We Study Billionaires - The Investor’s Podcast Network - TIP293: Intrinsic Value Assessment of Bank of America w/ Bill Nygren (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, we're going to be doing a deep dive intrinsic value assessment on an individual stock pick, and the company today is Bank of America. To help us with today's assessment, we have Mr. Bill Nygrin and Mike Nicholas. Bill is the CIO at Oakmark Funds, which has over $76 billion under management. So get ready to hear some in-depth discussions about the intrinsic value of Bank of America. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. My name is Dick Brulerson, and as always I'm here with my co-host, Preston Pesh.

Starting point is 00:00:55 On the show, we have Bill Nygrin and Mike Nicholas. How are you guys today? We're hanging in there, Stig. I can't really say we're good. Markets down 10% today after a couple bad weeks, but we're doing okay. And it is definitely special times. As Bill said, there, the market is down 10%. Yes, you heard it right, 10%.

Starting point is 00:01:15 We're recording here in March 16. But guys, I'm sure someone like you managing a lot of money, your inbox must be full these days. What are the typical questions you're beginning? And what do you tell your clients? I think the question we get most often is what we're, think will happen with the coronavirus. And 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. And we are certainly not infectious disease experts here at Oakmark. We read a lot of what they write,

Starting point is 00:01:50 we listen to what they say, and unfortunately the views of the path this could take are so diverse, it's hard to base any kind of investment strategy off an opinion on where the virus might go. But what we are good at 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 buy targets. And 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

Starting point is 00:02:41 targets. Today, we'd be selling close to a buy target to buy something that would have to double to be in its buy target. It's really unusual times. 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 MasterC. And on today's show, we're going to be talking specifically about Bank of America. The ticker for Bank of America for everyone out there is BAC. But Bill, could you please provide us just a basic overview of the business model? Bank of America is one of the largest money center banks in America today.

Starting point is 00:03:18 In our opinion, it has perhaps the best consumer banking franchise in the U.S. and one of the industry-leading wealth management platforms that typically operates under the Merrill Lynch brand, a really great management team, a strong balance sheet, and in our view, quite 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 smaller 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.

Starting point is 00:04:07 So we believe the valuation is attractive, the scale that they operate within will continue to remain a significant competitive advantage, and that the quality of their underlying business segments are on par with some of the best financial institutions around. 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. And today, it changes all the time, but it dropped another 12%.

Starting point is 00:04:39 I mean, 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 question at hand is how negative the impact will become, how long to persist, and finally how the economy will behave after the coronavirus resides. 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? I think one of the things we do well at Oakmark Stig is to focus on business value.

Starting point is 00:05:17 and what a business would be worth in, for lack of a better term, we call normal times. And 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 America or 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. And that's basically, what, 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 at our best, but 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. As Bill mentioned, our guess is no better

Starting point is 00:06:11 than anybody else's. And 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 how America's economy, and 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 perform particularly poorly during the last downturn. But I think what's missing in some of the analysis in the way the stocks have traded

Starting point is 00:06:51 recently is how much improvement there's been in the banks since the last downturn. And perhaps some of that perception, the old perception, is stale. There's been an enormous amount of capital built by Bank of America, a number of the large banks. They performed very well during stress tests. And they do have really diverse revenue streams. And, you know, unlike a lot of other cyclicals that we invested, 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 during prior downturns. And really, this is an opportunity for them to prove that the underwriting discipline and the capital build and the way they do business is far superior than the way that

Starting point is 00:07:30 they used to. 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 lot. 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?

Starting point is 00:08:06 How are you guys seeing that? All 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 of where shorter term rates are today. 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 can imagine that the more narrow that difference or that spread is, the more impactful it will be on its net interest margin. and net interest income makes up roughly half or so of Bank of America's revenue.

Starting point is 00:08:39 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. On 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.

Starting point is 00:09:11 When you think about the services that the banks provide from a bigger picture 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 what 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 the highly competitive operating environment they already are in. So from our perspective, what you see this year is not likely to be, from our perspective, the normal earnings power of the bank. One thing to remember if we're in a lower for longer

Starting point is 00:09:45 rate environment is that bank business models have been very adaptable over time. If you think back to the 1980s when interest rates were in the high teams, most FDIC insured banks were generating a mid-to-high-teens percentage of their revenue and fees. But if you fast forward to today, some of the big money center banks like Bank of America are generating almost half their revenue from fees. So it's not just interest income that dictates the growth of the business anymore. But of course, there's also the other side of the distribution. And I think Jamie Dinah talked about this in the past where rates could go up or look more like they have historically where the long end is at a bigger premium to the short end that we're

Starting point is 00:10:23 seeing today. And in that specific instance, we think the banks have significantly higher earnings power, or 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, the so-called Internet banks that compete much on deposit late, 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 continue to take share.

Starting point is 00:10:56 So let's talk a bit more about that. What are the key factors of success in banking? And what does Bank of America do better than its competitors? I think there's a couple. The stringent underwriting discipline, of course, a very sound risk management platform, increasingly scale being one of the biggest differentiators. Scale really enables the ability to invest in technology and into compliance systems for regulatory reasons. And it really allows them to build best-of-breed digital tools. for their customers. And 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, the number was about $3 billion. And it's been like that for almost half a decade, maybe a bit longer. And the magnitude of that is really enormous. I was listening to your interview with Sean's Standard Octan on First Republic not long ago and really enjoyed listening to Sean's

Starting point is 00:11:51 the interview of 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 product introduction alone every single year. So their ability to reinvest at multiples of some of the smaller and medium-sized banks total expense base, in our opinion, is really widening their mode and enabling them to reinvest their accounts in the customer experience. How would you describe the competitive situation between the biggest banks like Bank of America, Citigroup, Wells Fargo, and a few others. I would describe it as highly competitive, but in our opinion, the big three banks, Wells Fargo, JPMorgan, and Bank of America, of course, will and ultimately are the winners.

Starting point is 00:12:35 The all-end 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 the banks, those costs are about half of what most regional banks would pay. And if you think about user growth, 50% of all new checking accounts today are being opened at one of those big three banks, despite the fact that they only control about a quarter of the country's branch network. So we believe they're taking considerable share, even in younger cohorts. And most of that is due to what we talked about before was scale and their ability to

Starting point is 00:13:10 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 J.P. Morgan's franchise, but ultimately believe that the big three banks who 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. And Mike mentioned that the big three in the U.S. are at 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 50% market share. So I think there's a historical precedent that we've seen a lot of other countries where

Starting point is 00:13:55 the growth of the big three becomes the best part of this story. Yeah, Bill's right. Today, those top three are probably 30% of deposits, but a much higher percentage of new accounts that are happening in the market today. And if you look back maybe 10 or 12 years ago, that number was closer to 20%. So if you do look at a lot of developed markets, the top three own a lot bigger percentage of share of total deposits. And Bank of America alone 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. Let's take a quick break and hear from today's sponsors. All right, I want you guys

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Starting point is 00:18:42 So, 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 that's going on in 2020? 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 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

Starting point is 00:19:27 been written in the past 12 years has been to a substantially higher standard than it was going into the crisis. Frankly, banks thought of mortgage loans as all they really cared about was the quality of the house. They weren't worried about the quality of the borrower. And 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 high 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

Starting point is 00:20:15 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 much better positioned than 15 years ago. So banking stocks are extremely regulated. How do you recommend somebody get smart on all these legal frameworks that are very complicated so that an investor, a new investor can feel comfortable taking on a position? You're right, stick.

Starting point is 00:20:50 There's been a number of new regulations put in place since the great financial crisis in 2008 and 2009. Almost all of these regulations were designed to ensure that the banks are better prepared for the next downturn. There's 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 proprietary 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, Senator Chris Dodd and Representative Barney Frank passed probably the most sweeping bank regulation that we've seen since the Great Depression, the Dodd-Frank Act. And among a number of the different provisions within the Act, one of which forced the banks to adhere to annual stress tests.

Starting point is 00:21:36 And these stress tests would be conducted by the Federal Reserve, and they would put the banks through stress scenarios, one of which they call a severely adverse scenario. This scenario is very adverse. It assumes the equity markets decline by 50%. It assumes unemployment goes up to 10%. Fed funds goes to zero. So residential real estate prices decline by 25%, commercial prices down 35%. A tough environment, severely adverse. And 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

Starting point is 00:22:11 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 Dadfast annual stress test reports, to get a better feel for how your potential investment might perform in a much tougher environment. Interesting.

Starting point is 00:22:40 Mike, you mentioned the interview we did with Sean Stenard Talkton from Ensemble Capital that we had not too long ago where he was pitching First Republic Bank here on the Master's podcast. And one of the things that he highlighted was the net promoter score, and 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. So, whenever I was looking that up for Bank of America, the score was minus 24. And that is about as, as,

Starting point is 00:23:20 popular or as unpopular, if you like, as Facebook. Scores higher than zero are typically considered to be good, and scores about 50 are considered to be excellent. So in comparison, the industry average for financial services in banking is 18. And again, Bank of America that was minus 24. Should we as potential investors in Bank of America be concerned about the negative net promoter score? It's a good question. The net promoter score for Bank of America that you quoted It doesn't really seem to sync much with the business trends that they're actually seeing within their own business. Of course, their own customer satisfaction scores are at all-time highs.

Starting point is 00:23:58 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 base of nearly the 20th largest financial institution in America every quarter. So I think J.D. Power was just out talking about how the average customer relationship duration for Bank of America has increased significantly from 2008, 2009 to today. And you can't help us see references littered about customer centricity and doing the right

Starting point is 00:24:30 thing when you read Bank of America's annual report. So we think customers are voting with their actions. 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 MPS score that we're seeing. So, guys, thank you so much for laying all the groundwork there. So let's dive into the fun stuff here. How are you guys looking at the intrinsic value of Bank of America?

Starting point is 00:25:07 Sure. For any idea that we're looking at, we're looking for three criteria to be met. The first of which is that company is trading for a steep discount to what we think it's worth is. We always require that the business is run by managers that truly think and act like owners, and we want per share value to be growing over time. From our perspective, Bank of America passes all three of these tests. As you mentioned earlier, the stocks in the low 20s today call it $21 or $22 a share. And last year, they earned about $3 and generated roughly a 16% return on its tangible common equity.

Starting point is 00:25:39 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's going to be some headwinds that they're going to be facing. But over time, we believe Bank of America is capable of earning a load to mid-teens 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 $22, $23 a share.

Starting point is 00:26:04 So 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 about six and a half times our estimate of normal earnings that we think they can grow off of. Now, as you think about the valuation from a downside protection perspective, the stock is trading about at what we would appraised to be liquidation value or tangible book value, what we think they could sell all their assets and pay back all their liabilities for. And the valuation relative to the S&P 500 is near historic lows. So from our perspective, we don't think the market is really rewarding Bank of America for

Starting point is 00:26:38 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. And the company is taking advantage of that. They're repurchasing a high single-digit percentage of their shares. They're 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.

Starting point is 00:27:16 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. And that would lead you to believe the stocks were somewhere in the mid-40s or so or more than double today's share price. 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 important that it's just as valuable to an investor, and it creates just as high an EPS growth rate to see the denominator shrink is to see the numerator grow. Secondly, we see a lot of reports written that say over the past 30 years, the average bank stock, typical PE was 10 to 12 times earnings.

Starting point is 00:28:19 And 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 20 times 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, the safety of the companies much better than it was during the past 30 years, we think the gap to the market PE should be shrinking. So we're looking at a higher earnings per share number out five to seven years from now than the average analyst is, and we're putting a higher multiple on that.

Starting point is 00:29:07 So would you say that there's a catalyst to this happening, or is it just as much the, that's called the market wising up and understanding that difference? 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 of the internet names. I think one of the things we look for is companies that are generating a lot of excess capital. So the longer the market, the company undervalued, the more shares they can repurchase.

Starting point is 00:29:50 Another thing is we like companies that pay back their cash flow to shareholders via dividend. And the average bank paying out about a third of their earnings in dividend, the dividend yield will become so compelling on these stocks, as will the growth rate. Investors will have to stand up and take notice. Now, let's go to the next segment of the show. And we're not going to talk about Bank of America, but we're going to talk a bit more about the industry of asset management. Our audience are primarily value investors.

Starting point is 00:30:22 And the way that we are brought up is with the 0625 fee structure that Warren Buffett used for his partnership, as the optimal fee structure for both investors and portfolio managers. We also have other value investors like Guy Speer and Morse PopRai, who have been here on the podcast who have adopted the same structure for their fund. The fee structure implies that as an investor you pay 0% amendment fee, but their portfolio manager has a 6% annual performance hurdle with a high watermark. That means investors need a minimum of 6% return before the portfolio manager is paid,

Starting point is 00:31:00 paid, and the high watermark is the highest peak in the value that the investment has reached, meaning that the manager cannot collect an incentive fee unless the fund's value is above the high watermark and returns are above the hurdle rate. So the portfolio manager is then paid a 25% fee on returns over 6%. Now, that is not the model that Oakmark funds has chosen. Taking Oakmark Select Fund as an example, you are 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 0625 model? We would have loved to have gone to the model that you suggested the no fee until we make 6% and then a quarter of the profits above that. Since the Oakmark

Starting point is 00:31:49 Fund was launched in 1991, the fund went up about 24 times 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 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. So 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

Starting point is 00:32:47 structure. So the only way we can get the mutual fund industry to move to an incentive fee-based model to be a change in the regulatory environment, I'd certainly be supportive of that. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC to or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving. Instead of chasing spreadsheets and screenshots, VANTA gives you continuous automation

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Starting point is 00:36:07 Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. So mutual funds have really had a bad name in the marketplace in the last, I would say,

Starting point is 00:36:29 in the last decade relative to ETFs. If you were going to argue against that idea, what would you say? I think the biggest issue that active management has had generally, and also specifically within the mutual fund industry, is for a long time, mutual funds ran what I would call closet index portfolios, where a typical model might be the portfolio manager saying, I think utilities look expensive today. So instead of owning the market weight and utilities, I'll own 80% of the market weight. And I think banks look really attractive. So instead of the market weight, I'll boost that to 120%. But you have these industry weightings that are very tightly clinging to what the S&P index weighting is. And effectively, 80% of the portfolio or so is nothing more than an index fund. and then the manager is charging the fee only on the 20% that's actively managed.

Starting point is 00:37:35 So I think the active management industry has brought a lot of this problem on itself by basically running, call it 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. and we don't hug the indexes at all. We buy stocks we think are cheap, we hold them long term, we 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 an actively managed dollar.

Starting point is 00:38:16 And we've seen all the studies that say the funds that rely on long-term holdings of active share, high active share portfolios have tended to be the best performing funds. And I think it's 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. So 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 have changed dramatically over the past few decades. H passive management funds with lower and lower fees have increased in

Starting point is 00:39:01 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 active management funds employing traditional portfolio managers? It's interesting. I think it's been a lot of focus on passive management in just the past couple 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 I was in high school. And 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. And because of that, it's been an attractive place for individuals to put money.

Starting point is 00:39:50 Back in the 1970s and 80s, 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. And then you started to see mutual funds come in, and 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 index and charge a big fee? Let's lower the fee and just produce average returns. And then you saw the value-based funds and growth-based funds.

Starting point is 00:40:37 And 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 80s, 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. And there weren't a lot of easy ways for investors to access just a diversified

Starting point is 00:41:15 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 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 gap accounting doesn't do a particularly good job of defining. So the old statistics of price to book and PE don't work really well on a lot of the industry. And at Oakmark, we've evolved and we've owned a lot of the names that don't necessarily look cheap on gap metrics, but on another form of business valuation metrics look stunningly

Starting point is 00:42:11 attractive. And 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. The people thinking about a career in this industry just have to understand it's a constant evolution, and 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. But you have to have human judgment, human analysis that can't be done at effectively zero cost in order to make a career in this industry. 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

Starting point is 00:43:01 here today and you have been very gracious with your time. So thank you so much for coming on the investors podcast. I would definitely like to give you guys an opportunity to talk bit more about Oakmark funds, what you do, and where the audience can learn more about you? 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. So we've got the Oakmark Fund, the Oak Mark Select Fund, Oak Mark International, Oak Mark 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.

Starting point is 00:43:54 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 that a lot of our competitors do. If you go through and read a couple years' worth of our commentaries, you'll have a very good idea about how we invest. Everything we do is long-term value. So that in a snapshot is what we try and do at Oakmark. Fantastic. And we'll definitely make sure to link to all of that in the show notes.

Starting point is 00:44:25 And we'll also make sure to link to the previous interview that we have with Bill. Guys, again, thank you so much for your time and for coming on the Investors podcast. Thanks for having us. All right, guys, so at this part and time in the show, we'll play a question from the audience, and this question comes from Brad. Preston and Stig, I really enjoyed your recent episode number 288, where you both discussed 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

Starting point is 00:44:57 follow, like Ray Dalio, Luke Groman, and Rao Powell. On episode 288, you indicated it might make sense to purchase gold and, and 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 flock to cash is providing good bargains in the paper gold and silver markets? Thanks, guys. So, Brad, I think this is a fantastic question.

Starting point is 00:45:22 And to understand the argument for fiscal gold or paper gold, I think it's important to understand history. The U.S. dollar replaced the British pound sterling as the world's premier reserve currency back in 1945 in accordance with the Bretton Woods Agreement. And at the time, the US dollar was the currency with the greatest purchasing power and the only currency backed by gold. But in effect, the world was pegged to gold because other 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

Starting point is 00:46:03 by the Dutch and the enforcement of credit claims were 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 reason biggest change was in 1971 when Nixon took the 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 enter the realm of fear currencies where central banks around the world

Starting point is 00:46:38 could print infinite amount of money. And perhaps that is best exemplified here in the corona crisis where money has been printed and unprecedented levels. So when you look back in history, which currency has maintained its purchasing power? Gold has, and gold has for thousands of years.

Starting point is 00:46:55 So when we talk 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 percents in annual inflation or even higher than that, I think that is 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

Starting point is 00:47:22 significant risk that we'll have more inflation in the time to come. And especially in the case, should hyperinflation happen, physical goal becomes much more attractive than paper gold, because as soon as you have gold in the financial system, say through an ECF like GLD or through a derivative, it doesn't mean that you have access to the fiscal gold when push comes to shove, and that's whenever you need fiscal 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. And if you don't think that's possible, consider what happened in 1933. Through the executive order 6102, President Franklin D. Roosevelt made it a criminal

Starting point is 00:48:04 offense for U.S. citizens to own and trade gold anywhere in the world, with the exceptions for 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. And just in the last hundred years, we've seen dramatic changes in the monetary system. So fiscal gold does make sense over paper 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 Redalue. If you don't own gold, you know neither history nor economics.

Starting point is 00:48:48 So, Brad, I think Stig provided just an outstanding overview of kind of the history, 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 just have a different economy at this point. I don't know that I have a good answer for you. When I look at the physical gold market versus the paper market, these are my concerns

Starting point is 00:49:38 with the physical gold market, is just the speed at which you can receive your paint. it. And 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. And I don't think anybody can say with a whole lot of confidence what's driving that.

Starting point is 00:50:21 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 on the, from the side, kind of looking at what's happening and saying, this is very interesting. This is very fascinating what's taking place. And 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.

Starting point is 00:51:02 I do, as anyone who's listened to the show knows, I have concerns about fiat currency moving forward and not just the U.S. dollar, but all the fiat currency around the world because like Stig had mentioned, everything when the U.S. came off the gold standard in 71, everyone else came off the gold standard at the exact same time because they were pegged to the, they were pegging their currency to the dollar. So you've had this competitive devaluation that's been going on for literally decades, and now that you got interest rates in real terms pegged at zero, I just think you're going to see some crazy things happening in the market, especially with respect to volatility.

Starting point is 00:51:43 When they're printing this much money and they're pumping the QE and they're pushing interest rates, they're going to sustain interest rates at 0%. The market's going to be looking at that and saying, oh, well, things aren't unstable because the yields in the fixed income market aren't volatile. They're going to be pegged at zero. are going to be lulled into thinking that there's nothing wrong there, when in fact, behind the scenes, I think there's a lot of things wrong. And then what's the implications of all this universal basic income that's rolling out?

Starting point is 00:52:14 And what does that mean? And there's 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. And maybe it's helping you determine where you, maybe you have more confidence. confidence after hearing all that. So, Mike, for asking such a great question, we're going to give you free access to our TIP finance tool on our website. And one of the great things about the

Starting point is 00:52:43 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 U.S. markets. You can pull it up and 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. So if anybody else out there wants to get a question played on the show and get free access

Starting point is 00:53:18 to our TIP finance tool on our website, go to AsktheInvesters.com, and you can record your question, and if it gets played on the show, you get a free subscription to our TIP finance tool. All right, guys, that was all that Preston and I had for you for this week's episode of The Investors Podcast. We see each other again next week. Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional.

Starting point is 00:53:49 This show is copyrighted by the Investors Podcast Network. Written permissions must be granted before syndication or rebroadcasting.

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