Interview: Oakmark's Bill Nygren And Win Murray Discuss Value Investing

This article was originally published on this site

and Fiat Chrysler now earn almost all of their income from selling SUVs and pickups, which continue to take share from passenger cars. With their stocks selling at low single-digit P/Es and now also single-digit multiples of free cash flow, it isn’t farfetched to think they could be takeover candidates.

Revered investor Bill Nygren and his colleague Win Murray manage funds at Chicago’s Harris Associates, which has about $118 billion in assets under management.

Harris Associates

Question: How do you value businesses? Are asset-based or earnings-based valuations more useful?

Murray: A business is worth the sum of its future cash flows, discounted to today. Mathematically, that’s the only truly accurate way to value a company. At Oakmark, we estimate a business’s pre-tax, pre-interest cash flows (assuming a normal margin), apply an estimated tax rate, capital required for growth, and a projected capital structure, then estimate an intermediate growth rate. These factors, combined with an appropriate discount rate, tell us what multiple of cash flows the business likely deserves.

You mention two other valuation metrics: earnings based and asset based. Both have utility as shortcuts to a discounted cash flow model, although cash flows ultimately determine value. If the company’s earnings are approximately equal to their after-tax cash flows, then an earnings-based valuation model will likely be an accurate tool for determining the business’s value. This is not uncommon in a lot of mature industries that aren’t too research and development or amortization heavy and, therefore, is pretty widely used by investors.

Asset-based valuations are especially useful in very cyclical industries during time periods when current cash flows are far lower (or higher) than a company’s “normal” long-term cash flows. Take, for example, a deep-water drilling company. The company owns dozens of deep-water drillships, each worth hundreds of millions of dollars. When oil was more than $100 a barrel, these ships were contracted at exceptionally high rates, producing amazing cash returns on the original asset prices. However, when the oil price collapsed, many of these ships were left idle, producing no cash flows at all (and, in fact, requiring maintenance cash flows to keep shipshape for the future). A reasonable valuation methodology here would be to determine the replacement value of these assets if someone were to try to build the same fleet (adjusted for deprecation) and use this as a basis for valuing the company long term. You have to be careful when doing this, though, because ultimately all that matters are the cash flows. If, for example, circumstances in the industry have changed such that it would be impossible to get a good long-term return on a newly built drillship, then an asset value model would overstate the company’s value.

Question: Alphabet Inc. is one of your biggest positions, but it has a valuation of 32 times free cash flow. How is that justified?

Nygren: Value investors usually look at much slower-growth companies than Alphabet and are therefore accustomed to getting more of their return through the free cash flow yield than from organic business growth. In the case of Alphabet, it has achieved annual organic growth of 20% or so while still producing a 3% free cash yield, which, if there was nothing more to the story, would still be pretty amazing.

More importantly, though, we believe that looking simply at an Alphabet P/E or price-to-free cash flow (P/FCF) ratio ignores or values many of its assets at negative numbers. Let’s start with cash. The company is expected to exit 2019 with nearly $150 billion of net cash, or $212 per share. That cash earns about 1% after tax. Cash would have to sell at a P/E of 100 to fully reflect its value. We prefer to subtract the cash from the stock price and subtract the interest income from earnings per share to compute the P/E for the business.

Next, Alphabet’s “other bets” include the autonomous driving subsidiary Waymo, artificial intelligence, cloud computing, Google Play (Android) and many other venture stage investments. In total, “other bets” is projected to reduce earnings per share by about $5 next year. So to get a more accurate picture of value, we add “other bets” losses back to search earnings and also subtract from the stock price the estimated asset values for each investment. Effectively, this step is equivalent to what the GAAP presentation would be if Alphabet made these investments through a venture capital firm as opposed to making them in-house.

Finally, YouTube is intentionally under monetized (lower subscription fee and/or lower ad volume relative to other video content) to maximize growth in hours viewed. Were hours of viewing on YouTube valued similarly to current stock market values of broadcast or cable networks, YouTube would be worth hundreds of dollars per share. If you subtract the value of all non-search assets from Alphabet’s share price and divide the price you are paying for Google by its search income, you get a P/E ratio that is lower than the S&P 500 P/E.

Though on the surface Alphabet doesn’t look like a value stock, when you value the assets separately and sum them up, it is easy to get to numbers much higher than the current stock price.

Question: Given how beaten down brick-and-mortar retailers are, don’t you think there are some incredible opportunities in that sector (despite the secular risks)?

Murray: Many value investors use some form of “mean reversion” in their approach to setting price targets, assuming that over the long run, returns will revert to their long-term averages. But in the case of brick-and-mortar retailers, although some look quite inexpensive when applying historic P/E multiples to current earnings, we believe that this frequently far overstates the value of these businesses given the secular challenges many of them face. In addition, a number of them have many years of significant lease obligations, which aren’t properly accounted for in their stated enterprise values. These obligations impede the companies’ ability to restructure their store bases and are a call on future cash flows.

All of that isn’t to say that these companies are worthless, but we must be careful to model the cash flows using the correct (sometimes negative) future growth rates. We’ve owned a number of retailers in the past and continue to believe that many of these businesses have very durable business models (Tiffany, Home Depot, CarMax and Carters come to mind), but we are always quite price-sensitive when making our initial investments.

Question: Netflix is a large position in both Oakmark and Oakmark Select. What makes you think it’s undervalued given its high P/E and negative cash flow? Isn’t the growth rate in earnings per share that Netflix requires simply to justify the current price almost impossible to achieve?

Nygren: We believe that generally accepted accounting principles (GAAP) do a poor job of measuring business value and change in value for Netflix. Note, this isn’t specific to Netflix, but rather applies to many of the growing number of asset-lite businesses where investments for growth are expensed rather than capitalized.

Using typical GAAP metrics, like earnings per share and book value, Netflix appears ridiculously valued: It sells at about 100x expected earnings, and about 30x book value. But the company reminds us a lot of the cable companies Oakmark owned in the early 1990s. Those businesses had negative book value, negative earnings and negative cash flow, yet their stocks performed well and many were acquired by larger cable companies or private equity. The acquisition prices were consistently around $1,000 per subscriber. If you adjusted the GAAP book value to reflect that $1,000 per subscriber value and adjusted GAAP earnings by adding $1,000 for each net new customer added, the stocks looked cheap.

One of Netflix’s primary competitors is AT&T’s HBO NOW. When AT&T acquired HBO in the Time Warner acquisition, it appeared to pay about $1,000 per subscriber. At $16 per month and a 40% operating margin, that implies about 13x pretax earnings, which seems to be in the right ballpark.

So how does Netflix stock look relative to a $1,000 per sub value benchmark? It is expected to end 2019 with 168 million subscribers, which would be worth $168 billion. Subtracting $10 billion of debt would leave a value of $158 billion, or about $360 per share. Defining earnings in terms of subscriber additions gives 29 million new subs in 2019 for a $29 billion addition to value while adding $3 billion of debt, so a net increase in value of $26 billion. At $325, Netflix has an equity capitalization of $142 billion, meaning the stock is priced at less than 6 times the value added in 2019.

If Netflix subscribers are worth as much as HBO subscribers, it is a very cheap stock. Most Netflix subscribers say their Netflix subscription, despite costing less than $12 per month, is more important to them than HBO, Spotify, Sirius XM, etc., all of which are charging $15 to $20 per month. We believe Netflix is currently intentionally underpricing its product by at least $4 per month because it can create more value through subscriber growth than it could by maximizing current earnings. Because GAAP requires immediate expensing of customer acquisition cost rather than amortizing it over the expected life of the customer, the company reports trivial income relative to the growth in its value. Further, growing the number of subscribers makes it much more difficult for any competitor to catch Netflix. Because it has more subscribers, the company can pay more for programming yet pay less per subscriber than any competitor.

We believe there are numerous examples in the market today, and in the Oakmark Fund, where GAAP makes a stock look overvalued because investment spending, such as R&D or customer acquisition costs, is unduly depressing current earnings.

Stay tuned for the second part of this interview next week.

This article originally appeared HERE.