Bill Nygren market commentary for the third quarter ended September 30, 2015.
“If you don’t know where you are going, you might wind up someplace else.”
(May 12, 1925 – September 22, 2015) RIP
Bill Nygren - Party Like It's 1908
As I write this, something wonderful is happening in Chicago: There is excitement about winning an October baseball game for the first time in twelve years.1 The Chicago Cubs are finally back in the playoffs. As every Chicago Cubs fan knows, it has been a long road back from our last World Series win in 1908. In 2003, we were one game from going to the World Series, leading the Florida Marlins three games to one, but went on to lose three consecutive games to the eventual champions. Since then, the Cubs compiled a cumulative regular season record of 90 games below .500 and lost all six of their playoff games, bringing their post-season losing streak to nine games. Until this year.
Twelve years ago, in our June 2003 report, I wrote about the Michael Lewis book Moneyball. It tells the story of how Oakland A’s general manager Billy Beane built a team that made the post-season, even though it had one of the lowest payrolls in Major League Baseball. Beane used advanced statistics to identify valuable players whom other teams had given up on. (I liked how Beane’s approach resembled Oakmark’s approach to buying stocks.) In 2002, after taking the A’s to the playoffs for three consecutive years, Beane turned down an offer from the Boston Red Sox to become baseball’s highest paid general manager.
Spurned by Beane, the Red Sox instead hired another young statistical guru, Theo Epstein. The Red Sox had just missed the 2002 playoffs despite having one of baseball’s highest payrolls, and the owners had lost patience with the team’s direction. By 2004, Epstein had overhauled the roster, hired a new manager and won the World Series. From 2003 through 2011—while the Cubs struggled—the Epstein-led Red Sox won two World Series, went to the playoffs six times and ended each season an average of 25 games over .500.
In 2011, the Cubs’ record was 71-91. The Cubs’ owners lost patience with the team’s direction, so they hired Theo Epstein away from Boston. With a starting point of 20 games under .500, the Cubs were more of a teardown than the Red Sox had been. But by 2015, the roster had been overhauled and a new manager was put in place. The team’s record improved to 32 games over .500, they earned a spot in the playoffs and they are now widely considered the most promising young team in baseball.
Bill Nygren - Baseball and Business Aren’t That Different
Though I enjoy writing about baseball and the Cubs, the purpose of these reports is to share how we think about investing. Baseball is just a convenient analogy for examining businesses. An owner of a baseball team gets frustrated, hires a new GM and watches for signs of a turnaround. The shareholders of a poorly performing business get frustrated, the board of directors hires a new CEO and everyone watches for signs of a turnaround.
In both baseball and business, a turnaround isn’t always immediately apparent in the numbers. In Epstein’s first year with the Cubs, the team lost 40 more games than they won, 20 worse than the prior season. The next two seasons weren’t much better, totaling 46 games under .500. But beneath the surface, the culture was improving as toxic veterans were replaced by highly talented, motivated rookies. Strategic trades took advantage of teams that were focused on the short term. (Can you believe we got Jake Arrieta for a three-month rental of Scott Feldman? Or Addison Russell for three months of Jeff Samardzija?) A new manager was hired, Joe Maddon, who had a proven track record of getting the most from young players. Individual goals finally took a back seat to team goals. But it still took three painfully long years before that progress was visible in the number of wins.
I remember many years ago talking to Warren Batts, then-CEO of Premark, which he headed after it was spun out from Kraft. (We owned it in the Oakmark Fund.) Batts said that a new CEO needs about two years to complete strategic acquisitions or divestitures and to build a new team of top managers. Then it takes those managers a year to build their teams. So three years in, the turnaround is finally in gear, yet investors have often already given up. If Theo Epstein’s tenure with the Cubs was judged by the one-, two- or three-year win-loss record, it would have been deemed a failure. In year four, he looks like baseball executive of the year. Similarly, we’ve often used Oakmark’s long investment horizon to try to gain an advantage over shorter term investors. Patience is generally a virtue in management of a baseball team, a business or an investment portfolio.
Bill Nygren - What Is the W-L Record of a Business?
In baseball it is generally agreed upon that the number of wins defines success. (Some might say success should be measured by World Series Championships, but I agree with the purists who argue that luck plays too big a factor in an individual series whereas it tends to even out over the course of a 162-game season.) In business, however, there isn’t a generally agreed-upon metric to grade the success of a CEO. In a recent political debate, a particular candidate’s tenure as CEO of a public company became a topic of discussion. Various statistics were cited, including changes in sales, earnings, stock price, number of people employed and dollars spent on R&D. Depending on which statistic was used, the resulting conclusion ranged from miserable failure to huge success.
Of those metrics, the one that interests us most is the change over time in stock price. Stock price presumably takes into account all of the other metrics and weights them appropriately. If markets were perfectly efficient, we’d say that change in stock price is the best measure of a CEO. But since we have seen markets sometimes overwhelmed by irrational exuberance or pessimism, we believe that an individual CEO can be unfairly blamed or credited for what is in fact a broad shift in valuation of many similar companies. When Jack Welch retired as CEO of General Electric in 2000, he was replaced by current CEO Jeff Immelt. Say what you will about Immelt’s tenure as CEO, but it wasn’t his fault that it started just as the large-cap bull market of 2000 was ending, when GE traded at 40 times earnings, a multiple at which almost no large company sells today. So, we need a better metric than stock price.
At Oakmark, we believe CEOs should have one goal: to maximize the long-term value of the business (including dividends), adjusted for net-debt and measured on a per-share basis. Interestingly, during the political debate, not one person mentioned any metric that included changes in the balance sheet or the number of shares outstanding. I don’t know any business owners that would judge success or failure based on how their businesses grew without also considering how the balance sheets or their equity ownership percentage had changed. If a company doubles its size by doubling its share count, it is effectively just running in place. Many acquisitions that increase a company’s sales and earnings fail to add value when considering the cash or stock that was paid to the seller.
Today it seems unpopular, especially in the political arena, to say that a CEO’s goal should be to maximize value for the owners of a business. When you hear that view being challenged, remember that a company can only maximize long-term value by treating its employees fairly (or they will work elsewhere), by treating its customers fairly (or they will buy elsewhere) and by allocating its capital to the highest return projects. When a company doesn’t have high return projects to invest in, returning excess capital to shareholders either through dividends or stock repurchase frees that capital to be invested in other businesses that do have growth opportunities. A no-growth company building new plants doesn’t help anyone in the long run. For example, think of the societal gain that occurred when declining mainframe computer companies returned capital to shareholders and that money was invested in Internet startups. Capital returned to shareholders doesn’t just get stuffed into mattresses.
At Oakmark, we believe the win-loss record of a CEO is the change in value per-share over his or her tenure. A good CEO will build a team to help maximize that change, just as a good baseball GM will build a team to maximize the number of wins. I hope by the time you read this the Cubs have passed their first playoff challenge and are on their way to the World Series. But if not, we fans will take comfort that the foundation appears to be in place for long-term success. It’s a lot like our investment portfolios: When Oakmark invests in undervalued businesses run by CEOs with good win-loss records, our portfolios might not perform well next quarter or even next year, but we believe the foundation is in place for long-term success.
Bill Nygren, CFA