Identifying the true value of a quality action is like investigative work. With Daniel Nicholas of Harris Associates.
Of the brothers Irving and Neison Harris, natives of Saint Paul (Minnesota), who sold their company in 1946 to the leader of Gillette razors, Harris Associates maintained the spirit instilled by the parents of these entrepreneurs who left Yale: “You should be n #1 in its class.” The equity specialist Natixis-affiliated Chicago boutique manages its $118 billion in assets (as of March 31) through various vehicles, in particular the Oakmark Funds, true to its history. With the conviction of a businessman, the patience and precision of a private detective Interview with Daniel Nicholas, Portfolio Manager, Harris Associates.
What makes you say your job resembles that of a private detective?
Our investigation methods are similar. We don’t stop at appearances (eg price/accounting ratio) but look for evidence that we believe cannot be disputed. This approach has become essential since the economy shifted from manufacturing to service provision, where 90% of a company’s value is intangible and therefore doesn’t end up in the book value calculation. The ratio simply reverted from 90% tangible value and 10% intangible value in the 1970s to 90% intangible value and 10% tangible value today. In other words, the correlation between book value and the intrinsic value of a quality company has become very weak. The era of approximating a company’s valuation to a simple multiple of book value is over. This is why our management profession is, more than ever, a research profession.
“The era of approximating a company’s valuation by a simple multiple of book value is over.”
How does this investigative profession translate in terms of the selection and investment process?
Unlike managers who can use a quantitative matrix to narrow down their investment universe to just the cheapest stocks, we first look for high-quality companies and management teams and then wait patiently to get the right price for those companies. This requires extensive research to identify management teams that we believe will make long-term strategic decisions to enhance long-term shareholder value. Therefore, we spend time discussing with management before deciding to invest. Selecting experienced management teams is crucial as we estimate that 85% of a company’s value occurs after year three and extends into the distant future where today’s investments create future revenues. Once the intrinsic value is determined, we only invest when we obtain a discount of at least 30%, which is our safety margin. With a safety margin in hand, our evaluation criteria are met, which makes the classification of the index between “growth”, “value” and “mixed” irrelevant.
Can you give an example of an investment you made based on this investigative work?
Alphabet is one of the best examples of our approach. When we initially invested in 2011, we did so based on our analysis that while management used excess free cash from its research business for venture capital activities, we expected this allocation to strengthen future revenue growth. To estimate the value of intangible assets, we use many different techniques depending on the type of activity. For Alphabet’s cloud business, we ran a multiple of the 10-year discounted cash flow model and compared its fundamentals with those of its main competitors, Amazon Web Services and Azure. For YouTube, we classify it as a cable company using a per-subscriber pricing structure compared to the price paid by AT&T for HBO. We also value its autonomous driving division, Waymo, using valuation information from Cruise Automation’s private market transactions. By adding up the value of its venture capital investments and comparing them to the current stock price, we believe that Alphabet’s core business, Google, is trading at less than a market multiple despite its growth and returns. higher than those of an average company. Our process allows us to identify the value where a quantitative manager might ignore based on a metric like price-to-book ratio.
“Across our diverse portfolios, we are exposed to Holcim, Julius Baer, Novartis and Credit Suisse, because Switzerland is rich in quality companies.”
How do these values you seek best respond to current challenges?
When a company generates significant free cash flow, it gives its leaders leeway to manage long-term risks, such as the energy transition, or medium-term risks, such as inflation. General Motors dramatically improved production capabilities, reduced reliance on sedans in favor of more economical trucks and SUVs, made the necessary investments for electrification, and adequately addressed supply chain and semiconductor issues. Despite these challenges, its operating margins have increased and the company is showing the market that its business model is much more resilient than that of the automakers of the past. When we evaluate our US companies, we look for an average annual return of more than 7% per year of growth in value per share over three years as a benchmark for investment. Companies domiciled in China wait longer to compensate us for the additional risks – 14% and 10% in Switzerland.
Do you have an example in your portfolio?
Glencore is a very good example: when we invested in 2015, they were supposedly on the brink of bankruptcy. The plans they presented to us proved not only that they were successful in reducing debt, but also that they planned to generate free cash flow even as commodity prices fell. In addition, they implemented a “net zero” strategy, which consists of gradually reducing their coal production. In the current context of record coal prices, they illustrate their commitment to reducing global emissions. In addition, Glencore owns and produces essential raw materials for the energy transition: cobalt, zinc and copper.
Other Swiss stocks in the portfolio?
In our diverse portfolios, we are exposed to Holcim, Julius Baer, Novartis and Credit Suisse as Switzerland is rich in quality companies. Credit Suisse has taken restructuring steps to emerge from the current turmoil. We spend a lot of time with management and trust the board and management team to carry out the strategy of reducing the capital allocated to the investment bank and reallocating it to its franchise.