Found! Great Investor at Work: Oakmark’s Bill Nygren offers some places he’s finding value and one where he’s not

Bill Nygren is a top flight portfolio manager. He manages or co-manages several Oakmark funds, including Oakmark Fund and Oakmark Select. His long-term record is excellent, though like many marign of safety investors, he often makes concentrated big bets and his picks can lag (and have lagged) the market during the short term. Like other margin of safety adherents, he also tends to hold positions for several years, reaping the tax-efficiency benefits of successful companies re-investing profits at high rates of return year after year.

In his recent communications with his Oakmark shareholders, Nygren disclosed that he has been buying Best Buy, Capital One, and Federal Express–as well as his reasons for doing so. His discussion is a terrific window into how a great investor recognizes opportunities.

Best Buy: Nygren’s focus is on a market leader in a retail category (consumer electronics) that he expects to grow over time. Nygren observes that at 1100 stores and nearly $40 billion in sales, Best Buy is both twice as large as its nearest competitor and holds just 25% of the total market. Nygren also likes the annual rate of per share earnings growth (12%) and sales growth (18%)-two trends that the company’s rapid expansion seem likely to extend. Nygren’s thesis:

Despite the track record and the long-term opportunity created by their competitive advantages, the stock fell from $60 last year to $44. Subtracting their $6 per share of excess cash (and its related interest income) Best Buy stock now sells at only 14 times expected earnings. The company has been an aggressive acquirer of their own stock so far this year, and it just announced plans to buy back an additional 25% of their outstanding shares. We believe that Best Buy is a superior business and therefore believe that investors will again reward it with a superior multiple.

Capital One: For Nygren, Capital One is a story of a public stock market insufficiently appreciative of a company’s assets and economic franchise in an era of financial consolidation and big corporate acquisitions:

Capital One is one of the largest credit card companies with one of the most recognized financial brands. In both 1999 and 2000, Capital One sold for $73 per share and had earnings–per-share between $2 and $3. Last quarter, Capital One again sold at $73, this time with over $7 of earnings. Back in 2000, Capital One was a high growth story. The credit card industry was expanding, and monoline credit card companies were taking market share from the banks. Today, growth in credit cards has slowed, and in a move to lower its funding costs, Capital One acquired two banks, which further reduced its expected rate of earnings growth. We believe investors have overreacted, now pricing the stock at a single digit P/E ratio on expected 2008 earnings. Returns in credit cards are still high, and retail financial service companies are actively consolidating. Capital One’s assets—composed of credit card receivables, auto loans, and retail banking deposits—are in high demand. We believe Capital One is worth more than its current price and that if investors don’t accord it a higher value, an acquirer will.

Federal Express: Sometimes a good company will increase shareholder value more rapidly than the market bids up the company’s share price. Hence the discount between share price and intrinsic value may be widening even though the share has gone up. Nygren believes the case of Fedex is just that kind of opportunity.

FedEx created the next-day package delivery business and today remains the industry leader. As in other network businesses, as FedEx grows, so too does its competitive advantage. The business clearly has an exceptional history, with sales and earnings-per-share growth over the past decade compounding at 9% and 16% respectively. We believe that the company’s international expansion and e-commerce will sustain its exceptional growth. Though the stock has been a good performer, the increase in FedEx stock has lagged behind the increases in earnings and our estimate of business value. The stock sells at 15 times estimated calendar 2008 earnings, a relatively trivial premium to the average business. We believe FedEx is a great business and, like many of our other great businesses, is now priced as if it were merely mediocre.

Finally, it is important to note that Nygren has little use for the valuations (and the credit quality of debt underlying same) currently driving the very active private equity markets. Palmerston Group is dedicated to helping clients steer clear of crazy optimism because it’s, well, crazy. So Nygren’s insight on this topic is both cautionary and welcome.

In the most general sense, private equity is simply ownership interest in a company whose stock does not trade publicly. More specifically, the term “private equity” today usually refers to the capital, which is normally highly leveraged, that is used to purchase a publicly held company. This type of transaction has roots back to the 1960s, but really began to blossom in the 1980s with the emergence of what was then called the “junk bond” market. One of the most difficult hurdles to pass before paying a premium to take a company private was obtaining the financing that facilitated a highly leveraged acquisition. The creation of a public market for very high risk debt made getting past that hurdle much easier. The logic behind those transactions was typically that the entrepreneurial buyer had a plan to radically increase the value of the business, perhaps by making tough decisions that corporate managers lacking economic alignment with their shareholders were unwilling to make, such as selling divisions and downsizing. The debt for such a transaction was expensive, frequently six percentage points or more above Treasuries. But, with lots of low hanging fruit, it was worth the cost, and the returns on leveraged private equity were high.

As always happens, however, the markets adjusted. Competition among buyout firms grew, bond owners demanded higher returns, and most importantly, corporate managements reformed, adopting the “maximize shareholder value” mantra, making high-return targets difficult to find. For the next twenty years or so, private equity faded to the background. Recently, however, the spread between Treasuries and what is now euphemistically called the “high yield” bond market has hit record lows. Bond buyers, hungrier than ever for yield, now demand only a three percentage point premium to Treasuries, half the historical spread. With bond buyers taking so much of the risk for so little of the return, levering up has again become profitable. In fact the after-tax cost of capital is now lower for private equity firms than it is for many cash-rich companies. A private equity firm can offer a safe harbor with no Sarbanes-Oxley, no public disclosure of executive compensation, and no pressure from investors to meet quarterly earnings targets. Financially, a leveraged private company also enjoys a big reduction in income tax payments (which is because interest to debt holders is deductible, while payments to shareholders aren’t), and a leverage-enhanced equity return that is about twice the return of a typical stock.

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