Listening to a colleague present a short report on your portfolio holdings may be uncomfortable, but it is key to the investment process at Harris Associates, which manages $102bn in assets.
Although the firm specialises in a long-only mutual funds with a bottom-up value investment approach, analysts regularly write “devil’s advocate reviews” – which are essentially short reports – on their existing long ideas.
Any part of the investment thesis can be questioned: from the modelling assumptions to the quality of the business or management team.
Even challenging the firm’s chief investment officer and value investing veteran Bill Nygren is encouraged, says Michael Nicolas, partner and portfolio manager at the firm.
“Bill is open game,” he told FSA in an interview. “I think at most investment firms when you challenge the ‘Oracle’, you take enormous career risk.”
“But at Harris it’s the opposite: you take far more career risk by not speaking up when you have something important to say, even if it’s critical. It’s a true meritocracy and it’s a really unique and special culture.”
“We’ll have those debates in an open forum in front of our peers,” Nicolas (pictured) said. “As you might imagine, that can be quite uncomfortable for some people.”
“Nobody likes to be told that they’re wrong, that their math is wrong, that their views are incorrect, but at Harris we really view it as an asset.”
The reports are designed to help ensure the portfolio managers don’t fall into the psychological pitfall of groupthink – where consensus is prioritised over critical reasoning.
When Nicolas joined the firm in 2013, he said he was “blown away” by seeing junior analysts strongly challenging senior portfolio managers, and praised the flat investment culture this process helped enable.
Value investing philosophy
The firm’s investment philosophy is boiled down to finding businesses with three key aspects: value, quality and owner-operator style management.
In terms of value, they are looking for businesses that trade at least a 30% discount or more to their estimate of fair value.
The second aspect is about finding businesses that are growing per share value, which can be seen as a quality filter designed to avoid value traps, Nicolas explained.
He said: “There are times where there’s a company that is masquerading as being cheap, but the underlying business is actually structurally declining; it’s a secularly challenged company.”
“In those instances, time is your enemy, and the business is getting worse with each passing year. We do our best to attempt to avoid those by ensuring that our businesses are constantly growing per share value over time.”
The third aspect is finding management teams that think and act like owners of the business, which Nicolas deems as crucial to the process.
“If your time horizon is measured in just a couple of quarters, management quality and capital allocation might not matter that much,” he said.
“But if your time horizon is measured in multiple years like it is in our firm, how a given management team allocates the excess cash flow that they generate can often dictate whether or not the investment is successful or not.”
Current opportunities
After a massive rally in large-cap technology names on the back of artificial intelligence hype, some market participants fear their new lofty valuation multiples make them slightly more vulnerable.
Indeed, many of the large cap US technology names sold off sharply following disappointing earnings reports. This was made worse by growing recessionary fears after a weak US jobs report.
Some investors make valid arguments for these stocks warranting higher valuation multiples because of how consistently they have delivered earnings growth and maintained dominant market positions.
But Nicolas believes he and his colleagues have built a portfolio of discounted stocks without giving up much earnings growth.
“We think you can construct a really attractive portfolio at a heavily discounted multiple to the S&P 500 index and with far less concentration risk than what’s lurking in these indices,” he said.
“I think people look at the S&P 500 and assume with 500 names in there, it seems very diversified, but there’s actually a tremendous amount of concentration.”
Indeed, just three companies make up almost 20% of the entire S&P 500 index: Apple, Microsoft and Nvidia. When you add the next three largest technology companies, they collectively account for almost a third of the index.
Looking under the hood of the firm’s flagship $9.4bn Oakmark fund, it has a more eclectic mix of stocks than investors would normally find in a traditional value portfolio.
Although several banks and an energy company feature in its top holdings, it also holds a large cap tech name: Alphabet.
The portfolio managers at Harris saw opportunity in Google’s parent company Alphabet during late 2019 despite it trading at a relatively high multiple of 30 times earnings.
Since then, profits have more than doubled and the share price has closely followed. The stock still forms the largest position of the fund at 3.8%.
Looking at the current market environment, Nicolas believes there’s a large pocket of stocks that have been left behind in the recent tech-driven rally.
“It’s not just financials and energy where we’re finding interesting opportunities today,” he said. “We’re seeing high-quality, cheap businesses in areas like industrials and healthcare and even consumer staples.”
In addition to co-managing the Oakmark fund, Nicolas is co-manager of the Harris Associates US Value Equity Fund, the firm’s $1.7bn Ucits strategy. Harris Associates is an affiliate of Natixis Investment Managers.
