10 Questions With Oakmark's Bill Nygren

Bill Nygren knows what he's doing.

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He and his colleagues at Chicago-based Harris Associates are value managers (read: bargain-hunters) who buy shares of a company only when it's trading at 60% or less than what they think it's really worth. Nygren has run the focused and now closed OAKLXOakmark Select fund since its 1996 launch, and its 28% annualized gain over the past five years tops all mid-cap value funds and ranks third in the entire fund universe. Nygren took the reins of the broader OAKMXOakmark fund just as the tech sector peaked last March and has since been trouncing his peers and the S&P 500.

Today, Nygren is finding value in big-cap stocks like Fannie Mae FNM, American Express AXP and Gap GPS, but he's not finding any bargains in the punch-drunk tech sector. Where are today's bargains and what would he buy today and hold for five years? Read on.

1. What do you make of the tech rally we've seen since the Nasdaq bottom Sept. 21?

I'm surprised at the strength of the tech rally. At the market bottom in late September, we were finding many tech stocks that were close to fairly valued, but nothing priced at less than 60% of what we thought it was worth, so we weren't buying. It's been an awfully powerful rally, but nothing has changed in terms of our estimates of what the businesses are worth. We continue to be underweighted in technology, and our best guess is that some future time will provide us a better opportunity to buy these names than today.

2. Beyond tech, the broader market has risen quite a bit over the past six weeks. Where do you turn when everything on your radar screen gets more expensive in a hurry?

Broad-market indices are up 20% since the bottom last month, and values, in our opinion, relatively unchanged, so there aren't as many bargains out there today. But I also wouldn't say the market looks crazily overpriced, either. At the end of September, we thought stocks overall were quite attractively priced. Lots were meeting criteria, and it wasn't just the underanalyzed, out-of-the-way mid-cap names. There are a lot of big-cap names that have fallen to levels we think are bargains.

Talking With: Bill Nygren

Fund: OAKMXOakmark

Managed Since: March 21, 2000

Assets: $3.1 billion

1-Year Return: 24.2%/ Beats 91% of Peers

3-Year Return: 3.3%/ Trails 88% of Peers

Sales Charge: None

Expense Ratio: 1.21% vs. 1.46% category avg.

Top-Three Holdings: Washington MutualWMU; H&R BlockHRB; KrogerKR

Sources: Morningstar. Returns through Nov. 26.

3. Where are you finding bargains today?

There's been a change in the kinds of stocks we're buying today compared to what we were buying two years ago. Then it was generally industrial companies that were at very low price-to-earnings multiples, like Cooper Industries , Fort James [bought by Georgia-Pacific last year], and Jones Apparel JNY.

Our recent buys have been larger companies that have experienced better-than-market growth and appear to be leaders in their industries. In the last quarter, that list included American Express, Fannie Mae, Gap Stores, Interpublic Group IPG and Safeway SWY. That's basically the nontechnology list that would have been owned by growth funds a couple of years ago. They didn't rise like tech stocks, but they've fallen to pretty big discounts to the S&P 500 based on what people think they're likely to earn in a few years.

4. When we last spoke, you said you and your team were spending more time looking at tech companies, but not buying. Is that still the case?

Tech stocks are filling up a smaller percentage of the inbox for our research department.

Did you add any tech stocks to the portfolio in the third quarter?

No. Nothing at all. If you really stretch it and call Honeywell HON a technology company, we did add that.

5. Some well-known value managers have bought shares of ravaged telecom-equipment companies like LucentLU, CorningGLW and TellabsTLAB. Did you look at these?

It piqued our interest when we saw them make additions in the names you just mentioned. We looked at those names, but they aren't selling at less than 60% of what we think they're worth. I think that highlights how extreme the bubble was; that you can have stocks that have fallen 80% or 90% and you can debate whether they're attractively priced. They still just don't jump out at me as incredible bargains. A lot of the demand that was created for the telecommunications companies was only there because of the bubble and is gone.

Bill's Resume Nygren has rung up solid gains running the now-closed Oakmark Select fund since 1996

*Closed to new investors. Source: Morningstar. Returns through Nov. 26.

6. What are a couple of companies that stand out to you as solid bargains at today's prices, and what's your rationale in each case?

First, I'd choose Washington Mutual WM. It's a $32 stock that we think should earn about $4 a share next year. It's grown above 15% per year historically going back over the last 15 years. Looking forward, we think it should continue to grow at a faster rate than the S&P 500, something into the teens per year. It pays a 3% yield right now, which is pretty competitive with short-term interest rates.

If you compare it to leaders in other commodity businesses, where a company's cost advantages is helping it build market share, then you see similarities with a Wal-Mart. If I'm wrong, eight times next year's earnings is a fair price anyway. If I'm right, you've got the potential of a doubling or a tripling of the P/E multiple while earnings go up 10% to 15% per year. To get upside like that with as little risk as this seems to look like an incredible opportunity.

I'd also look at Honeywell. General Electric tried to buy it for about $55 per share. The deal was blocked, and the stock fell to the mid-$30s. We had just started building a position in Honeywell prior to Sept. 11, and we felt that [former AlliedSignal boss] Larry Bossidy was the right guy to be running this company. We felt very confident that with him cutting costs, earnings could rise dramatically even with relatively small sales increases. By 2003, maybe it could earn $3 a share. Post-Sept. 11, Honeywell hit a low of $22. At that price, we felt that Honeywell was selling at a discount to what the business was worth.

This is a company that a smart management like GE felt was worth mid-$50s, selling in mid-$30s, with a good chief executive, a good track record and a cost-cutting plan. It's selling at maybe about 12 times 2003 earnings, which compares to maybe 20 times for the S&P in 2003, and in the past Honeywell has sold pretty close to a market multiple.

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7. The value and growth styles change leadership every few years. Value has had the lead for two years now, and some are thinking growth is poised to come back. What's your response?

In the last three years, probably 70% of an investor's returns have been determined by whether you have growth or value managers. With the focus so much on value or growth now, I wonder if we're going back to a time when stock picking within the style matters much more than the style itself. You want your money managers to be smart people who are open to new ideas and are passionate about stock picking. Whether they call themselves growth or value may be much less important going forward than it has been.

8. History actually shows that owning both styles gets you similar returns with less volatility. Does that make sense?

Yes. I think it's important to remember that when a company files its IPO , it doesn't get pegged as growth or value. It's not like it's a static group of stocks that's always growth or always value. Price changes change the opportunities and change the set of companies that present value in the market. An investor would be stupid if they weren't willing to pay a little more for a company that's growing much more rapidly. The idea that value and growth oppose each other is really kind of silly.

Do you own a growth fund?

I do not. My largest investment is the Oakmark Select fund, my second-largest is the Oakmark fund, and my third-largest investment is the other funds we manage.

9. We always talk about buy criteria, but knowing when to sell is just as important. When do you sell a stock?

We sell when a stock exceeds 90% of our estimated business value. We'll also sell if we lose confidence in a company's ability to grow earnings by at least 10% per year. We'll also sell it if we lose confidence that management is competent and working in the shareholder interest.

10. Which two companies would you be most confident buying today and holding for five years based on their current valuation, their earnings growth, the reliability of their earnings and their management?

With the caveat that we tend to be wrong somewhere [on] between a third and half of our choices no matter how strongly we feel, I'll do my best. The reason that we have the weighting we do in Washington Mutual is that we believe that it is significantly undervalued and the range of potential values of the company is quite predictable and quite narrow. We believe that the management is the best in the industry, and they have most of their net worth invested in the company.

Another name I would point to is another one of our large holdings, H&R Block HRB. Not quite as cheap as Washington Mutual, but the business has some of the best cash-flow-generation characteristics of any business. I like the predictability that the number of tax returns filed five years from now will be higher and that more people will want or need professional help with those returns, and that H&R Block will continue to grow its industry-leading market share. I have strong confidence in this stock.