CIO-US Equities at value-focused Harris Associates, Bill Nygren, shares his insight on value opportunities for the reopening, value’s recent outperformance, inflation, and the importance of a long-term investment horizon.
When might equities be back to “normal” pre-pandemic levels?
Nygren: We believe that normal is going to come back much faster than people expect. So it’s not a question of if the economy is going to recover, it’s a question of when.
With the disruption in 2020, we immediately went to a severe recession scenario, thinking that we wouldn’t see any recovery until the second half of 2021 – in hindsight, we weren’t too far off, maybe a little bit too pessimistic – and that by 2022 we’d be back to normal levels. Forecasting out five to seven years from now that the world will be normal typically doesn’t give much of a macro-overlay tilt to our portfolios. The view that we would get back to normal relatively quickly, in say, less than five years, gave us an outlier projection – the result of which was that our portfolios were heavily oriented toward business reopening.
What value trends are you identifying?
Nygren: We think there’s tremendous pent-up demand for vacation travel and believe business travel will also come surging back. For example, we think companies like Hilton have become stronger businesses during Covid and are continuing to grow market share because some of their weaker competitors haven’t been able to spend as much on their futures. Hilton’s stock has recovered nicely, but we think there’s more to come there. Our projection is that by sometime next year and certainly for the entire year in 2023, business travel will be back to normal.
We also think the new normal is going back to work. For most businesses, collaboration and collegiality is an important part of corporate culture, and it’s difficult to maintain those elements via video conferencing. We think industry’s leaders in commercial real estate, and even something in consumer products like single-serving coffee machine distributors, are well positioned.
We believe the ultimate beneficiaries are some quality financial sector companies. The move to online banking is going to allow them to have a permanently lower expense ratio than they had pre-Covid. Because some of these stocks are cheap at single-digit price-to-earnings, we think it’s the most attractive area in the stock market. We are very much looking for a modern-day version of the Roaring Twenties to match what happened in the 1920s after the Spanish Flu pandemic.
What are your thoughts on value outperforming?
Nygren: A couple of quarters ago, we hardly saw any outperformance by value. But on those few days when value outperformed the S&P 500®, our strategies were consistently performing stronger than the Russell Value Index, even when the Russell Value was doing better than the S&P 500®.
We think that value’s underperformance has been historic, and that we’ll be in a good position to benefit from any reversion in that growth outperformance. We believe that the fundamentals should dictate a continuation of value outperformance. Valuation extremes are very similar to what we were facing back in 2000, and if I’m right on that, then this value run has a good distance left to go.
Are you concerned about inflation? Could it impact portfolios?
Nygren: A return of inflation and a positive real interest rate would hurt growth stocks a lot more than it would hurt value stocks. Two areas we have been favoring are financials and oil. US financials should benefit most from higher interest rates. Their price-to-earnings are barely double-digit, so it would take a much higher long bond to suggest that some quality financials are overvalued at nine times next year’s estimate. But a return to inflation and a Treasury bill at 2 or 3 percent instead of zero would be very good for our banks – especially the traditional banks that have a business model where they pay you interest.
Our oil stocks have benefited already this year with the fear of inflation’s return. That’s because hard assets do pretty well against inflation and people will stop talking about $70 per barrel being an unsustainable price for oil.
What do you look for in a company before investing in it?
Nygren: At Harris Associates, we are long-term value investors. Our portfolios are based on our fundamental analysis, and we look for three things in any company we consider investing in. We want the stock to be priced at a discount to our estimate of business value; we want business value to be growing as fast as other companies – as fast as the S&P 500® Index; and we want management teams that are aligned with their outside shareholders.
Clearly, stock selection is the strength we bring to the table. We are not market timers in any way and, in order to maximize the impact our stock selection has on the portfolios, we run focused portfolios, generally between 20 and 70 names. Compare that to a typical mutual fund today that owns somewhere between 100 and 150 names. Each stock that we decide to own has a much bigger impact on our performance than it does for our peers.
We invest for a very long-term time horizon. If you have something that is undervalued and the value’s growing at least as fast as other companies – and management is aligned with outside shareholders – it gives us the luxury to think really long-term.
How long is your time horizon?
Nygren: Our analysts forecast out to a five to seven-year time horizon. I think of that as bringing a private equity perspective to investing in public equities. We’re looking at what a business looks like today, how different it might look five to seven years from now, and how differently investors might value that same company if it goes along the path that we expect it to over the next five years.
Many private equity firms typically buy poorly managed companies where they have to change out the management teams. We differ from them by trying to identify well-managed companies where we want to partner with the existing management teams. This helps us avoid getting into a situation where there could be somewhat of a race against time of the team destroying value while we try to change out management.
How did your high conviction approach help you during the Covid crisis?
Nygren: I recently read Jack Schwager’s book, Unknown Market Wizards. The chapter that spoke the most to me was about a commodity trader whose big idea was to take the Silicon Valley statement of “You need to have strong opinions, weakly held,” and apply it to investing. He believed in the importance of having conviction in order to take a position that’s different from the market, yet constantly be looking for new information that suggests that your original conviction might have been unwarranted.
That thinking has always been a big part of our process at Harris Associates, but it became even more important last year when our world turned upside down due to Covid. Suddenly, all our forecasts for our companies were completely off. There were some businesses whose growth was going to accelerate because of Covid, and there were others that faced a couple of really tough years. I was really proud of our analyst team who, in about a week and a half, went from expecting normal growth in the economy to expecting a recession that would take a couple of years to exit.
We didn’t think 2021 would be a normal year, we thought that would take until ’22, so we had analysts roll out their detailed forecasts through 2022, and we very quickly had an approved list that re-ranked the attractiveness of each of our companies. I think this quick reaction was one of the biggest reasons we were able to significantly outperform our value peers in the six months after March 2020 – before value really started to rebound.