Bill Nygren (03:07):

Say we expect earnings growth of about 5% at the S&P with a 2% dividend yield. We want ours to have a combination of at least 7% and we’re agnostic as to whether it’s a 7% dividend yield with no growth or 7% growth with no dividend yield or anywhere in between. And then the third thing that we want is we want a management team that’s aligned with the outside shareholders whose intent on maximizing long term per share business value. And all those terms are important. We want long term value maximization, not next quarter. And we want them to think on a per share value basis.

Bill Nygren (03:46):

We don’t want management teams that are just trying to grow the value of the enterprise, maybe by making overpriced acquisitions and issuing lots of stock. On a per share basis, we want them taking actions that maximize value for the long term. And when we get all three of those, it gives us the luxury of a timeframe that’s longer than almost any of the other investors in public markets are using. Our analyst look out seven years and work very comfortable maintaining our positions over that length of time. We like to say that gives us almost a private equity perspective to public equity investing.

Clay Finck (04:23):

We’re going to talk a little bit more about your process later in the episode, but let’s talk about Fiserv first. Before we dive into the specifics of the company, could you please briefly walk us through the lines of business that Fiserv has for those in the audience that might not be familiar?

Mike Nicolas (04:39):

Fiserv is one of the world’s largest financial technology companies. Its business is really organized around three core divisions. The first segment is what they call their base software segment, or it’s typically referred to as core account processing software. And this software kind of acts as the central nervous system of a bank. It’s basically the back office operating system that allows a bank to process loan and deposit accounts and run the general ledger and manage regulatory and compliance requirements.

Mike Nicolas (05:10):

About 40% of US banks today use Fiserv software to run their business, but it’s primarily small and medium sized banks. Since many of them kind of lack the resources to develop these types of software solutions internally. This division makes up about 20% advisors revenue, it’s very sticky, but the market’s mature. We expect Fiserv’s bank software division to grow around mid-single digits organically moving forward.

Mike Nicolas (05:33):

The second main division is their payments and networks division. And this division, it’s about 40% of the company’s sales. And it’s really just a broad collection of digital banking solutions for small and medium size banks like bill pay capabilities and mobile digital banking, P2P transfer result, but even card issuer processing. And in addition to that, Fiserv actually owns the third largest debit network in the US behind MasterCard of Visa called the star network.

Mike Nicolas (06:01):

The average Fiserv customer probably has 15 plus of these products and the revenues are typically tied to the number of accounts on file or the number of transactions for period. With this division, we expect it to grow kind of mid-single digit plus over the medium term and largely in line with the company’s expectations. That last 40% or so comes from the company’s merchant acceptance division. And this is the segment that represents really the majority of what they bought from First Data in 2019. And these technologies enable merchants to effectively accept payments in almost any form.

Mike Nicolas (06:36):

The company is the number one merchant acquirer and payment processor in the world. And they’ve got trillions of payment volume and millions of merchants using these services. I’d say the most exciting asset within this division, probably the company for that matter is Clover, which is a merchant acquiring platform, that’s really focused on small and medium sized businesses. Again, it competes hand to hand with square seller business, as well as vertically focused players like toast.

Mike Nicolas (07:02):

And this business, it’s exciting, it’s been growing rapidly and by some estimates may be worth a real considerable amount of Fiserv’s total enterprise value today. This division is the fastest growing within Fiserv, expected to grow high single to low double digits over the coming years. Just stepping back, Fiserv, it’s the number one core account software provider. Number one merchant acquire and issuer processor in the country. And we believe it’s well positioned to benefit from kind of high level trends like the continued conversion of cash to card and really the secular trend toward increased spending on technology by financial institutions and banks.

Clay Finck (07:38):

Yeah, it definitely seems like they’re very well diversified when it comes to all their lines of business. They have those three main branches that you outlined. And it seems to me that Fiserv is just one of those companies that’s naturally underappreciated because many investors just aren’t familiar with what they do or who they are. Fiserv made the massive acquisition of acquiring First Data back in 2019 for 22 billion, which you alluded to, and that was an all stock transaction. Could you talk about what First Data brings to the table for them and what synergies you expect between them and Fiserv?

Mike Nicolas (08:16):

What was, I would say historically or rather straightforward investment case for legacy Fiserv became significantly more complicated when they made the offer to acquire First Data in 2019. And as I mentioned, together they operate the largest card issuance and merchant acquiring platform and an industry that really benefits immensely from scale advantages. Increased scale was certainly one of the benefits to the deal.

Mike Nicolas (08:40):

Another real big benefit of that deal was distribution. And if you think about legacy Fiserv, they provided core account processing software for 10,000 plus banks and credit unions around the country. And they obviously rely on this to run their business. But these banks have small business lending arms with an enormous number of merchant relationships sitting underneath them. And Fiserv believed at the time that they could really stimulate First Data’s growth by offering its customers, the banks, the opportunity to generate additional fees by becoming really a distributor of their payment solutions like Clover and these relationships, they benefit the bank, they benefit the merchant.

Mike Nicolas (09:19):

And of course they benefit Fiserv. And I’d say the success we’ve seen at Clover over the past few years, which we can get into in more detail later serves to at least partially validate management’s views there. We thought Fiserv paid a pretty attractive price for First Data. It traded at a significantly lower multiple than peers at the time, despite what the company believed to be vastly improved technology and business mix. And in our view, First Data CEO, now Fiserv’s, Frank Bisignano, did a really good job improving the First Data business and accelerating growth after years of just higher merchant churn or customer service and capital constraints. And just a lot of executive turnover under KKR’s ownership.

Mike Nicolas (10:01):

The logic underpinning the transaction from both cost of revenue perspective was quite compelling and I think was almost somewhat validated by the knock on deals that it sparked. I mean, shortly after the Fiserv First Data merger, the company’s chief competitors, which are FYS and Global Payments, they each announced 20 billion plus mergers in their space as well. So post the deal we expect organic revenue growth to accelerate given the higher base rate of growth and payments, as well as the 600 million of revenue synergies they’ve identified. And operating margins should expand considerably. They’re talked about 1.2 billion of cost energies they expect to realize from the combination. We think the business will go faster, more profitably than legacy standalone Fiserv did.

Clay Finck (10:45):

I’m interested, since it was a $22 billion stock deal. And Fiserv’s, their market cap today is roughly 70 billion. From a financial perspective, how does the all stock transaction work. Did they simply buy out all the public shares on the market at a premium and fund the deal with debt?

Mike Nicolas (11:04):

The 22 billion figure you referenced was the value they paid for First Data’s equity. And that was, if I recall, about a 30% premium to where it was trading at that time, it wasn’t all stock transaction. And that really resulted in Fiserv issuing new shares to First Data shareholders such that Fiserv shareholders owned, call it roughly 60% of the combined company. And First Data shareholders owned the remaining 40% or so. But they also assumed a significant debt load from First Data in this transaction, such that the total acquisition clause was actually much closer to 39 billion at the time of the announcement. And Clover came to Fiserv through First Data with the benefit of hindsight, that one asset Clover may prove to justify the entire deal.

Clay Finck (11:51):

That’s interesting. Did you become really interested in Fiserv once they completed that First Data acquisition? You’ve talked a lot about Clover or were you interested in Fiserv prior to the acquisition?

Mike Nicolas (12:04):

It was really following the acquisition that we became more interested, legacy Fiserv at least had historically traded at a comfortable premium to the market, a considerable one. And had been a consistent double digit earnings grower for decades. But once the deal was announced and this stock had sold off, and this was really during COVID when we decided to revisit it, that’s when we became more interested. But we typically find that M&A tends to be an interesting space for us to revisit names that we’ve historically looked at or potentially define new opportunities, if the market may take a different view on that transaction than we do.

Bill Nygren (12:40):

Mike had mentioned earlier that the story had gotten a little more complicated after the First Data acquisition. And to us, that’s a good thing. When a story’s simple and the company’s growing rapidly, it’s almost always a company by a price that’s too high for us. But you do an acquisition like this, and some of the shareholders on one side or the other side of the deal don’t really like it and they sell their stock. You’ve got management talking about large potential synergies, both in revenue and in cost.

Bill Nygren (13:10):

And a lot of analysts get sloppy and assume that they’ll only achieve part of that and kind of wait and see on the rest of it. We dig deeper and get comfortable with a specific number of synergies that we think they can meet. And then also a lot of times, especially in the stock deals, you’re creating amortization, which depresses reported earnings without depressing cash flow. And we dig into that as well to see if we think those are real economic charges, or if it’s just kind of an accounting loss. The amortization charges can kind of camouflage a cheap stock. We find a lot of times that these company altering acquisitions provide good hunting ground.

Clay Finck (13:54):

Bill, you mentioned at the beginning of the episode, the three things you look for in the companies that you invest in at Oakmark and that’s companies that are trading at a significant discount, they’re growing their dividend and per share value at least as high as the S&P 500. And they have managers that think and act like owners. I’d like to start with that second point of the dividend growth and per share value growth as high as the S&P 500. When I was looking at Fiserv’s 2020 annual report and preparation for the meeting, one of the things they show on the annual report towards the top is their EPS adjusted growth has been double digits for the past 35 years, which really is just incredible. And also goes back to the management as well. I want to ask how does Fiserv’s dividend growth and per share value growth compare to the S&P 500?

Bill Nygren (14:45):

Well, on that backward look, the S&P’s grown a little more than 5% over the past 20 years, probably closer to a 6% or 7% annualized growth rate in EPS, along with paying out a 2% to 3% dividend. You get somewhere on a historical basis something like an eight or 9% a year compound growth rate. And as you said, Fiserv had been double digit for 35 years, so they’ve been comfortably exceeding S&P 500 growth.

Bill Nygren (15:14):

Now, as we think about it and how we build the basis for our valuation, it’s not backwards, it’s what we expect going forward and Michael get into more of the detail. But we think that the combined Fiserv and First Data ought to continue growing more rapidly than the S&P 500. They generate excess cash flow. You’ve still got KKRs influence on the board of directors because they were the company that was involved when First Data had been taken private. We’re pretty comfortable with the combination of business growth and reduction in capital base will continue to exceed the S&P 500 going forward.

Clay Finck (15:56):

Moving on to having managers that think and act like owners, what all are you looking for on this item specifically?

Bill Nygren (16:06):

Well, in general terms, what we want to avoid is the professional manager that gets paid based on how big the business is. And we think that type of compensation structure for management teams has led to a lot of value destructive acquisitions. It’s led to a lot of efforts to grow in unrelated businesses where the company isn’t competitively advantaged. What we really want is a management team that thinks like an owner, as if they own the whole business themselves, what would they do with the capital?

Bill Nygren (16:39):

Clearly they would reinvest in the business where they think they’re competitively advantaged. And if they don’t think they’re competitively advantaged, they’d take that capital away from the business and invest in something completely different, maybe another company. The way a public company can do that is by either repurchasing shares or paying the money back to us in dividends. We want that kind of thought process in the management team.

Bill Nygren (17:03):

We want them to think like a single proprietor would think who was building business for the next generation, not just trying to maximize next quarter or next year, but what should they do? How should they invest, best position of the company for five years, 10 years, 20 years from now. We’re quite comfortable that the KKR mindset and the mindset of the other directors at Fiserv is that very long term per share value maximization approach that we like to see in all our businesses at Oakmark.

Mike Nicolas (17:37):

Yeah. So we do focus a lot, Clay, on incentive compensation metrics and making sure in most instances that they have denominators to prevent some of the empire building that Bill was referencing and focus more on total shareholder return or EPS growth. Of course we’d love to see the managers own a tremendous amount of stock personally. And I think in Fiserv’s case, their CEO, Frank Bisignano does own hundreds of billions of dollars of stock. And we want to make sure that when they’re making any decision, M&A, they’re measuring against every purchase and making sure that that’s the benchmark with which they deploy capital, so all very important metrics for long term owners like ourselves.

Clay Finck (18:16):

I really admire you guys’ ability to really simplify the valuation process in the companies that you guys own. Could you walk through how you think about the valuation of Fiserv?

Mike Nicolas (18:29):

I guess the simplest way to describe it is that we believe Fiserv is an above average business trading for a well low market multiple. And we do expect the company to be a mid single digit to high single digit organic revenue grower over the medium term. And we would expect that to be a company with a good amount of margin expansion per year. Today, if you look at the stock, it trades for about 14 times our estimate of next year’s after tax earnings, which is a considerable discount, 25% or so to the market.

Mike Nicolas (18:57):

Now, as I referenced before, historically it had traded closer to a 25% premium to the S&P 500, that’s legacy Fiserv. We find that dynamic interesting since growth today is above historical averages and expected to be, margins are higher and innovation in R&D spend is bigger and accelerating relative to legacy Fiserv. We think there’s considerable upside from here without having to rely on overly demanding assumptions, or even just putting a market multiple on it.

Mike Nicolas (19:23):

But to get maybe a bit more granular, you can look at a company like Fiserv through more of like a sum of the parts sleds if you will. And there are some specific assets briefly touched on Clover that make up a relatively small percentage of the company’s overall revenue today, but it’s growing rapidly and likely worth a real big chunk of the company’s total EV or enterprise value. And there’s third party estimates of Clover’s value today that are in the 30 to 40 billion range, which even at the low end would account for more than a third of Fiserv’s enterprise value. And it’s only 10% or so of the company’s 15 billion of revenue.

Mike Nicolas (20:02):

If these estimates of third party estimates of Clover’s value are remotely accurate, the implication is we’re paying a very, very low multiple for the earnings of the remaining 90% of Fiserv’s business, which we still expect to be growing in the low to mid single digit range. We like the fact that there’s some kind of newer age, quickly growing assets buried within their portfolio that we don’t believe at least today that are receiving the same type of credit as some of these standalone peers.

Mike Nicolas (20:29):

One last thing, we expect much of the company’s free cash flow to be returned to us via share purchase over time. The company has kind of reiterated its intention to return the 30 billion dollars to shareholders over a five year period. That’s 40% of the company’s market value, so we’re going to get a healthy portion of our investment back in the form of a greater ownership stake just by waiting patiently here.

Clay Finck (20:52):

When I look up Fiserv’s P/E ratio on the stock screener, I see 55. And you mentioned that the forward P/E is 14 in that they’re currently trading below that of the market. Are you calculating those adjusted earnings yourself or is that an earnings amount that is provided in their financial statements?

Mike Nicolas (21:16):

It’s something we’re calculating ourself, it’s something that Wall Street calculates itself as well but it gets back to what Bill explained earlier about some of the amortization that gets born through a transaction like they did with First Data that is non-cash, it’s something that we believe is not a true charge or tax against the company moving forward. Typically, we don’t ignore amortization, but in this specific instance, we don’t believe it’ll be a true operating expense for the business.

Bill Nygren (21:40):

And that’s one of the exciting things, we think we know one of the big reasons why this is under priced in the market. A typical value investor, who’s doing a screen like you’re doing, sees it at 55 times earnings, nothing to see here or move on. And when you dig a little bit deeper and you see how much cash the business is generating, you see that it’s a remarkably different multiple on cash flow generation than it is on P/E.

Clay Finck (22:06):

Now, why do you believe that there’s such a large disconnect in the valuation between Fiserv and maybe some of their competitors like Square and PayPal?

Bill Nygren (22:15):

I think that’s something we find in a lot of businesses today, where you have a potential disruptor that the market is valuing extremely high level, lots of optimism about what the disruptors future might look like. And then inside of the traditional business, you’ve got very heavy R&D spending, in a lot of cases, advantaged relative to a newcomer in the business. And yet the market just doesn’t seem to pay much for it. We see that with GM and their investments in autonomous driving, Lyft, electronic vehicles. You see it in a company like Ally Financial that we own where people think of them as kind of a legacy auto lender, but they’re actually the largest internet bank today. It’s not too surprising to us that the pure plays like Square or PayPal sell at much higher multiples than what’s implied for Square inside of Fiserv.

Mike Nicolas (23:12):

Yeah. As our chairman likes to say, in this market you’re either a unicorn or a dinosaur. And I think Fiserv is the largest and one of the oldest payments company in the world is perceived to be the dinosaur. And despite being a so-called legacy FinTech company, Fiserv is still a good company. As you mentioned, it’s grown adjusted earnings at a double digit rate for many decades, that’s expected to grow high single digits going forward EPS at 15 plus percent. It generates high returns on invested capital. It’s levered to good end markets like payments and bank IT spend.

Mike Nicolas (23:43):

And even average performance in the payment sector tend to be well above average companies in general. It is surprising to us that a business that grows faster in higher returns in index and these businesses are pretty resilient over time is trading at such a big discount. But there are fears that the company will be a share donor over time. But even if they did undergo the market by a few percentage points and we believe they’ve been holding share, but if that wouldn’t make it necessarily uninvestable to us, price needs to come into the picture here as well.

Mike Nicolas (24:14):

And we start to consider that Fiserv trades at 14 times next year’s after tax earnings, while some of the newer companies trade for comparable multiple of revenue, we just believe there’s so much more that has to go right for the other group to justify their valuation. And we don’t believe that’s the case for Fiserv, and that’s why we like the risk reward. But Fiserv is not standing still, they’re spending a lot to continue to innovate. And as the incumbent, there are some disadvantages, but there are some advantages too. They have the resources and the R&D budget and the existing customers and a really talented employee base to continue to develop and innovate and remain a leader in the space.

Bill Nygren (24:52):

It’s funny how the term legacy has taken on such a negative connotation. A business that’s a leader today kind of by definition is the legacy in that industry. And lots of times that’s a really a good thing, not a bad thing.

Clay Finck (25:08):

Makes a lot of sense to me. Now, your team sees a ton of potential in the value of Clover going forward as it’s growing its GPV at a very fast pace. And Clover is a competitor to Square, a direct competitor. What are the big different differentiators between Square and Clover? Are they really similar or does square have better technology that the market likes a lot more or what’s going on between those two?

Mike Nicolas (25:36):

Yeah, good question. Maybe just stepping back, over the past decade or so, smaller merchants have been kind of shifting away from standalone payment processing and toward integrated software offerings that provide both payment processing capabilities, as well as various other business management applications, and Clover and Square are leading players in this space.

Mike Nicolas (25:59):

You can think of really both companies as somewhat of a business operating system for small merchants. Of course it’s primary purposes to accept to process these payments. But in addition to doing that, the Clover software applications will allow merchant to track inventory, to manage payroll and scheduling, store company files, create loyalty programs, all from one unified platform.

Mike Nicolas (26:22):

And integrating this payment processing capabilities into that software really dramatically reduces merchant turn, provides more utility to the merchant and it makes it more disruptive to switch providers. And for these reasons you tend to see that the economics for a Clover or a Square tend to be much better than pure payment processors or enterprise merchant acquiring at the large merchant level. They really own the customer relationship. I guess getting back to your more specific question, Clover is a horizontal platform serving the retail and the restaurant, the services at markets.

Mike Nicolas (26:55):

And there are competitors out there like Toast that focus specifically on one vertical like restaurants. And you also have Square, which tends to be a bit more horizontal, but focused a bit more on the … it’s really a stronghold on the micro merchant. Whereas Clover tends to focus on larger SMBs. They both have really well developed app marketplaces on their platform. I’d say one big difference is that Clover uses third party distributors like I explained before to sell its product, whereas almost all of Square’s business is direct.

Mike Nicolas (27:27):

And I’d say they’re both considered to be great products by merchants, but the market treats them a bit differently. Clover is bigger than square today in payment volume with roughly 200 billion or so annualized and it’s growing faster. The total addressable market is measured in trillions of dollars. And our view is that both these companies can have a lot of success in global for quite some time at high rates. And you’re looking at Clover, it’s grown at about high 30s or so compounded over the last several years. And it’s really expected to sustain that 25% to 30% growth over time.

Mike Nicolas (28:00):

Square seller business is being valued at above 50 billion by many sales side analysts. Most people think Clover might be worth 30 to 40. Fiserv full enterprise value is 85 billion today. It’s a really interesting asset. We think if those estimates are remotely accurate, the value of the business is quite compelling. But we consider them to be two of the three or four leading products in that space today.

Clay Finck (28:24):

This reminds me of PayPal’s payment platform, Venmo, competing with Square’s Cash App, where it seems that it’s not a clear winner take all market. There’s multiple players that are operating that have very similar products or might just be serving a slightly different customer base. Are you familiar with what the take rate is on trans actions for both Clover and Square?

Mike Nicolas (28:48):

Yeah, that’s an interesting analogy that you brought up, but yes, the take rate for Clover is about 85 to 90 basis points, which compares to Square’s estimated take rate at about 1% to 1.1%. And like I mentioned before, Square is really 100% direct model almost, whereas Clover uses others like banks and independent sales organizations and software vendors in addition to a direct offering. But direct distribution is the most profitable up to a merchant and you don’t have to pay sales commission.

Mike Nicolas (29:15):

I think Fiserv has clearly used its expansive channel partnerships to its advantage to accelerate growth. Both of the US and increasingly the rest of the world, but their economics are a bit inferior to Square seller business. The flip side is I think we can attribute a good portion of Clover’s ability to eclipse Square in transaction volume to these distribution relationships that they have.

Clay Finck (29:37):

It seems like it’s impossible to talk about the payment space without bringing up cryptocurrencies. Do you foresee any disruptions in the payment space with the rise of things like lightning network on Bitcoin or stable coins, or maybe something that could take away the take rate that many of these businesses are getting?

Bill Nygren (29:56):

I would say you can put us down as crypto skeptics. We don’t want to invest in something unless we think we’ve got a pretty good idea of the estimated value of it and what kind of range there could be around that. And I think that’s very difficult to get to with something as new as crypto. We also tend to think that new innovations, the champions of those innovations always anticipate a much faster adoption rate then ends up being realistic. I don’t think it’s a big risk for Fiserv, but let’s say we’re wrong. I mean, Fiserv has figured out how to become the market leader doing transactions in something like a hundred different currencies. If one of the cryptocurrencies takes over and becomes a primary mean of exchange, pretty confident that Fiserv is going to find a way that you can transact over their network in crypto the same way you could in euros or yen or dollars or any other currency.

Clay Finck (30:56):

Now, cryptocurrencies obviously are a big risk for you guys. Are there any other risks that you see with Fiserv outside of potentially the competitive landscape?

Bill Nygren (31:06):

Let me start with two that we would always think of as a risk for any company that we invest in. One is do they have the management in place to achieve their operating plan? And as Mike has mentioned, we’ve got tremendous confidence in the CEO at Fiserv, so we don’t think that’s an unusual risk. And then with any company that’s generating as much cash as Fiserv is, your big risk is that they don’t invest that cash well, that they aren’t looking for the value maximizing opportunities.

Bill Nygren (31:35):

And with Fiserv committed to give that capital back to the owners of the business, largely through repurchases, we’re pretty comfortable that we don’t have a lot of risk of them doing acquisitions that are value destructive or starting in on new unrelated businesses that they aren’t competitively advantaged in and end up investing for a lower rate of return. On those two big picture items, I would say we’re more comfortable than average that the risk level here is low, and I’ll let Mike address the company specific risks.

Mike Nicolas (32:11):

Yeah, Clay, I mean, I would say heightened competitive intensity is clearly the biggest risk in our view, and it can manifest itself in various ways. But beyond competition to your question, like many companies, cyclical companies, payment volumes are sensitive to the state of the economy. If we entered a recession, things like spike in unemployment or slower wage growth could have an impact on consumption of course. We’re focusing a lot on 40% of the business that’s payments, but away from that, to the extent that we witness big reduction in bank IT spend, a massive consolidation of smaller, medium sized banks as they try to compete against the larger banks, that could put pressure on Fiserv’s bank software division over time.

Mike Nicolas (32:49):

But competition is the market’s biggest concern, it’s certainly ours. But Fiserv is a heavily diversified business and it’s unlikely that one single business line can take down the company. And I think that’s a dynamic that we believe is not well appreciated or maybe fairly reflected in today’s values, a better way of putting it. But those would be some of the bigger ones that we think of outside of competition.

Clay Finck (33:11):

Now that we’ve talked a lot about Fiserv, I’m curious, how did Fiserv even come up on your radar? There are thousands of stocks in the market, so you have to come up with some way to narrow down your investible stocks to invest in. What is it that you look for in new companies to invest in that lead you to researching a business further?

Mike Nicolas (33:33):

Yeah. I mean, in this specific instance, there was a company that I had been looking at for quite some time and maybe even stepping back further, all of us here at Harris Associates and Oakmark were constantly reading and researching and doing work on companies every day. And the best majority of the time we’re doing a lot of work, but maybe one of those three criteria that Bill mentioned at the top of the show, we just couldn’t get confident enough in. Maybe we weren’t quite confident in management yet, or that it wasn’t trading at a cheap enough discount to intrinsic value. Or we were having a hard time trying to project out what we thought a reasonable growth rate would be for, call it the next five plus years or so.

Mike Nicolas (34:11):

But we still follow those names. We’re constantly going to conferences, jumping on their earnings calls, speaking with other CEOs and CFOs to try to get as much as we can about these companies, especially the pieces of the puzzle we weren’t able to put together perfectly at the start. Now with Fiserv specifically, I think that kind of how this one came about, it was a name that was always intrigued by, felt they had a really good competitive position. You had mentioned before they had grown like clockwork and really delivered through up markets and down markets, but it was really never just selling at a cheap enough price.

Mike Nicolas (34:44):

And three events really took place at once, you had the transaction with First Data, which created a little bit of confusion in the market and the opportunity for us to revisit the name. You had a sell off in the stock and you had a new manager come in, take over the company. And I think those three factors really moved it back up to near the top of our radar screen and made it a good opportunity to revisit it. And our conclusion was that we were able to get more comfortable with those factors and thought it was cheaper, but expected to grow quicker. And that’s really what brought it back to our radar screen.

Bill Nygren (35:18):

Speaking more generally of where we find ideas at Oakmark. 30 years ago when we started Oakmark, you could pretty much just do a screen on P/Es. Look for the low P/E companies, buy the cheap stocks, wait for reversion to the mean, and that was a pretty effective strategy. One of the reasons it worked is because we didn’t all have tremendous computing power on our phones or on our laptops. And it was a hassle to get a screen together, clean up the data and really find the stocks that were selling at low P/E ratios.

Bill Nygren (35:55):

Now that anybody can do that really easily, the value of that has fallen dramatically. And now we have to look more for a company like this, where the stated numbers don’t really reflect what’s going on inside the business. We find that in a lot of companies, that gap accounting that was really designed for a bricks and mortar world, where investments were made in fixed investments, you put them on the balance sheet, you depreciate them.

Bill Nygren (36:25):

Today most investment is made through the income statement. It’s not in assets that you can touch and feel, it’s R&D spending. It’s building a global network, it’s intellectual property, it’s advertising, customer acquisition. All those things go straight through the income statement. We spend a lot of time looking at companies that don’t look cheap on the surface, that when you dig into them, you find that accounting is doing them an injustice.

Bill Nygren (36:55):

We look for these transformational events where the future might be a lot different than the past. We look for managerial changes where maybe a new management team is coming in that can earn a very different return on sales than the old management team could. Our approach to finding new ideas has become much more eclectic than it used to be. And I think that’s just kind of the history of investing. You do something for long enough that works, other people copy it and it stops working. So you kind of have to stay ahead of what other people can do easily on their computer. And I think at Oakmark, we’ve done a better than average job of that.

Clay Finck (37:39):

Your Oakmark Funds are typically more value funds with companies like those in the financial and energy sectors. And they tend to have lower P/E ratios. It’s something like Fiserv where you’re adjusting the P/E and saying it’s lower than the market multiple. However Alphabet and Facebook are both holdings of yours in your large cap fund. Could you talk about what led you to own these higher growth and very large companies and your fund that’s more value focused?

Bill Nygren (38:11):

Yeah, it’s funny. I think a lot of times people get the idea that value investors are stuck investing in below average businesses. What Warren buffet or Benjamin Graham called the cigar butt companies. But to us value just means that you’re getting a lot more than you’re paying for. And through some of these accounting issues where a company is making a lot of investments for the future that aren’t creating current earnings, it’s creating the misperception that the company’s expensive.

Bill Nygren (38:44):

You look at a company like Alphabet and they’re investing a tremendous amount in autonomous vehicles in healthcare, in Google Cloud. None of which really is earning any money today. In fact, it’s losing significant money. We think about it, if they made those investments with a venture capital firm instead, the accounting would be very different. It would be a big asset that goes on their balance sheet and the losses that are going through those venture companies don’t go through the income statement, so we add them back.

Bill Nygren (39:18):

We look at something like cash, both Facebook and Alphabet have a ton of cash. You’re lucky if you can earn 1% on cash today that maybe is two thirds of 1% after you pay income taxes on it. If you had a dollar that was invested in a treasury bill earning 1%, two thirds of 1% after tax, that dollar is selling at 150 times earnings. Any company that’s got a lot of excess cash today has almost a hidden asset there. When we look piece by piece at the values, we separate out the cash. We look at the venture cap investments that aren’t earning money. We look at the under monetized investments like YouTube and Alphabet, that’s still through either subscriptions or advertising is monetizing at a fraction of what other streaming services are.

Bill Nygren (40:09):

And we do a piece by piece valuation. And when we sum up the parts, we subtract that from the stock price and say, we’re really getting the search business at less than a market multiple. Or in the case of Facebook, if you look at WhatsApp, the investments in artificial intelligence and Oculus, look, you try and break it down to get down to what are you really paying for Instagram and blue Facebook. And again, we think we’re able to purchase those at substantially less than a market multiple because the market just isn’t paying much for cash and those venture cap like investments.

Bill Nygren (40:49):

And as we move to more and more of a business world that’s based on intangible assets, intellectual property, venture capital like investing, R&D, we think there are more and more of these opportunities where really good businesses look like they’re selling at an expensive P/E ratio. But by the time you do the work and dig into it, there’s a core piece of the business that everybody agrees is a great business. And we think we’re buying them at less than a market multiple. To us, this is still just as much value investing as buying GM at six times earnings was, it’s just a little more complicated to get there.

Clay Finck (41:31):

Now, your primary large cap fund holds about 50 companies, which seems fairly diversified for how thoroughly you guys are doing your research on these. When you look at your investments in companies like Google and Facebook, do you ever think about increasing your concentration in these businesses due to the just massive mode and competitive advantages and growth rates that these companies have?

Bill Nygren (41:55):

Well, just for a frame of reference, our typical competition in the mutual fund business owns about 150 names. And most mutual funds have a goal of being so diversified that they can’t underperform the market by very much. It’s kind of a don’t lose by enough to lose the client mentality. We go the opposite direction and say, “The skill we bring to the table is stock selection.” And from what Mike has talked about on Fiserv, you can tell, we know our company’s in depth, we don’t just take flyers because we think it’s a cute ticker symbol or we heard somebody say something positive about the name.

Bill Nygren (42:33):

Because we know so much about the businesses, we want to own a lot fewer names in our portfolio than our competition does. Getting it down to 50 names already gives us a much more concentrated product than most of what else is available in the marketplace. But because we know a lot of people who use our funds build their own portfolios of mutual funds, we also have a more concentrated product, the Oakmark select fund that only owns 20 names. And whereas Alphabet makes up about 4% of Oakmark Fund, it makes up about 10% of the Oakmark select fund.

Bill Nygren (43:10):

Now, somebody who’s going through a life changing event, they sell a business, they get an inheritance, maybe they get a divorce settlement, they get a big raise they weren’t expecting. They come to us and say, “What do you do that we can invest this in and not have to think about it for the next decade?” We’re going to say the Oakmark Fund. But if somebody says I own a growth fund, I own a couple good international funds, I’ve got a lot of other investments outside the stock market, where can I invest where your favorite ideas really dominate your portfolio? We’d tell them the Oakmark select fund is a great spot for that capital.

Bill Nygren (43:46):

It’s going to be more volatile than the Oakmark Fund is when we’re wrong. It’s going to perform worse than Oakmark does. But over a long period of time, the Oakmark Fund has done very well. And the Oakmark select fund has done better. It’s a bumpier ride and people have to know that before they get in. But that’s what happens when you concentrate your holdings, each name matters more to the overall results and it creates a more volatile fund. But if you’re right more than you’re wrong, the benefits of concentration are indeed positive.

Clay Finck (44:17):

Your Oakmark Fund has 34% of its assets in the financial sector. What is it exactly about the financial sector that you guys like? Is it just a very attractively priced sector at the time or what do you guys see in there?

Bill Nygren (44:33):

What I would say is we look at that sector as being the most under priced sector in the market today. We think a lot of investors after the great financial crisis in ’08 kind of gave up on banks and some other financials because they thought it was too hard to understand what the companies were actually doing. I mean, we look at it and say, “If you’d told us back in 2007 that real estate prices were going to fall by 30%, do you want to own companies whose assets are almost all tied to real estate that are levered 15 to one?” We would’ve said that we want us stay as far away from that industry as you could get.

Bill Nygren (45:14):

But we weren’t that pressured, we lost a lot of money on financials in the great financial crisis, but we think the businesses are very different today. They’ve got a lot more equity, typically 10% to 15% in equity instead of five to 10. Most loans today are done on what I would call kind of good old fashioned banking standards. Before ’08 banks got the idea that you didn’t really need to worry about the person you were giving the loan to. You could just base your loan on the property because worst case you just repossess it.

Bill Nygren (45:44):

And I think they learned a valuable lesson. And today you have to put more down to get a mortgage. You have to be a more responsible credit to get a mortgage. And yet despite these improvements banks that used to sell at about three quarters of the market multiple, the S&P at about 20 times earnings today, that would be 15 times earnings. You can buy the best banks in the United States for seven to 10 times earnings.

Bill Nygren (46:09):

Mike could spend another hour talking about Ally Financial, it’s our largest holding today in the Oakmark Fund. But auto loan retailer with an internet bank to gather deposits, it’s selling at about seven times estimates of this year’s current earnings. And by the end of this year, tangible book value should have grown to almost the share price or maybe the end of next year. The point is you don’t have to believe these are the best businesses in the world to want to own them.

Bill Nygren (46:37):

But if they got back to selling it three quarters of the market multiple, even though we would argue they’re better businesses today than they were during the time period they average that discount, this company like Ally Financial, their P/E would double. They’re buying back about 10% of their stock a year, they’re paying a 3% dividend and selling at seven, eight times earnings. The market today is just very bimodal. You’ve got these high growth businesses that are selling at a hundred times earnings if they earn anything at all.

Bill Nygren (47:08):

And then we have legacy businesses that people worry are going to get disrupted. And if disruption takes 10 or 15 years before it happens, they’re going to return all that capital to us. They return their whole share price in share repurchases and dividends in less than a decade. We think the risk is very low with financials and the potential return quite high.

Mike Nicolas (47:32):

Yeah. And it’s important to remember, Clay, that there really isn’t eclectic combination of various financial services companies. I mean, there are some really cheap banks that are selling around the value as Bill mentioned that we thought they could sell all their assets, pay back all their liabilities and give us close to our money back or the market price. But there’s other names in there like get American Express or a KKR or Schwab, that might act a little bit different than a Wells Fargo or an Ally or a Bank of America would in different environments. We own these businesses because we think they’re cheap on a bottoms up absolute basis, and not because they’re labeled as financials, but it’s really a pretty well diversified mix of some pretty cheap businesses in our view.

Clay Finck (48:12):

It’s funny that I’ll hear so many people talk about how expensive the market is today. And then I’ll listen to guys like yourselves that really just make so much sense and take a lot of the speculation out of investing. And I just think that’s so powerful and so important for people to learn about for those who are looking for value in the market. Now, Bill and Mike, thank you so much for coming onto the show to talk about your fund and talk about Fiserv. I’ve really enjoyed this episode and I think the audience will really enjoy it as well and find a ton of value in it. Before we close out the episode, where can the audience go to learn more about you guys and your fund?

Bill Nygren (48:50):

I think the easiest spot to go is our website, oakmark.com. You can also find us on Twitter under Oakmark. And I think a good way to learn about how we think about investing, I write a quarterly commentary piece, you can find five years of those on our website. Somebody who invest a couple hours to read five years of those quarterlys would have a very good understanding of how we think about investing and why we think the Oakmark Fund is an unusually good opportunity for people to commit long term capital to.

Clay Finck (49:26):

Awesome. I’ll link all of that in the show notes, and I’ll be sure to check out some of those commentaries myself as I really enjoy learning from you guys. Thanks again for coming on, I really appreciate it.

Bill Nygren (49:36):

Clay, thanks so much for having us. This has been a lot of fun.

Mike Nicolas (49:39):

Thanks a lot, Clay.

Clay Finck (49:40):

All right, everybody. I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app, so you can get these episodes delivered automatically. And if you haven’t already done so, be sure to check out our website, theinvestorspodcast.com. There you’ll find all of our episodes, some educational resources we have, as well as some tools you can use as an investor. And with that, we’ll see you again next time.

Outro (50:03):

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