[00:02:57] Bill Nygren: No surprise for a firm like us that doesn’t try to be market timers is that once the news was out, it was too late to sell. And the typical bear market, you know, after it’s down 20%, it continues to go down, it hits ultimate bottom about six months later. And I pointed out if the market followed that same trajectory, It would go down another 10%.

[00:03:22] Bill Nygren: That bottom would be somewhere around October, and that’s basically what we went through. Now, of course, that’s no guarantee that we’re done with the market going down, but I thought it would be comforting to individuals who are thinking, maybe I should sell, because we’re in a bare market to know we’ve already experienced what a normal bear market has.

[00:03:42] Bill Nygren: And we’ve already experienced the decline of a normal recession and already experienced the decline of high inflation. So at Oakmark, as you know, what we try to do is estimate the long-term business value, and then we look for large deviations between the stock price and that estimate of business value.

[00:04:00] Bill Nygren: And with the market down so much, it’s no surprise we are seeing more names that we’re meeting our criteria being significantly undervalued. I think one way to look at. Is to look at the portfolio turnover we’ve seen. Typically, the Oakmark fund owns just over 50 names and in a 12 month period you might see us have 10 new ideas.

[00:04:23] Bill Nygren: In just nine months, I believe we had 12 new ideas, and in the Oakmark Select Fund, much smaller portfolio, only about 20 names. Typically, we see about four new names in a year and in just nine months, we’d already seen eight new names. We see the volatility and the more you spread out the performance, the greater the opportunity for us to sell the names that have held up well and then recycle those dollars and the names that have become attractive.

[00:04:53] Trey Lockerbie: So Bill a little bit further on that. When you mentioned stocks becoming overvalued and now maybe undervalued, how are you juggling that when interest rates keep rising and you know your discount rates assumingly are changing? 

[00:05:07] Trey Lockerbie: Well, we always define business value based on alternative investments. And one of the alternatives that an investor has is a long-term bond.

[00:05:17] Trey Lockerbie: We look at about a seven year bond trying to come reasonably close to matching the duration of an equity in a bond. And for many of the past years when we had interest rates close to zero, we were artificially inflating the discount rate that we required for an inequity because we thought interest rates were unsustainable low.

[00:05:39] Trey Lockerbie: Now they’ve risen. That they’ve gone above our floor interest rate. And as rates go up, it decreases the value of all of our investments because the alternative that an investor has to invest risk free in a similar duration asset has become significantly more attractive. So over the course of this year, you’ve seen probably our average stock have a decrease in estimated value of somewhere around 10%, but the markets come down significantly more than that, and more importantly, it hasn’t been uniform.

[00:06:12] Trey Lockerbie: You’ve had some companies that he have held up unbelievably well and are actually up year to date, and then a lot of others that are down more than 50%. And it’s that spread between the names that have held up well and. The percentage of business value that they sell out has actually increased this year versus those companies that have come down significantly more than the market and also fallen a lot more than their business value has fallen.

[00:06:40] Trey Lockerbie: So that’s really what we’re trying to capitalize on, is taking advantage of where investors have become disconnected with long-term business value, and those stocks are available at a cheaper fraction of business values than they were a year ago . 

[00:06:56] Trey Lockerbie: So Alex , Bill just mentioned the Oakmark Select Fund, and that fund has underperformed the S&P500 this year by quite a margin. The largest detractors to performance have been Meta charter and alphabet. Did the thesis change with any of these picks, or did you find opportunities to actually lower your cost basis? 

[00:07:16] Alex Fitch: I would build on what Bill said about interest rates, and just say that I think the biggest surprise to us, if we went back to January 1st of this year and you told us that interest rates were going to go from 0% to almost 4%, I don’t think we would’ve guessed that it would’ve hurt our portfolio as much as it has.

[00:07:33] Alex Fitch: Interest rates clearly reduce the value of some of these faster growing businesses. The tech companies where you have long duration cash flows that are worth less today. It should on balance, help the value of financials and of our bank holdings, right? These are companies that have spent the better part of 15 years.

[00:07:49] Alex Fitch: Plagued by low interest rates, right? Where even if you pay zero on deposits, you can’t lend at a high enough rate to earn a historical interest margin or historical spread, and you’re seeing interest margins climb back towards historical norms and it’s driving a lot of earnings growth. And you know, in our view that is a very good thing for business value.

[00:08:08] Alex Fitch: There’s so much concern about a recession though, and so much of this investor tendency to be like the general fighting the last battle and worried about another 2008 like crisis. And I think there’s not enough appreciation for just how much the banks have changed over that period. You’ve seen equity capital levels at the largest banks, roughly double.

[00:08:27] Alex Fitch: You’ve seen liquidity increase. You’ve seen their reserves grow significantly through new accounting rules. You’ve seen their funding sources move towards stable deposits instead of the kindness of strangers and wholesale markets. And so, you know, line item after line item in the bank, financial statements we think have changed in a way that reduces the risk.

[00:08:46] Alex Fitch: And yet investors are, I think, treating them as if they’re just as dangerous as they were 15 years ago. In a way, I think that’s potentially, it might mean that a recession is the best. That can happen to bank values over the long term as the companies use, specifically noted as detractors. When a given name starts un underperforming, our fundamental estimates and we’re worried about our thesis being incorrect, we have a pretty standard process for adjusting, addressing that.

[00:09:12] Alex Fitch: I think Netflix is a good example. Earlier this year, they disappointed on some subscriber growth. Two quarters in a row, the stock fell from $600 a share to 160. Our reaction to that was to take Netflix and talk about it as a team in our investment committee, and to have one analyst take over as a devil’s advocate, making the case for why we should sell Netflix.

[00:09:32] Alex Fitch: We meet with management. We sit down as a group, we debate the assumptions, and we decide if we still have confidence in our investment thesis. And with Netflix, the reaction and the ultimate conclusion was that we do have confide. And so we bought more shares near the lows, and I think these subsequent performance has at least thus far vindicated that decision.

[00:09:52] Alex Fitch: It’s the same process for some of the names you listed where we’re going to reevaluate our assumptions, have a devil’s advocate review and come to conclusions. And there’s no guarantee on the same outcomes but that’s the process. 

[00:10:03] Bill Nygren: If I could just chime in. You know, Alex was talking about how the concern about recession has hurt financials.

[00:10:09] Bill Nygren: Something I’ve been saying is I think anybody under 40 years, Hasn’t been in this profession during what I would call a normal recession, and we had the recession that was induced by the pandemic two years ago. And then the great financial crisis back in oh eight, and those are almost more like generational recessions, you know?

[00:10:30] Bill Nygren: That’s why they call it the great financial crisis, because it was so much worse than a normal recession. Most of the recessions that I’ve been through in my career are more like what we were going through in the first half of this year, where you see GDP go down a little bit. There’s debate about whether or not you’ll see that happen for another quarter, and by the time you have it pronounced as a recession, They’re already green shoots suggesting that we’re on the way out of it, and you might even have an up year of GDP.

[00:11:00] Bill Nygren: It’s just so much more minor than what we went through in the GFC or the Covid recession. I think investors are making a significant mistake when they look at banks and say, well, let’s look at what charge offs were in the last two recessions and that’ll be our guess of what will happen. If we go into another recession in 2023, you know, normally the banks in most of my career didn’t trade on this, like risk on risk off, like, like such procyclical stocks as they have recently.

[00:11:34] Bill Nygren: Banks traded more like they were safe havens and it’s because in a typical recession, The damage that’s done through charge-offs is just not that big a deal to the long-term survivability of those companies and changes to business value relatively little. It’s just, it’s nothing like what we went through in 2008.

[00:11:57] Trey Lockerbie: Touching there on banks for a second Bill. So I’m curious about that because it seems like the Fed is inducing this sort of quantitative tightening in this form of the reverse repo markets. So banks are making more on their reserves and then less likely to lend that money out. And it’s the form of tightening, if you will.

[00:12:13] Trey Lockerbie: And I noticed that. I’m spacing if it’s the select fund or not, but I believe you sold out of your Bank of America position for, you know, in light of something else that was more appealing. And you and I did speak about Bank of America on a prior episode. I was kind of curious how the thesis has changed for you on banks and particularly Bank of America.

[00:12:31] Bill Nygren: I wouldn’t say our thesis on banks has changed at all. We certainly have nothing negative to say about Bank of America, but what you see, and we still own Bank of America in the Oakmark. So it’s in our 50 favorites, but not in our 20 favorites. What you see in the Oakmark Select Fund is for a name to be cheap enough for us to own in that fund.

[00:12:54] Bill Nygren: There almost has to be significant controversy about that company, and as Bank America navigated the recovery after the GFC and Brian Moynihan started to be named enlists of best managers or best CEOs in the banking industry. A spread started to develop between Bank America and some of the other banks.

[00:13:16] Bill Nygren: And a company like Wells Fargo where there are still significant question marks. Relatively new management team, still a lot of government oversight going on there that some of the other banks aren’t having to deal with. The spread of where Bank of America was trading relative to its book value next to where Wells Fargo was trading relative to book just got to us to look too large relative to what we saw, the quality differences of those two companies.

[00:13:44] Bill Nygren: So our investment in financials and the select funder as high as they’ve ever been, and it’s just the names have changed a little bit as to which ones we think have the best risk return. If I could go back to one point, I really want to make sure we don’t overlook this, and the question that you asked Alex, you asked if we’d had the opportunity to lower our tax basis in some of these names, and we consider tax management to be a key competency of the Oakmark funds.

[00:14:13] Bill Nygren: And I would point out throughout the course of the year, we are always trying to lower our tax basis in any of the names that have gone down in price. And we like to accumulate those losses so that. We don’t have to make cap taxable capital gains distributions any more than is absolutely necessary. And neither Oakmark Fund nor Oakmark Select fund will have a capital gain distribution.

[00:14:39] Bill Nygren: And you know, despite this year not being the greatest performance here, especially for select, the three year return is still pretty good in both. And I think in the Oakmark fund, we’ve had like just a shade over 1% of capital gains distributed over the past three years. And in select fund, it’s been less than that.

[00:14:59] Bill Nygren: That stacks up really well versus our peer group, especially peers that have changed their portfolios as much as we have this year in both Oakmark and Oakmark. So I know sometimes open-end mutual funds get a bad wrap for paying taxes when they aren’t earning money. We think our tax management allows us to be every bit as tax efficient as a separately managed account or even an ETF fund.

[00:15:26] Trey Lockerbie: So Bill, you mentioned controversy, and I can’t think of another company with more controversy this year than Meta, which you and I spoke about back in March of this year. It was episode 430, and given its poor performance this year, I wanted to circle back to see if you think the market simply doesn’t like the new mission of the company and the amount of investment required.

[00:15:44] Trey Lockerbie: It’s already spent 36 billion since 2019 on this new Metaverse project. And is projected to invest a lot more, or is the market missing other aspects of the company’s future that it isn’t being priced in? 

[00:15:57] Bill Nygren: When Meta stock fell after they reported such disappointing free cash flow numbers in the past quarter, we went through the same process that Alex described for Netflix.

[00:16:08] Bill Nygren: Let’s assign a devil’s advocate. Let’s meet with management basically to re-underwrite. Is this a company that we would be comfortable investing fresh money in? And in the case in Netflix, we came out saying, yes, we’re just as comfortable with this as we were when we first bought Netflix. Our Meta outcome wasn’t as positive.

[00:16:28] Bill Nygren: The apps were a separate company and we could just invest in blue Facebook and Instagram, and that cash flow was coming back to us as shareholders. I think we’d be every bit as excited about Meta as we were when we first bought it. That’s not what’s happening. All of that cash flow and more is getting invested in artificial intelligence and alternate reality, and we are less confident even with our long-term time horizon that has. An economic return to shareholders, and maybe it’s just because we don’t understand it so well, but if we don’t understand the rationale behind the investment, we’re not as comfortable with it. And you’ve seen in our monthly releases that our Meta position is less than it was. Several months ago, and it will stay that way until we can get confident that there’s going to be an economic return on all of this new investment.

[00:17:28] Bill Nygren: And I just wanted to add one more comment on Meta. One of the things we have always liked about Meta is the controversy was almost exclusively on the blue Facebook app, and we think Instagram makes almost as much money as the Facebook app does. I think you can make an argument that Instagram alone is worth more than where Meta is selling today.

[00:17:53] Bill Nygren: So if we could get confident that the cash flow from Instagram was being invested well, or if they would ever decide to spin off Instagram. That would be an investment that we would be very excited about. 

[00:18:07] Trey Lockerbie: Yeah I very much understand that. It’s almost like they should spin off the apps portion of the company into its own thing.

[00:18:13] Trey Lockerbie: And I’d like to maybe, I guess in the spirit of spinoffs, talk about a different company that’s, I think, relatively new to the portfolio. It’s the Warner Brothers. Discovery and this company was spun off after the merger of at t’s Warner Media and Discovery back in April. But the stock which launched at around a 50 billion market cap, has dropped basically in half, around 50% since the merger completed.

[00:18:37] Trey Lockerbie: And Jeff Bewkes, who was Time Warner’s ex CEO, he said that the value destruction has been, quote, monumental. The newly formed company essentially kicked off with around 43 billion in. And that seems to have led management cutting significant projects and personnel. I’d like to get your take on how the newly formed company is shaping up.

[00:19:01] Alex Fitch: Yeah, so Warner, you know it’s another name with no shortage of controversy, and I think you’re taking two big companies, you’re combining them and you’re kind of simultaneously overhauling the strategy. So, you know, there was no real scenario in which this was going to be perfectly smooth and there was not going to be a bit of disruption.

[00:19:19] Alex Fitch: I think AT&T got caught up a little bit in the gold rush in streaming, right? Chasing subscribers, trying to spend whatever it takes to become the largest possible streaming business. And it caused them to neglect their legacy franchise, and I think forego a lot of profit opportunities there, right?

[00:19:35] Alex Fitch: They pulled back on licensing content and rather than monetizing content through theaters, they prioritized the DTC segment. And it simultaneously drastically increased the amount of spend going towards DTC. And in hindsight, it looks like a bunch of that spending came at very low or even negative returns.

[00:19:53] Alex Fitch: Now you closed the deal and you inherit this Warner Media asset as Discovery with, I think worse than expected economics. Given all that spending. And then layer on top of it, the fact that some 71% of the owners of the new company are AT&Tshareholders. Who are predominantly retail investors that are dividend focused, and the turnover in selling pressure, I think isn’t unexpected and it is something that Discovery anticipated, but broadly stepping back, you know, the deal rationale here is intact.

[00:20:22] Alex Fitch: You’re combining two of the largest linear players. You have a combined portfolio now that’s almost 25% of non-sports television viewing hours, which is a level of scale that’s going to give you a lot of negotiating leverage with the cable companies. It is going to enable you to provide better advertising products to advertisers and increase ad prices.

[00:20:41] Alex Fitch: You have an enormous cost saving opportunity. The overlapping back office infrastructure that leads to around three and a half billion of anticipated cost savings, which comes out to more than a dollar a share of incremental earnings power. And you have this logic of combining the two direct to consumer businesses where HBO Max has this headline worthy content blockbuster content.

[00:21:02] Alex Fitch: And Discovery has this nourishment that drives a lot of viewing hours, but maybe doesn’t gather the same level of buzz. And in putting the two together, you have this opportunity to create a streaming service that engages more members of the household, drives more viewing hours, and has lower churn. So the promise of the deal, I think, has always been inherently long term and it’s intact.

[00:21:22] Alex Fitch: I think we just unfortunately had a few billion dollars of earnings evaporate in the process. Discovery management, I think is taking the right tack, inevitably breaking eggs in, in the process of putting this new company together. And I think that they have the right game plan, so we’re happy to own shares.

[00:21:40] Bill Nygren: And you know, I would just add, you know, somebody listening to this might think. Why would you ever step in, in front of all this controversy? Why not buy something where the consensus is just so much more positive? You know, this stock sells at like four times earnings, expected earnings for next year, you know, a quarter of the S&Pmultiple.

[00:21:58] Bill Nygren: So there’s no question you’re getting paid to step into the controversy. And if what Alex outlined is right about the cost saving opportunities and the increased revenue opportunities. And this migrates up toward a more normal PE ratio, this stock is going to be an incredible performer. 

[00:22:15] Alex Fitch: Yeah. Maybe just to add to that for a little bit of background, we bought the shares in the third quarter and they were already down quite a bit from the closing price of the deal and from the highs prior to that.

[00:22:27] Alex Fitch: The way that we view the company, it’s an $11 stock today. And if you were to just look at the reported results, there’s about a dollar 50 of e p s this year. You layer on those cost synergies that I was talking about, and the underlying earnings power is $2 and 50 cents. So we’re at, you know, roughly four and a half times earnings.

[00:22:42] Alex Fitch: The really incredible thing to me, Is that is despite still losing around 2 billion in their streaming segment. And the implication is that the streaming business is worth a negative being capitalized at a negative by the market in at a very low multiple. Well, Warner Brothers has one of the largest.

[00:23:01] Alex Fitch: Content back catalogs in the business, right? They’ve been almost 25% of non-sport viewing for years. Warner Brothers Studios has been number one or number two in box office for decades. You have HBO, which was the original direct to consumer service that used to just a few years ago, earned two and a half billion dollars a year in ebitda.

[00:23:19] Alex Fitch: You know, Game of Thrones, Harry Potter, you have these tent pole franchises. And Warner today is deciding to take all of that value, all of that content and back catalog. And try to monetize it through a streaming service. And there’s good reason to do that, right? There’s a strong case for eventually building enough subs pricing and reducing churn to generate very healthy margins there.

[00:23:40] Alex Fitch: But the more important thing from our perspective is that even if that proves to be the wrong approach, and streaming doesn’t work, it doesn’t mean that massive back catalog is worth zero or a negative. It means that Warner then just has to go back to the old model. Where you close down the streaming platform, remove the technology and marketing spend and begin licensing all of that content to third parties.

[00:24:03] Alex Fitch: And you know, the opportunity to own the Warner Brothers and HBO O back catalog, I think can put somebody on the map from a streaming perspective. And you know, you could imagine very large payments. For access to that catalog by capitalizing negative 2 billion of earnings today in the market. I think the market’s ignoring the fact that basically every branch of the decision tree comes to a better positive outcome than where we are at present.

[00:24:27] Alex Fitch: And so we look at the underlying earnings power as something closer to $4 per share and the stock at less than three times that figure. 

[00:24:34] Trey Lockerbie: So I want to talk a little bit about risk because. I believe before this merger happened, the estimated cost to restructure was around 1.5 billion, and now they’re saying it’s going to take up to 4.3 billion in restructuring charges, including, I think you highlighted this, but around 2.5 billion in content write-offs.

[00:24:52] Trey Lockerbie: You, were talking about the loss of 2 billion in around streaming. I’m not sure if that’s what you’re referring to, but do you believe at this $11 share price? Now that we have a margin of safety, that’s enough to kind of counter. These unforeseen risks and maybe a few more that might perk up along the way.

[00:25:08] Alex Fitch: Yeah, I mean, just to put that in context, it’s a business that should be in the next couple years generating, you know, six to 10 billion of free cash flow annually, and so there are numbers that can be absorbed. As for the content writedowns and a lot of the restructuring costs, they’re essentially sunk, right?

[00:25:24] Alex Fitch: It’s cash that went out the door years ago where there’s some type of asset on the balance sheet or whatever you spent it on that we’re now determining. Worthless or worthless. And so it doesn’t directly impact the leverage profile of the business. I think the balance sheet is in a reasonable spot.

[00:25:40] Alex Fitch: They’re on a path to being sub three times levered in the next two years. They have a 14 year average debt maturity. The interest rates are around 4% that they’re paying. So I think from a leverage perspective, it’s manageable and the actual cash charges are just a subset of the numbers that are being laid out.

[00:25:56] Alex Fitch: But all of it within the scope of the broader business economics, I think is easily manageable. 

[00:26:01] Bill Nygren: It’s funny, the stock’s down from what, like 27 to $11 a share and people are all bent outta shape over the costs you’re referencing that are one time in nature and totaled like one or $2 per share. The market has certainly fully charged the stock for those surprise costs.

[00:26:22] Trey Lockerbie: Now, the newly formed company, as you mentioned, kind of has missed a few quarters of earnings now, and it’s just getting skewered by the media, especially the New York Times. They quoted that Discovery has blamed at and t’s mismanagement for the grim result, and in the latest. Investigated allegations that AT&T engaged in questionable accounting tactics to inflate the projections on which the value of the Warner assets were based, and so much so that AT&Thas actually agreed to pay Warner Brothers Discovery, 1.2 billion.

[00:26:54] Trey Lockerbie: By the end of August. I’m kind of curious how this plays into your assessment of management and how you’re looking at management on going forward with the new company. 

[00:27:03] Alex Fitch: Yeah, it’s a great question and it is a question that we’ve spent a lot of time on. Know, you want to make sure that the mistakes that have been made don’t, you know, increase your concern that they’re going to be more mistakes in the future, obviously.

[00:27:16] Alex Fitch: So we spent a lot of time with management and amongst ourselves talking about these issues. I think at a high level, the big problem was that there was a, an enormous mismatch in the strategic direction that AT&Twanted to take compared to the one Discovery wanted to take. And you had this prolonged period between the announcement of the deal and the closing of the transaction.

[00:27:35] Alex Fitch: There are guardrails in place, there’s limited information that can be exchanged. And from everything we can gather, there was just not a lot of receptiveness on the part of AT&Tto adapting their course based on what Discovery plans to do in the future. So for instance, AT&Twent ahead with CNN Plus and launched it despite what they expected to be a billion dollar burn rate in the first year, and not actually including CNN in the product in terms of the live news.

[00:28:00] Alex Fitch: And I’d imagine that Discovery. Had plenty of opportunities to indicate to AT&Tthat this isn’t so. That they’re comfortable with. This isn’t something that they would pursue, but AT&Twent forward anyway. And you know, I think it led to some bizarre outcomes like canceling CNN plus just some four weeks after it launched.

[00:28:18] Alex Fitch: And each one of these decisions, I think, gets headlines. You know, you cancel back girl and it gets headlines. Warner has a tough job, and I am mostly encouraged to see that CEO David Zaslav is willing to execute on that job because there are a lot of uncomfortable decisions that do have to be made.

[00:28:35] Alex Fitch: It’s not easy to shut down projects that have sunk costs. It’s not easy to let people go, but creating the right company to go forward that’s going to optimize the value of each piece of content and try to deliver better profitability think, requires these steps. I trust his framework, and I think each of them have moved us in the right direct.

[00:28:52] Alex Fitch: Inevitably, there are going to be bad headlines when you’re doing things like this. I mean, 3.5 billion of cost synergies necessarily comes with bad headlines. I think it’s the right thing to do for the business though, and it’s going to leave it in a better place.

[00:29:04] Bill Nygren: I think a lot of the press is also. Just upset about the decision by David Zaslav and the rest of the management team.

[00:29:12] Bill Nygren: They believe that CNN will be a more profitable, long-term asset if it presents news down the center of the fairway rather than presenting opinion, which. Recently has leaned pretty much one direction and I don’t think a lot of the written media likes acknowledging that it would actually be better to get CNN back to the kind of center of the Fairway news presentation that they had historically.

[00:29:40] Trey Lockerbie: Well said. I’d like to ask one more question about that because I mentioned this company started off with around 43 billion of debt, and while it seems highly likely that they can afford this and easily afforded the interest ratios are a little over three, I believe. I’m curious as to the interest rate environment we’re going into.

[00:29:56] Trey Lockerbie: Does the higher interest rate environment affect this debt in any way? If interest rates were to keep increasing, are these fixed rate loans that they’ll be able to afford for a long time to. 

[00:30:05] Alex Fitch: Yeah, I think for starters the 14 year average term helps quite a bit, and if you refinanced all the debt today, you’d obviously be paying a significantly higher interest rate.

[00:30:15] Alex Fitch: It would be harder to afford. It’s actually an asset. I mean, to some extent that. You have this debt with very long term at very low rates, right? And so that liability is actually worth less than what it’s marked at on the balance sheet. And that’s an opportunity, you know, Warner is generating quite a bit of free cash flow that should generate north of 2 billion next quarter, and they’re going to be able to go into the market and repurchase that debt at a discount to par, and that should accelerate the de-leveraging process.

[00:30:41] Alex Fitch: So there is. Real benefit that’s going to accrue to them over time from the fact that they locked in such long-term debt at low rates. 

[00:30:50] Trey Lockerbie: And last question around Warner, because I’m just curious how much you’ll be willing to share here, but at $11 stock price, how undervalued are we thinking as far as the margin of safety and maybe the long-term potential of where we might see this stock go from here?

[00:31:04] Alex Fitch: Well, it’s a range. There’s a range around the value and it really does depend on some of these outcomes, you know, there’s a scenario. In which HBO Max and Discovery Plus launched this new combined product and it scales and becomes highly profitable. And we’re talking about valuing 150 million sub-business at a thousand dollars a subscriber.

[00:31:24] Alex Fitch: And then you know the outcomes, just a multiple of the current stock price. And then there’s a scenario where streaming doesn’t work and you end up shutting it down and returning to a licensing model, and you end up with $4 of roughly $4 of earnings power, but a much more challenged growth trajectory.

[00:31:40] Alex Fitch: And the multiple that it deserves is much lower and you know, you end up with less upside. I think we get comfort from the fact that in almost any of those scenarios, there’s significant upside and we don’t have to be exactly right on which scenario plays out. 

[00:31:54] Trey Lockerbie: All right, so I’d like to shift gears a little bit, pun intended here, and dive into another stock in the portfolio.

[00:31:59] Trey Lockerbie: And that is Lithia Motors, a used car dealership and also has ancillary services as well. So Lithia, Carvana and others have had this huge runup since 2020. Due to this high demand for cars and the lack of supply of chips, both have come down considerably from their covid. Give us an overview of Lithia and how you see it today versus the previous Covid prices we’ve seen.

[00:32:25] Alex Fitch: Sure. So Lithia is another relatively new addition to the portfolio. It is a, it is the largest auto dealer group in the United States, so it’s a franchised auto dealer selling new used cars and service and parts under a variety of different brand names. I think in general, Lithia is viewed as a pretty material covid beneficiary, right?

[00:32:44] Alex Fitch: We’ve all seen what’s happened with used car prices going through the roof, and to your point, all of the supply chain pressure. And the shortages that ensued have caused auto dealer margins to skyrocket. Right? And so you’ve seen what used to be a $2,000 gross profit margin for a dealer selling a car grow to something north of $3,000 per car and used a north of $5,000 for new cars.

[00:33:06] Alex Fitch: I think the tendency for investors is when you see one of these covid beneficiaries to look back to 2019 earnings and to say that’s the run. How does it look on that base? And back in 2019, Lithia was earning around $12 per share. And so with the stock at $220 today, it doesn’t look like a screaming bargain.

[00:33:23] Alex Fitch: I think the trouble with that type of analysis for Lithia is that it misses just how much this business’s earnings power has grown over the last three years. You know, if you step back, this is a company that under its CEO, Brian Deboer, had a consistent strategy for a decade. Of acquiring dealers, improving their operations, and then redeploying the free cash flow into further acquisitions.

[00:33:45] Alex Fitch: 10 years ago when I first started following Lithia, the company had around $2 of earnings power. This year it’s 45, and you had a stock price that’s up 10 x over that 10 year period. I mean, it’s been a remarkably successful track record of acquiring dealers at attractive multiples and improving their operations.

[00:34:01] Alex Fitch: Over the last three years, Lithia has doubled down on that. And so the store base has grown from 180 stores in 2019 to 300 stores today. They’ve gained market share on a per store level and new and used, and there’s been sg and a efficiencies through covid that they believe are permanent and they’ve flared on some new business lines.

[00:34:18] Alex Fitch: And so to us, when we look at the underlying earnings power today, even in an environment where gross margins fall back to 2019 levels, Of $2,000 per car, Lithia should be generating something like $35 of EPS. So that means the stock has to touch over six times earnings on our underlying earnings estimate today, which is a multiple that if you look back, had historically been reserved for the depths of a crisis.

[00:34:44] Alex Fitch: I think Lithia briefly touched six times earnings in 2008, briefly touched it during Covid, and then today, and it is a record discount for Lithia to the S&P500. So we think it’s pretty materially undervalued. 

[00:34:57] Trey Lockerbie: Now, I would argue that Lithia is not as much of a household name as a lot of its competitors, which is really interesting because, you know, if I pull out, you know, Carvana for example, that’s maybe even a brand name people have heard of at least recently, and maybe not for good reasons, but you know, Carvana was founded in 2012.

[00:35:13] Trey Lockerbie: Lithia was founded back in 1946, so I’m kind of curious because Lithia stock price has been cut in half and Caranas has nearly gone to zero. So clearly you don’t see the same kind of opportunity in Carvana, even though it’s at a much steeper discount. I’m kind of curious how the strategies you mentioned differ from some of its competitors, maybe Carvana or others.

[00:35:34] Alex Fitch: Yeah, well, primarily, you know, Lithia is a franchised auto dealer, and so they’re selling new cars under OEM licenses, and they’re taking in used cars and reselling those, and they’re providing service and parts work. So it’s a much broader spectrum of services than Carvana, and it’s enabled, I mean, Lithia has a very profitable history.

[00:35:52] Alex Fitch: It was profitable in 2008. It’s a business model that has a number of different ways. To monetize their customer relationships and is not just solely dependent on use CAR e-commerce. I think Carvana, though, has been a really interesting learning for Lithia and for investors in the space in general. You know, first off, Carvana proved that there’s huge demand for an online e-commerce based offering where you have a fixed price and there’s transparency and.

[00:36:17] Alex Fitch: Delivered to your home. And I think that for a lot of us just confirmed our intuition that you buy everything else online. You’d also like to buy a car, but Carvana’s proved that out. They’ve also, to a lesser extent, but also somewhat proved out the unit economics. Now, Carvana’s been making around $4,000 of gross profit per unit on the cars they sell.

[00:36:34] Alex Fitch: If you were a traditional dealer, You’d have around 3000 to 3,500 of SJ and a costs and you’d have a profitable business model. And so it’s a really compelling combination that there’s a huge market demand and there are unit economics and it’s particularly compelling for Lithia. You know, I think if you step back and you said, what do you need to be a national used car online retailer?

[00:36:54] Alex Fitch: I think you’d say, well, you need a lot of inventory. Cause you need to have breadth and depth of different models for customers to shop your site. You’d say you need local logistic. Storage and reconditioning centers that are near customers, you can house the inventory and deliver it cost effectively.

[00:37:09] Alex Fitch: And I think you’d say you need nationwide coverage, right? So you can leverage your brand across all possible consumers. Lithia has all three of those things. I mean, it’s 300 stores. Can essentially serve as storage, logistics, reconditioning centers for an online e-commerce business. They blanket the United States and add more normal production levels.

[00:37:28] Alex Fitch: They have around a hundred thousand cars in their inventory, which is about twice what Carvana carries. So Lithia is very well set up to attack this online space where there, where it seems like there is a lot of demand. The most important part here is that the vast majority of Lithia competitors are not set up to go after that.

[00:37:45] Alex Fitch: So if you look at Lithia, Lithia is going to sell close to 600,000 cars this year across new and used. That’s barely over 1% of the combined new and used marketplace. And if you looked at the top 10 auto dealers, they have something like 8% market share. So 92% of the share outside of the top 10, the vast majority are one, two, maybe three store auto dealers that really have no chance of succeeding in an online world, right?

[00:38:08] Alex Fitch: They don’t have the inventory depth. They have a useful website. They don’t have the national presence to be able to market. And so you have the largest category in retail, a 2 trillion market that hasn’t moved on, but looks like it could. And you have a handful of companies that might be able to address it being one of.

[00:38:25] Alex Fitch: So while we have not been willing to buy Carvana shares, I think we’re pretty intrigued by the idea that this shift towards e-commerce could be a great thing for the other large auto retailers. And, you know, Lithia could be one of the primary beneficiaries. 

[00:38:38] Bill Nygren: And inside a Lithia, you know, we aren’t paying anything for that.

[00:38:41] Bill Nygren: Alex talked about how it’s selling it like five times earnings and this business is not making significant profits for Lithia today. So it’s kind of a free option. 

[00:38:53] Trey Lockerbie: Could you see. A potential for a special situation, sort of, I mean, the way Carvana is going, Lithia is around six times or more larger than Carvana at this point.

[00:39:03] Trey Lockerbie: Given the market cap and their acquisition strategy, do you think there’s a world where absorbing Carvana could be in Lithium’s future? 

[00:39:12] Alex Fitch: Never say never. I think the Carvana brand is very valuable. I think. You know, there’s a chance it still turns out to be a very valuable company. The big problem there is that, well, the $1 billion market cap looks like something that could be absorbed.

[00:39:24] Alex Fitch: They have 7 billion of debt, and so it’s, the total acquisition requires 8 billion of spend, and it’s pretty expensive debt. So, you know, the cost of carrying that, I’m not sure that would be something that Lithia would be interested in doing, but it’s certainly a possibility. 

[00:39:39] Trey Lockerbie: And just digging a little bit more on the market share that Lithia has, because you, you mentioned that they’re relatively small, if you compare them to other dealers, what gives you the confidence in Lithium’s moat given that they’re still such a small participant in the market?

[00:39:54] Alex Fitch: So Lithia is the largest of the auto dealers. They surpassed AutoNation a couple years ago. They’re the largest in the United States. But despite being the largest, still have just over 1% market share. And so it’s just, it gives you a sense of just how extremely fragmented this market is and hopefully how much runway that means Lithia continues to have to acquire dealers and improve their operations.

[00:40:16] Alex Fitch: The moat in general, you know, there are, it’s hard to be a really strong operator in this space, and Lithia has pretty consistently differentiated themselves. There are some benefits from scale, you know, consolidating back office systems and the like. Increasingly, there are advantages in this online world from scale.

[00:40:33] Alex Fitch: The biggest thing though is just the franchise laws and the OEM agreements. I mean, part of the reason that Lithia has been able to acquire dealers at such attractive prices for so long is that a big chunk of your competition that you would see normally in other industries being private equity firms are.

[00:40:49] Alex Fitch: Basically unable to enter the market because they have a hard time securing the OEM approvals to own the stores and the OEMs have to approve any given store purchase. And so you’ve had, you, you’ve kept private equity out of the market and it’s kept the pricing from escalating to the point where Lithia can’t earn good returns on its deals.

[00:41:07] Alex Fitch: It’s, you know, even another example, Berkshire, a few years ago . and the idea was that they were going to use this as a platform to buy up other auto dealers and grow the business. They have not had no eem approval for a deal since the Berkshire takeover. So it’s a tough space to enter because the OEMs have to want to work with you and they prefer to be working with somebody with a demonstrated history of being a really value additive retail partner, and where they know that the person that they’re talking to is the person that the buck stops with.

[00:41:35] Alex Fitch: And so it keeps a lot of competition that have otherwise entered out of the space. 

[00:41:40] Trey Lockerbie: Talk to us about the management of Lithia led by Brian Deboer and perhaps his recent new hire of Adam Chamberlain, formerly of Aston Martin, and how it might impact the management team you’ve assessed there. 

[00:41:51] Alex Fitch: So, I don’t know Adam personally and haven’t met him, but I, we know CEO Brian Deboer pretty well and we followed him closely for a long time and, you know, he’s, the executives around him have changed somewhat over the years, but he’s had a consistent ability to set the right incentive plans to judge people by the right metrics and to prioritize the right things.

[00:42:11] Alex Fitch: And Lithia has been, Lithia stores have outperformed industry peers consistently despite the growth through acquisitions over his tenure. So I know Adam’s going to be responsible for helping manage their Eastern region operations. I think that Brian’s been a remarkable leader of an auto dealer for a long time, and I’m confident Adam will slot in well, but been a much to say on him individually.

[00:42:33] Trey Lockerbie: So what would you say are the biggest risks associated with Lithia and what would impede it from achieving its potential growth? 

[00:42:41] Alex Fitch: There’s, so there’s a handful. I think one risk is electric vehicles generally, you know, a big chunk of auto dealer profits, probably 30% of profits come from service and parts.

[00:42:52] Alex Fitch: And, you know, electric vehicles still have some issues. You can get flat tires, you can have your windshield get cracked by a pebble or you know, you can have your infotainment display stop functioning. You don’t need oil changes and you have fewer moving parts, so it should be less service intensive. And so over time, as EVs gradually take share of the installed base that could shrink the service and parts network, that’s.

[00:43:12] Alex Fitch: One potential risk. I think the other one is that some of these newer OEMs, like Tesla and Rivian, who never built out a dealer base, can sell direct to consumers, and that doesn’t matter too much for Lithia today, given their relationships are primarily with the old OEMs that already have a dealer base and can’t sell direct based on the franchise laws.

[00:43:31] Alex Fitch: But it does mean that to the extent that the new entrance gained a ton of market share, you’re effectively carving off a part of the. Lithia is just unable to address. I think they’re both relatively small and manageable. The final one, and maybe the biggest one to me is that at some point you might not be able to complete further dealer acquisitions, right?

[00:43:49] Alex Fitch: Maybe the price eventually does get competed up to the point where the returns are not that attractive. You do have framework agreements with OEMs that will cap you at around five to 7% market share of dealerships, and so there is a limit to the m and a and you know, relative to the potential. For Lithia to keep growing through this m and a process.

[00:44:08] Alex Fitch: I think that’s the biggest risk. Doesn’t affect current earnings as much as it does the future trend line. 

[00:44:13] Trey Lockerbie: Going around buying up dealers is one strategy. Given these risks, do you think the strategy is going to shift at all and maybe those dollars will be repurposed elsewhere? 

[00:44:23] Alex Fitch: Not in the near term. You know, there’s 17,000 dealerships in the US and Lithia owns about 300 of them.

[00:44:29] Alex Fitch: So you have, even at the high end of those master frameworks, you still have room to more than double your store base. So there’s plenty of room for deals. You know, lithium management’s been very thoughtful about. How they address the market, right? They go through the 17,000 dealers and they’ve identified 2,600 stores that have the right location, the right performance metrics, the right opportunity, and they focus on building out relationships with those owners and waiting for the right moment and then being ready to strike.

[00:44:55] Alex Fitch: And that’s a very large group and huge compared to the 300 store. Base that Lithia has today. So I think there’s runway. The one thing that has changed is that in the past, I think Lithia would’ve described themselves as just a value investor, right? They’re looking for the best possible return on investment on any given store.

[00:45:11] Alex Fitch: And in recent years as this e-commerce opportunity has become more apparent, I think the focus has shifted a little to say we’re a value investor, but we also have a broad strategic goal. And you know, we don’t have any stores in Indiana, so we should prioritize that. And so there’s a little bit of adapting the framework to try to.

[00:45:28] Alex Fitch: Optimal network to be a national retailer through their driveway brand. But in general, I think the focus is basically the same.

[00:45:35] Bill Nygren: I think sometimes value investors take a knock for people thinking all we ever want is to get earnings returned to us and that, you know, we want share repurchases, we want dividends and.

[00:45:47] Bill Nygren: The cost of that is not being able to grow businesses. I mean, we couldn’t be more different than that at Oakmark. We are excited when you get a company like Lithia that appears to have a lot of opportunity where they’re competitively advantaged and should be able to re-earn an excess return on their investments.

[00:46:04] Bill Nygren: And when those conditions are present, we’d much rather have the company reinvesting in their basic business where they’re competitively advantaged than giving that capital back to us. You know, that’s very different than the Warner situation we talked about earlier where a company like AT&T looked at their own future, thought it wasn’t very bright, and decided they wanted to go into industries.

[00:46:26] Bill Nygren: They didn’t really know much. In a case like that, we would’ve been interested in that company only if capital was coming back to shareholders, not in reinvesting in businesses they didn’t understand, trying to get away from the basic business that they had. 

[00:46:42] Trey Lockerbie: Talk to us about the financials, because the way I’m seeing it, I mean, Lithia can be in these positions where it’s just, you know, throwing off free cash flow and the, and it seems to be growing rather rapidly, but there are these occasional declines I get, I’m assuming a, around the acquisition periods.

[00:46:56] Trey Lockerbie: Talk to us about how you’re seeing the free cash flow growth from here.

[00:47:00] Alex Fitch: So there’s a couple of nuances. I think the financials have been a bit noisier lately, partly because they’re building an in-house finance company, an in-house auto lender, and they have the dealerships that can integrate directly, they can put these offers directly in front of customers in a way that takes a bunch of market share.

[00:47:16] Alex Fitch: And it’s been a very successful effort so far. But they primarily funded it with equity capital and. The free cash flow looks depressed today because they’ve built up 750 million of book value in a finance subsidiary. If we carve that out, put that to this to the side, pretend it’s a separate entity and they get the free cash flow Lithia has is something north of $1 billion, maybe close to $1.5 billion next year.

[00:47:41] Alex Fitch: In free cash flow likely to come through all depending on how quickly the car environment used, car environment normalizes, and you know that’s somewhere between a 15% and the 20% free cash flow yield on the current stock price. The companies reduced their shares about 8% this year through buybacks because for the first time in a number of years, they’ve thought that buybacks were cheaper than actually going out and continuing acquisitions.

[00:48:02] Alex Fitch: And they look directly at that trade off and thinking about what they pursue. I would expect that a meaningful portion of that 1.5 billion of free cash flow is going to go toward acquiring dealerships that further build out this network and hopefully come with something like the 25% return on investment that they’ve historically achieved in dealership acquisitions.

[00:48:22] Trey Lockerbie: Now, can you give us a range for where you expect this price to go? Because the way I’m seeing it, the earnings are growing rapidly as well around 46% over like say the last five years. And you mentioned that this stock is currently trading at around a five x earnings. So if that were to continue that multiple, I mean, where would we see this stock in a few years from now?

[00:48:41] Alex Fitch: Yeah. I hate to give almost the same answer as for Warner, but it really, it depends on the outcomes and, but there’s a lot of potential. I mean, there was a kernel of truth that kind of spiraled out of control in the Carvana situation, right? Auto retailing is the biggest retail market in the country.

[00:48:57] Alex Fitch: It’s a 2 trillion market. If there is a large e-commerce player there, it’s going to be a very big, very valuable company. And so the critical kind of question mark is what happens with their driveway e-commerce offer. Leaving that aside though, I think you have this dealership business that’s generating $35 of earnings per share in a normal environment, and you have an opportunity to continue deploying most all of your cash flow into acquisitions.

[00:49:22] Alex Fitch: If you looked over the last 10 years, they’ve compounded their earnings per share at 32% for a decade, which is remarkable and you’d hate to predict anything close to that going forward, but it’s pretty reasonable to think that a few years out, we’re looking at 50, 60, you know, 60 plus dollars of earnings.

[00:49:38] Alex Fitch: I would think a fair multiple on that if it traded anything like the auto dealers traded before, oh, the concerns recently, I think it would be north of a $600 stock. 

[00:49:47] Bill Nygren: The point that Alex makes there. About the optionality in both of these names. It’s something that’s a theme you see across a lot of oakmark investments where there’s concern about disruption and they’re separate companies that are valued quite generously, that don’t have much of a legacy business, but have a potential success as a disruptor.

[00:50:08] Bill Nygren: We think when that. Potential for disruption lies inside of a traditional business. The market often values it at zero, or as Alex said, On Warner, maybe even capitalizes it as at a negative number because that part of the business is currently reducing earnings. So we love these situations where we think there’s a reasonable chance of success.

[00:50:30] Bill Nygren: It’s far from a certainty. And if they don’t, , they’ll stop losing money on that business and the true earnings of the basic business will come through. But if they do succeed, you know, it takes something from, you know, being a 60 cent dollar to being something that’s going to be worth multiples of the price that we paid for it.

[00:50:49] Trey Lockerbie: And curious on that, if you were to hold this and it were to grow as we kind of expected from here, how does Oakmark manage the rebalancing of even top performers, which this might be one day versus, you know, some of the declining stocks we talked about before? 

[00:51:03] Bill Nygren: So the way we think about the two funds, Trey in the Oakmark fund, the more diversified fund, the one if somebody came to you and said, I want to make an investment in a mutual fund and not look at it again for a decade.

[00:51:15] Bill Nygren: That’s how we think about managing Oakmark Fund and you know, stock selection’s where we add value. So we want less securities than the average mutual fund. Typical fund has about a hundred investments. We have about half of that in Oak. So a typical holding for us in Oakmark is 2%, and then in select, it’s about double that, about 4% when a stock performs well.

[00:51:40] Bill Nygren: And that waiting doubles, it’s rare that the risk return on that new higher price merits an even higher waiting than that. So after that kind of performance, we would generally start trimming our position so that we aren’t letting the market take this to a very high waiting, just as the risk return is getting much less attractive than the rest of our portfolio.

[00:52:05] Trey Lockerbie: Well Bill, it’s always a pleasure to have you on the show and Alex, this was a really fun first conversation with you as well. I gotta agree with you guys on a couple of these stock picks, no matter which way I cut it. They do seem both very undervalued, so it’s definitely merit for a deeper dive here.

[00:52:18] Trey Lockerbie: Before I let you go, I want to give you the opportunity to hand off to the audience where they can learn more about each of you and your writings. You guys give great quarterly commentary and also about the funds themselves. 

[00:52:28] Bill Nygren: So one of the things when we launched Oakmark, Trey, is we wanted to give industry leading communication to our shareholders and potential shareholders.

[00:52:38] Bill Nygren: You can find a history of what we’ve written at oakmark.com. My quarterly commentaries are under the commentary section, and then I think it’s called Comments from the cio. One of the things I think about when I write those is if somebody wants to go back and read, you know, six or 10 of those quarterly comment.

[00:52:57] Bill Nygren: I think they would get a really good idea of how we at Oakmark think about investing, and we think that’s important because people who understand how we invest are more likely to stick with us during difficult periods. And we know the history that investors usually perform worse than the funds they invest in because they, they buy after they go up and they sell after they go down.

[00:53:18] Bill Nygren: We’d like to think that a well-informed investor who reads our commentary won’t make those mistake. And then additionally we have a spot on the website that’s called Insights, where you see writings from other people on the investment team. And Alex has a fairly recent piece there that’s talking about ESG and how long-term investors are naturally ESG sensitive.

[00:53:44] Bill Nygren: I think that’s something that the market doesn’t think too much about and I think he. A very different way of looking at that to that piece, and it’s something I’d highly recommend to anybody who’s interested in learning more about either Alex as an investor or about the way Oakmark thinks about long-term investing.

[00:54:04] Bill Nygren: So it’s oakmark.com. 

[00:54:07] Trey Lockerbie: Bill and Alex, thank you so much again. I hope to have you guys both back on and maybe sooner than later, and we can reassess some of these stock picks we talked about today. So thanks. 

[00:54:15] Bill Nygren: Thanks for giving us the opportunity. Thanks, Trey. 

[00:54:19] Trey Lockerbie: All right, everybody, that’s all we had for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app, and if you’d be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter @TreyLockerbie. And don’t forget to check out all of the amazing resources we’ve built for you at theinvestorspodcast.com. You can also simply Google TIP Finance and it should pop right up. And with that, we’ll see you again next time.

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