Bill Nygren  01:29

I think the question we get most often is what we think will happen with the Coronavirus. I think something that’s always important for investors in a crisis is to remember what you’re expert at and what you’re not an expert of. And we are certainly not infectious disease experts here at Oakmark. We read a lot, we flip play right, we listen to what they say. Unfortunately, the views of the path this could take are so diverse. It’s hard to base any kind of investment strategy on opinion on where the virus might go.

But what we are good at Oakmark is valuations, and that’s been our expertise for a long time. Stocks are really cheap today, if you believe as we do, that five to seven years from now, things will look sort of normal again. Most of our approved list I think all but one or two names are beneath their buy targets. Typically, it’s a third to a half of our list that’s below by targets. Like 2008, we’re trying to take advantage of the market volatility to restructure portfolios. Typically we sell things close to sell targets and buy close to buy targets. Today we’d be selling close to a buy target to buy something that would have to double to be at its buy target. It’s really unusual times.

Preston Pysh  02:51

So, Bill, the last time you were on our show, you talked about your investment process. Some of the picks that were on your radar back then were Netflix, Alphabet, and MasterCard. On today’s show, we’re going to be talking specifically about Bank of America (BAC). Bill, could you please provide us just a basic overview of the business model?

Mike Nicolas  03:13

Bank of America is one of the largest money center banks in America today. In our opinion, it has, perhaps, the best consumer banking franchise in the US, and one of the industry-leading wealth management platforms that typically operate under the Merrill Lynch brand. It has a really, really great management team, a strong balance sheet and, in our view, going a long runway for above-market growth.

We believe that the bank is priced very attractively today, and continues to really widen its moat, specifically, as it relates to its lead within consumer-facing technology, where Bank of America, in part, due to its scale, has been able to invest at much higher rates than a lot of their lower and regional competitors into technology solutions, which have really enabled it to lower their direct deposit costs and continue to focus on the consumer and drive more value to their customers. So, we believe the valuation is attractive. The scale that they operate within will continue to remain significant competitive advantage, and that the quality of their underlying business segments is on par with some of the best financial institutions around.

Stig Brodersen  04:20

Thank you for your thoughts on that, Mike. Now, I also want to preface this by saying that, at the time of recording, Bank of America has dropped from just short of $35 to $21 in less than a month. Today, it changes all the time, but it dropped another 12%. It’s just incredible just even talking about these numbers.

Now, the Coronavirus has already had a meaningful negative impact on economic activity and this negative impact will continue. I’d say that the crystal hand is how negative the impact will become, how long it will persist, and finally, how the economy will behave after the Coronavirus subsides.

Now, what are your thoughts on the economic impact of the Coronavirus? and has it already been priced into the current stock price of Bank of America?

Bill Nygren  05:11

I think one of the things we do well at Oakmark, Stig, is to focus on business value, and what a business would be worth in, for lack of a better term, we call normal times. We’re not going to be any better guessing than anyone else as to how severe the impact could be in the short term for Bank of America nor how many quarters of bad performance has been already discounted. But what we do know well, is to say, “The stock price has gone from 35 to 21.” That’s basically but four or five years of free cash flow that we expected at Bank America. So a lot has been priced in. Things would have to be really dire to justify this kind of decline. We’re in our best when we can focus on saying, “This is what we think would have to happen to justify how big a move the stock has already had.”

Mike Nicolas  06:09

As Bill mentioned, our guess is no better than anybody else’s. We saw yesterday that even the Fed chair, Jerome Powell, had a difficult time coming up with a forecast for economic activity for 2020. What we do know is that we have a resilient economy. Bill’s written some of our past letters about our America’s economy, by extension, the equity markets, have grown through a number of scares throughout time; wars and natural disasters and real estate downturns and other viruses, you name it. We ultimately feel this will be no different. The banks, as you mentioned, have proven punished. They’re viewed as macro proxies that report particularly poorly during the last downturn. But I think what’s missing in some of the analysis in the way the stocks trading recently, is how much improvement there has been in the Bank since the last downturn? Perhaps some of that perception, your perception leads to stale.

There’s been an enormous amount of capital built by Bank of America and a number of the large banks. I think to perform very well during stress tests, and they do have really diverse revenue streams. And, unlike a lot of other cyclical that we invest in, they set aside money for rainy days and for really tough times like the one we’re experiencing, so we think they’re going to perform much better than they have been in prior downturns. And really, this is an opportunity for them to prove that the underwriting discipline in the capital belt and the way they do business is far superior to the way that they used to.

Preston Pysh  07:31

So guys, talk to us about the low-interest rates. Just recently, Fed chair Powell has cut the rate by 100 basis points. It’s been since 1982, that we’ve seen such a significant cut, not to mention all the bailouts and quantitative easing. And now for a bank, lower interest rates simply mean that interest income gets smaller and smaller, which is the top line of the business. So do you guys see this as a bad thing? Or do you think normal interest rates are going to be coming back into the future despite the downward pressure that we’ve seen in yields for decades at this point, how are you guys seeing that?

Mike Nicolas  08:08

Low rates are undeniably worse for banks than higher rates, especially with the shape of the yield curve as we see it today, where the longer-term rates aren’t too far off from where shorter-term rates are. And if you think about a bank or Bank of America, in particular, that’s largely funded by overnight deposits, but that ultimately lands further out in the curve. You could imagine that the more narrow that difference or that spread is, the more impactful it’ll be on its net interest margin. And net interest income makes up roughly half or so a Bank of America’s revenue.

Today’s rates look nothing like history, whether it’s the absolute level or the spread between the shorter-term rates and the long term rates. We don’t necessarily believe that this looks like a normal environment. In the short term this year, Bank of America’s earnings are going to be under more pressure. They’ll have lower net interest income, likely higher charge-offs, that expense, as the economy slows down here. So, the earnings number that we see here for 2020, we don’t think is what they’re capable of earning throughout a business cycle on average over time.

When you think about the services that the banks provide, and from a bigger perspective, they’re very necessary and they’re extremely valuable to their consumers. They store money, they protect your money, they allow you to move and transfer money. They give you advice on where to invest your money. And, from our perspective, we don’t believe that they’re over earning relative to the value that they’re providing, or certainly not with the highly competitive operating environment they already are in. So, from our perspective, what you see this year is not likely to be the normal earnings power of the Bank.

One thing to remember if we’re in a lower-for-longer rate environment is that the bank business models have been very adaptable over time. If you think back to the 1980s when interest rates were in the high teens, most FDIC-insured banks were generating mid to high teens percentage of their revenue in fees. But if you fast forward to today, some of the big money center banks, like Bank of America, are generating almost half the revenue from fees. So it’s not just interest income that dictates the growth of the business anymore.

Of course, there’s also the other side of the distribution. I think Jamie Dimon talked about this in the past where rates could go up or it could go as they have historically, where the long ends have bigger premiums to the short end that we’re seeing today. In that specific instance, we think the banks have significantly higher earnings power, perhaps even higher than what we saw last year when Bank of America earned about $3 a share. So from our perspective, they’ll be able to weather the storm, they’ll be able to adapt their business model, perhaps even cut costs if they need to. And some of their competitors, so-called internet banks that compete much under positively might have a harder time competing in this market as well as they face the same reinvestment risks on the asset-side of their balance sheet. Bank of America might be in a better position to pitch invitation.

Stig Brodersen  10:57

Let’s talk a bit more about that. What are the key factors of success in banking? What does Bank of America do better than its competitors?

Mike Nicolas  11:06

I think there are a couple of factors. Stringent underwriting discipline, a very solid risk management platform, and, increasingly, scale. Being one of the biggest differentiators, scale really enables the ability to invest in technology and into compliance systems for regulatory reasons. It really allows them to build best of breed digital tools for their customers.

When you think about the absolute scale that the Bank of America is deploying right now into new technology facing services and solutions; last year, that number was about 3 billion and it’s been like that for almost half a decade, maybe a bit longer. The magnitude of that is really enormous. I was listening to your interview with Sean Stannard-Stockton about the First Republic not long ago. I really enjoyed listening to Sean’s interview and reading Sean’s blog as well. But First Republic’s total operating expenses for the whole bank is less than what Bank of America spends on new products in production alone every single year. So their ability to reinvest at multiples of some of the smaller and medium-sized banks. Total expense based, in our opinion is really widening their knowledge and enabling that to be Ambassador accounts in the customer experience.

Stig Brodersen  12:17

How would you describe the competitive situation between the biggest banks like Bank of America, Citigroup, Wells Fargo, and a few others?

Mike Nicolas  12:24

I would describe it as highly competitive. But in our opinion, the big three banks, Wells Fargo, JP Morgan, and Bank of America, of course, will, and ultimately are, the winners. The all-in deposit costs for the big three banks today, which is an important driver of profitability given how significant deposits are as a percentage of the overall funding sources for banks. Those costs are about half of what most regional banks would pay. Also, if you think about user growth, 50% of all new checking accounts today are being opened at one of those big three banks, even though they only control about a quarter of the country’s branch network. So, we believe they’re taking considerable share, even in younger cohorts. Most of that is due to what we talked about before, which was the scale and their ability to invest at much higher levels than many of their smaller competitors to improve the customer experience.

So, Wells is obviously going through its own issues today. And we have a lot of respect for JP Morgan’s franchise, but ultimately believe that the big three banks that are spending by far the most to continue to separate themselves in terms of digital solutions and services that they offer will ultimately be the winners in a highly competitive market.

Bill Nygren  13:35

Mike also mentioned that the big three in the US earn about 50% share of new accounts. If you follow the model that you see in most of the rest of the world, it’s unusual for the top three banks to only have a 50% market share. So, I think there’s a historical precedent that we’ve seen a lot of other countries where the growth of the Big Three becomes the best part of the story.

Mike Nicolas  13:59

Yeah, Bill’s right. Today, those top three may have 30% of deposits, but a much higher percentage of new accounts that are happening in the market today. If you also look back maybe 10 or 12 years ago, that number was closer to 20%. If you do look at a lot of developed markets, the top three own a lot bigger percentage of share of total deposits. The Bank of America has talked about their desire to double their consumer deposit share over time, so we think there’s a long runway for Bank of America to continue to win in the market and continue to gain share.

Preston Pysh  14:31

Bill, the last time you were on the show, you talked about how the market remembers the 2008 crisis. You said that was maybe one of the reasons that banks were still so unpopular. How has that thesis evolved? And how do you see that today with the crisis is going on in 2020?

Bill Nygren  14:48

For starters, if you think about the way the banks were positioned a little over a decade ago into the great financial crisis, the quality of their balance sheet, in a lot of different ways, was way inferior to what it is today. First, if you start with the capital, the average bank today has almost twice as much capital per dollar of assets as it had in the great financial crisis. Then if you look at the quality of the underwriting, any loan that’s been written in the past 12 years has been subject to a substantially higher standard than it was going into the crisis.

Frankly, with regards to mortgage loans, banks only really cared about was the quality of the house, not the quality of the borrower. But today, it’s more like good old-fashioned lending where a bank is worried about whether or not they’re going to get paid back. I think investors have heavily punished the banks for this higher level of capital, which means the return on equities are unlikely to be as large as they were 15-20 years ago. But they haven’t given them credit for the flip side of that, which is they become much less risky businesses because they have so much more capital. In fact, some of the people who’ve been negative on the banks talk about the banks because they have so much capital becoming almost like utilities. We think they’re really cheap. They’re better businesses. Their moats are growing, their market shares are growing. They’re just in a much better position than 15 years ago.

Preston Pysh  16:24

Banking stocks are extremely regulated. How do you recommend a new investor get smart on all these legal frameworks that are very complicated?

Mike Nicolas  16:39

You’re right, Preston. There’s been a number of new regulations put in place since the great financial crisis in 2008-2009. Almost all of these regulations were designed to ensure that the banks are better prepared for the next downturn. There have been more stringent rules placed on the types of instruments that the banks can put on their balance sheet; the liquidity of those instruments, their ability to perform for monetary trading more recently, the way they reserve against bad loans, and, of course, the amount of capital they must hold throughout a cycle.

In 2010, former Senator Chris Dodd and former Representative Barney Frank passed probably the most sweeping bank regulation that we’ve seen since the Great Depression, the Dodd-Frank Act. Among a number of the different provisions within the Act, forced banks to adhere to annual stress tests. These stress tests would be conducted by the Federal Reserve. They would put the banks through stress scenarios, one of which is a severely adverse scenario. This scenario is very adverse that as soon as the equity markets declined by 50%, it assumes unemployment goes up to 10%, Fed Funds goes to zero, residential real estate prices declines by 25%, and commercial places down 35%. They’re tough environments, severely adverse.

What’s interesting is even at the trough of that hypothetical environment that the Fed would run somebody like Bank of America through. Bank of America has more capital at that trough than they did entering the prior downturn. So I think it really shows how much better-capitalized the bank and the whole system is, relative to what we saw 12 years ago, the regulators are taking a much more hands-on approach. But for your listeners, I would advise perhaps reading through which the Fed makes public a number of these reports, the Dodd-Frank annual stress test (DFAST) reports to get a better feel for how your potential investment might perform in a much tougher environment.

Stig Brodersen  18:29

Interesting. Mike, you mentioned the interview we did with Sean Stannard-Stockton from Ensemble Capital that we had not too long ago. He was pitching First Republic Bank, here on The Investor’s Podcast. One of the things that he highlighted was the net promoter score. He highlighted that as an example of the strength of the bank. Now, the net promoter score is a customer loyalty metric that measures customers’ willingness to not only return for another purchase of service but also to make a recommendation to the family, friends, or colleagues. When I was looking that up for Bank of America, the score was -24. That is about as popular, or as unpopular, as in Facebook, where scores higher than zero are typically considered to be good, and scores about 50 are considered to be excellent. In comparison, the industry average for Financial Services and banking is 18, but again, Bank of America was -24. Should we, as potential investors in Bank of America, be concerned about the negative net promoter score?

Mike Nicolas  19:35

That’s a good question. The net promoter score for Bank of America that you quoted doesn’t really seem to sync much with the business trends that they’re actually seeing within their own business. Their own customer satisfaction scores are at all-time highs. They continue to take a lot of market share for new accounts. And, the overall deposits for the bank have grown by more than 40 billion every quarter for the last five years. That’s adding the deposit banks based on nearly the 20th Largest Financial Institutions in America every quarter. I think J.D. Power was just talking about how the average customer relationship duration for Bank of America has increased significantly from 2008-2009 to today. You also can’t help but see references littered about customer centricity and doing the right thing when you read Bank of America’s annual report, so we think customers are voting with their actions. Now, I could certainly speculate as to perhaps why that perception may exist, or where it may have come from, based on some of the actions that took place during the great financial crisis. But when we look at the actual fundamental trends and the customer trends within the business, it really doesn’t seem to sync up well with the NPS score that we’re seeing.

Preston Pysh  20:45

Guys, thank you so much for laying all the groundwork there. Let’s dive into the fun stuff here. How are you guys looking at the intrinsic value of Bank of America?

Mike Nicolas  20:56

Sure, for any idea that we’re looking at, we’re looking for 3 criteria to be met: (1) the company is trading for a steep discount to what we think it’s worth is, (2) the business is run by managers that truly think and act like owners, and (3) per share value that grows over time. From our perspective, Bank of America passes all three of these tests.

As you mentioned earlier, the stock’s in the low 20s today, call at $21 or $22 a share. Last year, they earned about $3 and generated roughly a 16% return on its tangible common equity. This year is going to be more challenging. Rates, as we’ve talked about, will be a headwind. Bad debt expense or bad loan expense is likely to go up. There are some headwinds that they’re going to be facing, but over time, we believe Bank of America is capable of earning a 10~15% return on tangible common equity. And we think that tangible common equity on a per-share basis, looking out a few years is going to be $20 to $23 a share. Using our assumptions, we think the earnings power for the bank is north of $3 a share. So, today’s level the stock’s trading at ~6.5X our estimate of normal earnings that we think they can grow off of.

Now as you think about the valuation from a downside projection perspective, the stock is trading at what we would appraise to be liquidation value or tangible book value, what we think they could sell other assets, and pay back all their liabilities for. The valuation relative to the S&P 500 is near historic lows. From our perspective, we don’t think the market is really rewarding Bank of America for some of the improvements that we discussed since the last downturn, whether it’s in credit quality, or capital levels, or expense reduction, or more sustainable return profile. The company’s taking advantage of that. They’re repurchasing a high single-digit percentage of their shares, paying out a really competitive yield today, and the total capital yield the combination of the two is amongst the highest of any public company that’s in existence today.

God forbid there is some existential threat every business is facing some form of technological obsolescence today. In the case of Bank of America, if that were to come to fruition, It’s nice to know that the majority of today’s share price is reflected in tangible asset value that could be ultimately returned to shareholders. As for what it’s worth, by our math assuming that return structure and a reasonable discount rate, we see no reason why the bank can’t be worth two times tangible book value or more. That would lead you to believe the stocks were somewhere in the mid-40s or so or more than double today’s share price.

Bill Nygren  23:25

If you look at how our assumptions differ from consensus, I think the first thing you see is that most people who write about bank America are unwilling to give them as much credit for growth that comes from reducing their denominator, the share base, as they do for companies that grow the top line. But it’s just as valuable to an investor and it creates just as high an EPS growth rate to see denominator shrink is to see the numerator grow.

Secondly, we see a lot of people reports were written that say, over the past 30 years, the average bank stock, typical PE was 10X to 12X earnings. I think what that misses is during a lot of that time, the S&P multiple wasn’t much higher than that. But today, pre-Coronavirus scare, the S&P multiple was getting close to 20X earnings. And yet, the bank analysts were still talking about a target PE of 10 to 12 times earnings. As we said earlier, because of the way these companies have expanded their moats, their competitive power is growing, and the safety of the companies much better than it was during the past 30 years. We think the gap in the market PE should be shrinking. So we’re looking at higher earnings per share number out five to seven years from now than the average analysis is, and we’re putting a higher multiple on that.

Stig Brodersen  24:57

Would you say that there’s a catalyst to this happening or is it just as much of the market wising up and understanding that difference?

Bill Nygren  25:09

Catalysts have always been a hard thing for us to anticipate. Even when you look back on some of the biggest market turns, like when the internet bubble popped in early 2000. It’s still hard to look back and say, “This was what the catalyst was that started that decline.” I think one of the things we look for in companies that are generating a lot of excess capital; so the longer the market, the more a company is undervalued, the more shares they can repurchase. Another thing is we like companies that pay back their cash flow to shareholders via dividends. The average bank paying out about a third of their earnings and dividend, the dividend yield will become so compelling on these stocks, as well the growth rate, investors will have to stand up and take notice.

Stig Brodersen  25:58

Now, let’s go to the next segment of the show. We’re not going to talk about Bank of America. We’re going to talk a bit more about the industry of asset management.

Our audience are primarily value investors. And the way that we are brought up is with the 0/6/25 fee structure that Warren Buffett used for his partnership as the optimum fee structure for both investors and portfolio managers. We also have other value investors, like Guy Spier and Mohnish Pabrai, who’ve been here on the podcast and have adopted the same structure for their Fund.

The fee structure implies that, as an investor, you pay zero percent management fee, but their portfolio manager has a 6% annual performance hurdle with a high watermark. That means investors need a minimum of a 6% return before the portfolio manager is paid. The high watermark is the highest peak in the value that the investment has reached, meaning the manager cannot collect an incentive fee unless the fund’s value is above the high watermark, and returns are above the hurdled rate. So the portfolio manager is then paid a 25% fee on returns or 6%.

Now, that is not the model that Oakmark Fund has chosen. Taking Oakmark Select Fund as an example, you have chosen a more conventional fee structure with a 1% net expense ratio. Why did you choose your fee structure? What are your thoughts on the 0/6/25 model?

Bill Nygren  27:29

We would have loved to have gone to the model that you suggested. Since the Oakmark Fund was launched in 1991, it went up about 24X its initial value. The fees to us would have been substantially higher under that arrangement than they were as a fraction of 1% of the assets. But realistically, the reason we chose that fee is that regulation doesn’t allow the mutual fund industry to adopt that fee. If you’re going to take any positive incentive fee, then the shareholders have to get refunded that same amount if you don’t meet the hurdle. If you’re going to take 25% of all profits above 6%, then anytime you fall short of 6%, you have to return 25% of that shortfall to the investors. With the month that we’ve just been through, with a crisis like the Coronavirus, every mutual fund that has an equity portfolio would have been out of business if they had that kind of fee structure. The only way we can get the mutual fund industry to move to an incentive fee-based model could be a change in the regulatory environment. I’d certainly be supportive of that.

Preston Pysh  28:50

Mutual funds have really had a bad name in the marketplace in the last I would say in the last decade, relative to ETFs. If you were going to argue against that idea, what would you say?

Bill Nygren  29:03

I think the biggest issue that active management has had, generally, and also specifically within the mutual fund industry, is that for a long time, mutual funds ran “closet index portfolios”, where a typical model might show the portfolio manager saying, “I think utilities look expensive today, so instead of owning the market weight on utilities, I’ll own 80% of the market weight. And I think banks look really attractive, so instead of the market weight, to all boost that to 120%.” But you have these industry weightings that are very tightly clinging to what the S&P index weighting is. Plus, effectively, ~80% of the portfolio is nothing more than an index fund, and then the manager is charging the fee only on the 20% that’s actively managed.

I think the industry has brought a lot of this problem on itself by basically running an “index fund plus,” but charging active management fees on the whole portfolio. I think the way you defend yourself against it is you do what the Oakmark Fund family has done. We don’t hug indexes at all. We buy stocks we think are cheap, hold them long term, analyze them in-depth, and we don’t worry about what our tracking error is versus the S&P 500. Every dollar that’s invested in our portfolio is actively-managed. We’ve seen all the studies that say that the funds that rely on long-term holdings of high active share portfolios have tended to be the best performing funds.

Stig Brodersen  30:56

I think that is very important for the listeners also to hear that because we have covered a lot of ETFs, and we have caught a lot of different partnership models, and very often, mutual funds have been brought up as the scare example of how it’s not supposed to be. I really appreciate you stepping up to the plate and giving us another perspective for our listeners.

It would be safe to say that the asset management industry has changed dramatically over the past few decades. Passive management funds with lower and lower fees have increased in popularity, and we see more and more algorithm trading, just to mention a few of the changes. For us as investors, and perhaps those listeners who are thinking about a career in asset management, what does the future hold for actively managed funds employing traditional portfolio managers?

Bill Nygren  31:45

It’s interesting. I think there’s been a lot of focus on passive management in just the past couple of years, but my view of it is, if I look at the time I’ve been interested in the stock market which goes back to when I was in high school, there’s been kind of a natural progression where the equity market has been able to provide high rates of return better than almost any other asset category. Because of that, it’s been an attractive place for individuals to put money.

Back in the 1970s and 1980s, the easiest way to access that, as an individual, was through your local stockbroker. It was a very expensive way to do it, not a well-diversified way, but it beat putting all your assets in bonds. Then, you started to see mutual funds come in. That was a much lower-cost way of investing than the local stockbroker was. A typical fund had hundreds of holdings and basically performed in line with the market. Then you saw index funds come that said, “Why should we try and differ just a little bit in the index and charge a big fee? Let’s lower the fee and just produce average returns.” Then you saw the value-based funds and growth-based funds. After that, it was value ETFs and growth-based ETFs. All along the way, the active managers have had to do something that justified their fees, and I think that keeps changing.

When I started at Harris Associates, the advisor to the Oakmark Funds in the early 1980s, simply being a value manager was a reason to earn an active fee. It provided a better return over a long period than an index fund did. Also then, there weren’t a lot of easy ways for investors to access just a diversified value portfolio. Today, you can do that with a value ETF that charges almost nothing. That’s why it’s so important that we’ve had to evolve in our stock selection criteria.

You mentioned at the start of the show that the last time we were on, we talked about our holdings of Netflix and Alphabet, and how those are such unusual names to see in a value portfolio. We’ve had to be responsive to how the economy has changed to an asset-light model that GAAP accounting doesn’t do a particularly good job of defining. The old statistics of price-to-book and PE don’t work really well in a lot of the industry. At Oakmark, we’ve evolved and we’ve owned a lot of the names that don’t necessarily look cheap on GAAP metrics, but on another form of business valuation metrics, look stunningly attractive. That’s been one of the reasons that Oakmark Funds has been able to outperform most of its value peer group, over the past decade, as we’ve talked about what a tough decade it’s been for value managers. People thinking about a career in this industry, you just have to understand it’s a constant evolution. You have to stay a step ahead of the computers. If the computer can do what you’re doing, it’s going to charge a lower fee than you can. You have to have human judgment and human analysis that can’t be done at effectively zero cost to make a career in this industry.

Stig Brodersen  35:18

Thank you for the elaboration on that and for the piece of advice to many of the younger listeners. Now, Bill and Mike, you have been very, very patient with me here today. And you have been very gracious with your time. Thank you so much for coming to The Investor’s Podcast. I would definitely like to give you guys an opportunity to talk a bit more about Oakmark Funds, what you do, and where the audience can learn more about you.

Bill Nygren  35:44

The Oakmark Fund Family has seven funds. We invest with a long-term value framework, and we do that across markets, the United States, and internationally; equity and fixed income. We’ve got the Oakmark Fund, The Oakmark Select Fund, Oakmark International, Oakmark International Small Cap, and then three global funds where we handle the asset-allocation between international markets and domestic markets. We also have an equity and income fund where we handle the asset allocation between stocks and bonds. You can read about how we think about investing at our website, Oakmark.com. The commentary pieces that we write, we put a lot more focus on than a lot of our competitors do. If you go through and read a couple of years’ worth of our commentaries, you’ll have a very good idea about how we invest. Everything we do is long-term value. That, in a snapshot, is what we try and do at Oakmark.

Stig Brodersen  36:47

Fantastic! We will definitely make sure to link to all of that in the show notes. We’ll also make sure to link to the previous interview that we have with Bill. Guys, again, thank you so much for the time and for coming on The Investor’s Podcast.

Mike Nicolas  37:00

Thanks for having us.

Stig Brodersen  37:02

All right, guys! At this point in the show will play a question from the audience. This question comes from Brad.

Brad  37:08

Preston and Stig, I really enjoyed your recent Episode Number 288, where you both discuss current market views, positions, and how you believe the next few months are going to play out. I’m a big follower of the podcast and enjoy keeping up with some of the great minds you both follow, like Ray Dalio, Luke Gromen, and Raoul Pal. On Episode 288, you indicated it might make sense to purchase gold and oil towards the second half of the year. Can you provide some input on why you would favor physical gold over paper gold? Especially since the current flop to cash is providing good bargains in the paper gold and silver markets? Thanks, guys.

Stig Brodersen  37:46

So, Brad, I think this is a fantastic question and to understand the argument for physical gold or paper gold, I think it’s important to understand history. The US dollar replaced the British Pound sterling as the world’s premier reserve currency back in 1945, in accordance with the Bretton Woods agreements. At the time, the US dollar was the currency with the greatest purchasing power and the only currency backed by gold. But in fact, the world was pegged to gold because all the currencies were pegged to the dollar. Now, throughout history, you have multiple currencies that have been the dominant currency. For instance, in the 17th century, it can be argued that the Dutch currency was even the most important as the credit system was reinvented by the Dutch and the enforcement of credit claims was honored, no better place in the world.

Now, my point by saying that is that believing that the US dollar will forever be the world’s most important currency in its current form is just very, very unlikely. The recent biggest change was 1971 when Nixon took us off the gold standard. Yes, it was still called the US dollar before and after that, but it was a very different currency than it was before because we entered the realm of few currencies where central banks around the world could print infinite amounts of money. Perhaps that is best exemplified here in the coronavirus crisis where money has been printed at unprecedented levels.

So, when we look back in history, which currency has maintained its purchasing power? Gold has. Gold has for thousands of years. When we talked on the show about the risk of hyperinflation, one way to hedge against that is through gold. And, just for the record, I would like to say that I think the inflation numbers can go much higher than today. But anywhere near the hyperinflation rates that you have seen with hundreds of percent in annual inflation or even higher than that, I think that it’s very, very unlikely in the US. But I do think that we will have more inflation in the time to come, or at least there are significant risks that we’ll have more inflation in the time to come.

Especially in the case, should hyperinflation happen, physical gold becomes much more attractive than paper gold because as soon as you have gold in the financial system, say, through an ETF like GLD, or through a derivative, it doesn’t mean that you have access to the physical gold when push comes to shove. And that’s whenever you need physical gold the most. So, even if you do own gold on paper, it won’t really do you any good if the government takes away the gold from you. If you don’t think that’s possible, consider what happened in 1933. Through Executive Order No.6102, President Franklin D. Roosevelt made it a criminal offense for US citizens to own and trade gold anywhere in the world, with the exception of some jewelry and collectors coins.

But the reason why I’m saying this is that I hope that you, Brad, would look back in history and see that the system that we have, as stable as it may look like, we’ve just throughout history seen so many changes. Just in the last hundred years, we’ve seen dramatic changes in the monetary system. So, physical gold does make sense over paper for gold even though it can be a little more troublesome to own it. Now, I would like to end my response with a quote from Ray Dalio: “If you don’t own gold, you know, neither history nor economics.”

Preston Pysh  41:15

So, Brad, I think Stig provided an outstanding overview of the history, and the risks associated with governments potentially stepping in. Whether they can do that now with how interconnected and digital the economy has become compared to the last time that some of these things were implemented on the gold market is something that is just really insanely difficult to quantify what those risks really are. Because it is different. We have a different economy at this point.

I don’t know that I have a good answer for you. The physical gold market’s speed at which you can receive your payment; if there would be something else that would take off other than physical gold, your ability to sell out of that position due to the speed at which you can settle, I think is a concern for me personally. On the paper gold market, the big story right now, at least for the last month, has been the separation between the premium that you actually catch on the physical market versus the paper market. Now, whether that trend persists or not, or what’s even driving that is yet to be determined. I don’t think anybody can say with a whole lot of confidence, what’s driving that. If that trend would continue to persist in the coming months, I don’t know. I think that’s a little bit concerning.

So, I don’t have a good answer for you. I’m like everybody else, kind of standing there from the side, kind of looking at what’s happening and saying, “This is very interesting. This is very fascinating, what’s taking place.” I just don’t know if there’s a good answer as to where to be positioned based on everything that Stig laid out there, based on these nuances between the price difference between the physical market and the paper market, and then just the whole confiscation piece is just something that I don’t even know how you’d put a determination on that. I do, as anyone who’s listened to the show knows, have concerns about fiat currency moving forward. It’s not just the US dollar, but all the fiat currency around the world because, as Stig had mentioned, when the US came off the gold standard in 1971, everyone else came off the gold standard at the exact same time because they pegged their currency to the dollar. So you’ve had this competitive devaluation that’s been going on for literally decades.

Now that you got interest rates in real terms pegged at zero, I just think you’re gonna see some crazy things happening in the market, especially concerning volatility. When they’re printing this much money and they’re pumping the QE, and they’re pushing interest rates, they’re gonna sustain interest rates at zero percent, the market is going to be looking at that and saying, “Oh, well, things aren’t. Things aren’t unstable because the yields in the fixed income market aren’t volatile. They’re going to be pegged at zero.” People are going to be lulled into thinking that there’s nothing wrong when in fact, behind the scenes, I think there are a lot of things wrong.

And then what are the implications of all this universal basic income that’s rolling out? And what does that mean? There are so many unknowns. This is so crazy that what we’re seeing, I just don’t know that I have a good answer for you. So, those are our thoughts. That’s how we’re looking at all the different variables. Maybe it’s helping you determine where you are. Maybe you’ll have more confidence after hearing all that.

45:00

So, Brad, for asking such a great question, we’re going to give you free access to our TIP Finance Tool on our website. One of the great things about the TIP Finance Tool is, like you learned in this episode where we’re calculating the intrinsic value of a company, this tool on our website allows you to go into any company on the US markets, you can pull it up, and it automatically graphs the free cash flows of the company. You can come up with an array of what you think those future free cash flows will look like, and then the software automatically does the intrinsic value estimate of what that company will be worth.

We’re really excited to be able to give this away to you for free and we really appreciate you asking such a great question on the show. If anybody else out there wants to get a question played on the show and get free access to our TIP Finance Tool on our website, go to asktheinvestors.com and you can record your question. If it gets played on the show, you get a free subscription to our TIP Finance Tool.

Stig Brodersen  45:55

Alright, guys! That was all that Preston and I had for you for this week’s episode of The Investor’s Podcast. We’ll see each other again next week!

Outro  46:03

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