returns in our business.

I am sure there are horror stories. I have a separate account client who started with me in June 1998, right ahead of the problems with hedge funds and Russia. She obviously got off to a dubious start. In 1999, her returns lagged considerably, but in 2000, she had a great year. This year she's had a good start. With an all-equity individual retirement account (IRA), she's 55% ahead of the Standard & Poor's 500 now. A year and a half ago you would have thought this was impossible. When you start putting meaningful negative numbers into the S&P or the Nasdaq, it just destroys account size much faster than people understand. They think it's symmetrical up or down. You know the old rule Ñ if you double one year and go down 50% the next year, you're back to where you started. That's the way percentages work. In the value world, we have been able to generate positive rates of return in almost all time periods.

When didn't you? One difficult period for value was the second half of 1990, when value just didn't work. There was the unwinding of the leveraged buyout (LBO) phenomenon back then, and it put a damper on everything that was considered value. It diminished some wonderful long-term records. It was the first time we lost money for clients. But with that important exception, we've been able to keep grinding it out, year after year.

What kind of investors should be in value investing? People who are at risk of being chased out of their style when the markets go against them probably need to have part or all of their money in a value style, depending on how nervous they are. If they're nervous about the equity markets in general or can't stand downside returns, they ought to have a chunk of money with value-oriented investors. The more conservative they are, the more they should have in balanced funds because value people in general keep grinding it out year after year.

We obviously have our good years. Last year was a very good year for us, and for value generally. You keep stringing along 7%, 8%, 9% return years and then have the occasional 20% or 26% like we did last year. We had a 26% return in 1997, and all of a sudden our fund, which has never been more than 62% in stocks, had a 15.8% compound rate of return since inception. Now that's a stocklike return without stocklike risk.

Our philosophy is to invest in companies whose managers think of their shareholders as their partners, so we as fund managers have to think of our shareholders as our partners. We do that by making significant personal investments in our funds. I'm the largest investor in my fund.

I've noticed value managers tend to have their own money invested in their funds, whereas it hasn't come up with other managers. Why is that? In general, value managers tend to be older than other investment managers. I'm 48 and I'm probably at the younger end of value investment managers. The growth guys tend to be younger, and the momentum guys in general even younger. The younger guys don't have the capital or the kind of culture that the value guys have built up. If we don't eat our own cooking, so to speak, nobody should invest with us. By the same token, if the managements with whom we've entrusted our clients' money don't have meaningful personal commitments to their businesses, we shouldn't invest with them.

That becomes a harder rule to hold onto when we're seeing so much importance given to stock options. We really aren't happy with the development of options as the prime way of compensating people in some industries, and would prefer to give them more cash and have them actually buy the stock. We pay attention to that and think our shareholders should pay attention to that as well. Not everybody buys into this idea, though. It all depends on the philosophy of the manager.

So what do you think people should do? We still think people should have downshifted more in terms of their risk profile than the evidence suggests. There are many who want to get even before they reduce their risk profile or get out entirely. It's hard to say when the other shoe will drop. It's like trying to say why the Nasdaq peaked last March 10. There's no proximate cause we can point to, such as a change in interest rates or some world event. Changes in investor psychology tend to happen fairly randomly at first, and once it becomes more socially acceptable, it becomes a major move. But we're not there yet.

Looking at the fund, let's talk about your stock selection process. Do you use a bottom-up approach where you look at the companies first? Yes, we do. Our three basic premises are: Invest with companies whose managers view their shareholders as their partners; buy the stocks of those companies at a significant discount; and invest in companies whose intrinsic value has a positive growth associated with it.

Our process is bottom-up. Our analysts do some screening, but we stress looking at corporate change or getting hold of new information that has to do with valuing businesses. It's not Wall Street-derived; it's always derived from people in business. We may hear a tentative transaction announcing that X is buying Y. We look at the price implied in that transaction and study it to see if it makes sense. This helps us understand what's going on better.

Can you give us an example? When Quaker Oats (OAT) bought Stokely, the company that owned Gatorade, we didn't understand how they could pay so much for Stokely. The head of Quaker Oats eventually told us after we had gone through half of his staff and hadn't received a satisfactory answer. He got increasingly frustrated because nobody in the investment community could grasp a concept that seemed so simple to him. He said, "I have a national distribution system for packaged goods. When I can acquire a strong regional brand, I can expand its distribution through my system at virtually no additional cost. The price it makes sense to pay for a good regional brand equals its annual sales." To him, that was just as obvious as could be. But to the investment community, it was a new concept.

When was this? This was 16 years ago. Since then, we have studied the food industry more broadly. We looked at a lot of regional and national companies. They were priced anywhere from a low of 30% of sales up to 78%, 80% of sales. We bought a lot of them and they just kept getting taken over. Something as simple as a CEO's throw-away comment can inform us about what's going to happen in a way that Wall Street isn't able to do. We're always looking for these kinds of measuring yardsticks that we can apply to public companies.

Do those yardsticks alert you to a company to watch, or are they the catalyst -- the thing that tells you to buy? We have to have management in place that we can trust to serve our shareholders' interest, and we have to believe that the intrinsic value is growing. But yes, it helps us with the first thing, which is the intrinsic value per share of a company. Let me give you another example.

I went to a separate-account meeting in December. The clients were worried at that point, even though we were having a fine year for them. One of them, a minister from a town in Virginia, asked what the riskiest stock in the portfolio was. I told him the riskiest security was our holding of JC Penney (JCP) common stock. He almost fell off his chair laughing. In his rural community, JC Penney was still associated with motherhood and apple pie. It hadn't caught on where he was located that Penney's had lost a lot of market share and money. The stock had peaked at around $80 and was down to a low of $9. It sounds like a technology stock, except it's a name many of us grew up with.

What was the catalyst? The catalyst that got us into JC Penney was a change in management. They announced that Allen Questrom, with whom we had some previous good experience, was going to be the new CEO. That really got our attention, because this is a guy who had done a superb job of reinvigorating Federated Department Stores (FD) in the past. So we decided to find out what he saw in JC Penney -- at that point, the stock was at 16 or 17 and still going down.

What did you find out? We found that Penney was as bad on the department store side as we thought it was. About four years earlier, they had bought Jack Eckerd Drugstores. To most people, the drugstore business was considered very good. A chain like Eckerd that started in Florida and had good Florida real estate couldn't be so bad, right? But after Penney's purchase, a lot of good people left Eckerd, the company started having operational issues, their shrinkage had gone up, and their margins were poor, despite the fact their same-store sales were going up.

So there were conflicting signals. When we got into it further, we were lucky enough to have a meeting with Questrom. He explained some of the problems with Eckerd and said they could be fixed. We did some work and decided that Eckerd was worth, at a minimum, $10 per share. If its problems could be fixed, as we believed it could, it would probably be worth more like $20 per share. That creates our margin of safety, because that's a business we know will continue to exist. Their balance sheet was in decent shape and they brought in a guy to fix Eckerd, whom we also respect.

The intrinsic value case was strongest in terms of the drugstore business. The whole thing is bolstered by the fact that we think a change in the CEO of the department store business will fix the problems, or at least not make them worse. This is a stock that could go to at least $30. We started buying at $14 and averaged down at $9, which made our average cost around $12. It's $16 today as we speak. Not much has happened to the company since we bought the stock, but Eckerd does look better.

That's certainly an argument that the stock has bottomed and is building a base. These are the kinds of things we look for. One other nice thing from the standpoint of my fund is that this company has a big dividend and is supported by their cash flows. We can also get, say, a 5% yield on our cost, which is a nice thing to add into the total return picture. With that kind of dividend yield, the stock doesn't have to do as well.

You talked about intrinsic value. Can you explain what the term means? It refers to the amount someone would pay to own the entire business and get a fair economic return on that business. Different businesses have different parameters or measures that would produce that outcome, because they have different growth rates. It's a squishy concept but tends to be fairly hard in principle.

Some businesses don't lend themselves well to that kind of analysis. A simple one in the portfolio is Nova Corp. (NIS), which is the third-largest credit card transactions processor. In the 1990s, transactions took place between 15 and 18 times EBIDTA (earnings before interest, depreciation, taxes, and amortization) or pretax earnings, as the business migrated from smaller entities or from banks to the consolidators. It's a high multiple, but that was the price that was typically paid because it worked economically. They could be added to existing computer systems and overhead didn't go up very much. Your payback period on an investment of that type was comparatively quick, because there was so little cost attendant with it.

What was the deal with Nova? With Nova, we were buying the stock after they had made a bad acquisition and had some earnings problems. I think our cost is around $12 and the stock is $19 as we speak. If you just look at Nova's core business, at its low it traded at a quarter of the upside valuation. If you assume that the bad business can be wound down, you had a stock that was trading at a ridiculously low price relative to the industry's opinion of its intrinsic value.

Again, intrinsic value refers to the fair economic return if you own the entire business. It's what somebody would pay to own the entire company if they could never sell it again. That's one of those disciplines we have. We don't want to think in terms of the greater fool theory -- if I buy it, can I find somebody else who will pay a higher price for it? We want to think it is a good decision if we were stuck owning it forever.

That's an interesting way of looking at it. Is the timing of purchases something you concern yourself much with? We value guys are probably an embarrassment to our industry in terms of our abilities as timers. If I ever buy anything right at the bottom, I think I'll retire at that point, or maybe a year later, when I've figured it out. We never know when the thing really bottoms.

When I first started at Harris, one of our founding partners, who has long since retired, was the best I ever saw at buying at the bottom. But he also only ended up being 60% invested at the peak. He left a lot of opportunities on the table because he just barely missed them. He was running a partnership. It was a hedge fund, except it didn't ever go short. He was the biggest investor in his partnership, so he could afford to risk being underinvested all the time.

The products we're involved with today on the mutual fund side are a little different. With a mutual fund you've got money flowing in and out all the time, so you have to get acclimated to the fact that your tactical decisions are going to be less than optimal. Your strategic decisions and your adherence to your strategic perspective have to be as optimal as you can make them, but tactically, you're going to get in too early.

What we don't want to do is to buy Penney at $15 and decide at $9 that we've made a real mistake and get out. We do make those kinds of mistakes, but I can't think of anything in the last year where that has been the case.

Do you make revisions in your portfolio on occasion? In my early days as an analyst, I recommended Tonka Toys. This was back in 1982. Two weeks later, I said, "You know, I think we're making a mistake." We got out. Fortunately, we only owned about 10,000 shares, so it wasn't a big deal. There are very few experiences in the history of Harris Associates where we've done something like that. Our goal is to get comfortable with the true business value, or intrinsic value, or private market value of the business we want to invest in. If we start buying Penney at $12 and it goes to $9, we've got to have the confidence and courage to keep buying it on the way down.

There must also be times when that confidence has paid off. Yes. Washington Mutual (WM) is a good example. We started buying it at $36 two years ago. By February 2000, the stock was down to $22. We were just beating our heads into the wall, wondering what the problem was. The company was going to earn almost $4 a share, we liked the management, and they were doing interesting and creative things to expand their franchise. They own the mortgage market on the West Coast.

So they were doing all the right things. There was no obvious problem we could see, aside from the Fed continuing to raise interest rates. That didn't seem to be a big problem, so we kept adding to the stock, but questioning ourselves all the way. Recently, the stock hit $55.

That's quite a jump! It doesn't mean it's an appreciably different business at $55 than at $22. It just means that it's a different investment world out there. The interest rate environment changed from one where people feared interest rate escalation to one where they were expecting interest rates to keep going down.

Frankly, Washington Mutual is somewhat insulated from changes in interest rates, but that's how the market acts and that's all that matters because we can take advantage of it. We value guys are considered to be the bottom-fishers or the parasites. We're trying to bring things back into pricing equilibrium.

Can you give any other examples? Rockwell International (ROK). Last September, it went all the way down to $28 from $391/2 when they made an earnings shortfall announcement. Luckily, we had already done our work on it in and had it in hand. We had no idea the stock would go from $391/2 to $281/2 in two days. We started buying the stock and I think our average cost was $31. It went all the way up to $47, then recently sold down to $36 again, on worries of earnings announcements of other companies in the same industry. We added to our holdings at $36 and now it's back up to $42 again.

Obviously, we went through a period when there weren't many good businesses trading around 10 times earnings. At $42, Rockwell's 14 times, so it's no longer the table-pounding buy it was last September. But again, these opportunities keep cropping up. As value investors, it's our obligation to try to find the good ones and jump all over them.

How do you decide when to sell stocks that have produced good returns? We set buy and sell targets on all our holdings. When a stock goes on our buy list, our buy target is 60% or less of what we think the intrinsic value is. Our initial sell target is 90% of the intrinsic value. As we get more information about the company, the targets change. For example, if we perceive that Washington Mutual's effort to expand into Las Vegas and Arizona really looks to be adding to their footprint, we might increase the intrinsic value per share estimate for the company. Although we're not very mechanistic in what we do, we do have those buy and sell target disciplines.

Treasuries have been a prominent holding in your fund of late. Have weightings shifted away from them? When we founded this fund in 1995, we wanted it to have at least 25% in Treasuries. This was to be the least-risky offering of our mutual fund group. It was still going to be equity-oriented in terms of its return profile, but it would have stability and liquidity, so if things went awry, we could get money from the Treasuries. As the fund has grown over this period we added Treasury inflated-indexed securities in our portfolio, and that's been the area that has received the most new money of anything in the portfolio in the year to date.

We were buying them in January when they were priced with an implicit inflation forecast of 1.7%. Actual inflation last year in the Consumer Price Index was 3.4%. The 3.4% may have been pushed up by an unusual energy experience. If that is the case, maybe that will mean that inflation for 2001 will be lower, like at 2.2%, but that's still higher than 1.7%. If we're right on the Treasury inflated-indexed securities, it means we may gain an extra percent in total return over two years, which is nice.

Are there any other changes on the fixed-income side? Two years ago we had 10% of our portfolio in high yield, but that's down to 21/2% now. We have done a great job over the years of discovering situations in high yield that were soon to be upgraded. We find issues that have gone through reorganization, or perhaps an LBO, and are now high yield. We have never bought, nor do we have any intention to buy, high-yield new-issue telecommunications paper.

Give me an example of what you have bought. I'll give you a classic example. Ugly Duckling (UGLY), the used car retailing company in the Southwest, saw their stock go from around $20 to $5. The CEO of the company said, "Okay, I'll offer you guys the right to trade your stock for $61/2 per share, translated into bonds of 12% debentures." Nobody paid any attention to this, but we went out and bought a whole lot of stock at $4.80 on the dollar and then traded it in for the bonds. Now, our cost is $71 per bond and the bonds are now at just $79. They're still trading as pretty high-yield junk. They've got a 12.8% current or a 14% yield to maturity.

Sounds good! We know Ugly Duckling pretty well. We've owned it off and on, we trust the CEO there, and the cash flow characteristics of that business are stellar. In a recession, there is some risk their clientele will have a higher default rate on the loans, but most of them have bought a used car because they need transportation to get to work. Yes, some of them are going to get laid off and some of them will never get rehired, but most of them are going to move on to something else. They're still going to need the vehicle.

Ugly Duckling underwrites loans to customers at a 30% loss-ratio expectation. Throughout the first three months, they know exactly where they stand on a weekly basis. This is the kind of high-yield bond play that can be successful for our fund. We haven't been able to find enough of these types of investments, so it's a small part of a whole picture.

In fixed income, we create an unequal barbell -- a big Treasury piece at one end and a small high-yield piece at the other. We rarely put anything in traditional, investment-grade corporate in between. This is because we think there is a fair amount of event risk out there and history says that double-A or single-A bonds are much more likely to be downgraded than they are to be upgraded. We see no reason to take on that risk when we can synthetically create a similar risk profile by having a Treasury/high-yield portfolio. We're forced to stay on top of the high yields, because they are risky investments.

Is being a value investor an advantage when you're looking at high-yield issues? Yes, we value guys should be able to do that kind of analysis. It would be more alien for the momentum or growth guys. Maybe that's why some of them ended up buying the high-yield telecommunications debt that came out in 1999 and suffered thereafter. I'm not suggesting we had it right. We weren't smart enough to short these things personally for ourselves. We just thought they were really risky but didn't know how risky they were.

So how did you initially get interested in finance? My grandmother, who had a small investment portfolio, raised me. It was all she had left from her share of the family wealth. The rest of it was lost by her husband in the Great Depression. He bought bonds from South American countries and got wiped out. They thought this was a safer way of investing than our stock market, which proved to be wrong. I still have some of those certificates.

So I had a little experience through my grandmother with the stock market, but I really didn't have any personal money. In their graduate school program, the University of Wisconsin has a program that allows students to invest what was at that time a $300,000 pool. I enjoyed that. That was really my first experience as an investor. The amount of money sounds hilariously small today, but in 1976, $150,000 sounded like real money to us. I learned a lot from doing it. We had some successes and some failures.

That eventually got me a job at Northern Trust, where I worked for four years, and then I migrated over to Harris Associates 20 years ago.

And you still enjoy it. I get personal satisfaction and enjoyment from the daily competition. Obviously, there are days when you go home thinking you're an idiot, but I find the challenge invigorating. The only time I really felt stress was in 1991, after we had that 1990 experience. It was my first year as a full-fledged portfolio manager here, where I really had a lot of accounts under management. That was the one time when I felt I had done a poor job.

Even if you've told your clients you have a highly risky approach, often they don't listen. You have to keep telling them and telling them, but they don't listen until they see the numbers fall apart. We don't have that same degree of risk in this portfolio, because it's diversified by asset class. I've been lucky I haven't had to deal with extreme stress, just relative stress.

I do think the pocketbook-based attitude -- always keeping an eye on how it's going to affect your wallet in the long run -- is a good way for the basic individual investor to think about things. Investors should also do what Peter Lynch suggests, in my opinion. Invest in things you know something about and not what somebody tells you.

What are some common mistakes you've seen investors make? Buying a fund that doesn't fit well with their personalities. We managed two accounts for an institution before the crash of 1987. Their investment philosophy was to have 85% in equities at all times. During 1987, before the crash, two members of the investment committee retired from one of the two funds. The membership of the investment committee for the second portfolio stayed constant. Well, then the crash hit. With horrible bad luck, the committee with the new members had a regularly scheduled meeting on the Sunday after that disastrous week. The two new members said, "We're not leaving the room until we agree to liquidate all stocks." The consultant was there. He called me up the next day. He knew that this was a catastrophically bad decision, but he couldn't do anything about it.

The Monday after the crash, a week after, the market went down 9% that day. We were forced to sell good stocks nobody wanted. We knew we were selling at impossibly bad prices, but we had been ordered to do so. It's the clients' money, not ours. In any event, from October 1, 1987, to March 31, 1988, that fund had a -27% rate of return. The other one, the one that didn't change its investment philosophy, was up 2%.

And what's the message of the story? The message is not to pick on the people who made the unfortunate decision. The message is to have an investment approach or philosophy you can live with. That's my most important message. It's easy to say, but hard to do in practice.

I see what you mean. Do you have a market prognosis that you'd like to share? I think the market is closer to fair value than at any point in the last five or seven years. That doesn't mean you won't have these extreme daily movements like we seem to be seeing these days. I am expecting a real churn at these kinds of levels. There's a lot going on and the market is going to bounce around from one day to the next based on the news flow. But we don't think prices are as undervalued with the out-of-favor stocks as they were, or as overvalued with the stocks that were in favor.

I don't know what the fair value on the Nasdaq is, but we think it is close to some measure of fair value as a whole. I wouldn't want to encourage people to go out and short stocks vigorously, unless a drastic negative situation takes place. I think we will see a period where the market has a lot of daily movement, but not as obvious a direction as has been the case in the last year.

It's become tougher in the world of value. It obviously has been tough in the world of momentum, but now the best guess is an extended period of trying to find a bottom for the big-cap stocks. The environment is still recessionary. I don't think we're going to have a V-bottom. We're going to have an extended period of churning, and then I think in the next year things will get better. It may happen in the fourth quarter of this year like many people expect, but I think it's going to take longer than that. The boom, or the bubble, was so extended on the upside that it will take longer to change investor psychology.

Thank you for your time, Clyde.