OID: Basically private market value.
    Nygren: That's right. But one of the problems that investors who focus on private market value - or even those with a more broad value approach - can have is that they develop one favorite summary statistic. And then they try to make that work across all industries - whether it's high yield and low P/E, low price to book or whatever.
    We believe that in some industries, one statistic does a better job of capturing economic value than it might in another industry. For example, with cable TV stocks, we looked at price per subscriber and enterprise value to EBITDA. But when we look at an industrial company, we might look at market cap to sales and enterprise value to EBITA - because depreciation is a much bigger factor in that business than it is in the cable industry. Therefore, we allow ourselves the flexibility to select the measure that we believe is the best depictor of value in each industry.

OID: You're the lead portfolio manager on two funds - the Oakmark Fund and the Oakmark Select Fund. You discussed the differences at Morningstar…
    Nygren: Basically, although Oakmark Select contains large-cap value companies, it's more of a mid-cap offering. Within the smaller part of the mid-cap area - say between $1-1/2 billion and $3 billion - I don't expect to make new purchases for the Oakmark Fund, whereas I do anticipate that I will for Oakmark Select. So in the Oakmark Fund, we basically emphasize large-cap value.

OID: Morningstar seems to have a different opinion…
    Nygren: Morningstar just moved the Oakmark Fund from the large-cap value category to the mid-cap value category. That raises an issue I don't see discussed much.
    Morningstar includes a fund in the large cap category if it primarily owns the 250 largest market cap companies. Mid-cap is the next 750 as I recall and small-cap is everything below that. And they watch for style drift by the fund managers. Apparently, they felt that based on our recent portfolios that there'd been a drift - that the Oakmark Fund used to be a large-cap manager, but that we'd become a mid-cap manager.
    Well, that struck me as odd because I'd been working on the fund for a long time - first as director of research and now as the portfolio manager. And I know from what we do internally that nothing's changed at all.

OID: You don't think the change has been so gradual that you just haven't noticed it.
    Nygren: Nope. So I began looking into what was behind our apparent shift. And it's interesting - one of the reasons why they even bother with that system is that historically, large-cap companies have been less volatile. So they felt people should understand the size breakdown of the companies their funds owned.
    But the shortcut has always been market cap rather than the companies' fundamentals. And it didn't take long for us to figure out what had happened: We'd cut back on our ownership of formerly small and mid-sized companies that had achieved large-cap status. Why? Because the market had begun to value their stocks so highly.

OID: That is interesting.
    Nygren: So we went back and asked, "What would happen if instead of measuring size based on market cap, we used sales or net income or shareholders' equity? Using that measure, has there been a change in the percentage of our portfolio in those categories?"
    And it turns out that there hasn't been a change. The Oakmark Fund's always had the majority of its assets in companies that qualify as large based on their fundamental statistics. So although we're buying the same large companies by market capitalization that we've always bought, we're now being categorized as a mid-cap fund.
    What's changed is the percentage of large-cap stocks that don't qualify anymore as large-cap companies based on their sales, earnings, etc. In fact, we went back and looked over the last decade at the number of large-caps that weren't big companies based on any of those measures - sales, income or equity. And it turns out that the number's gone up about five fold.

OID: Fascinating.
    Nygren: But unsophisticated investors - even moderately sophisticated investors - trying to achieve a lower risk profile by buying large-cap names may find that they have inadvertently stepped into a very risky portfolio. In many cases, they actually own smaller companies that have achieved large-cap valuations.
    So they wind up with some kind of geometric increase in risk by combining those two factors - despite the fact that they're implementing an approach that would traditionally be considered a lower risk approach.
    In contrast, the Oakmark Fund has been, is and will continue to be a large company fund. But if we can buy large companies at mid-cap valuations, so much the better.