Beating the Market for 20 Years: David Herro of Oakmark International scours the globe for undervalued, unloved stocks

TUESDAY, AUGUST 13, 2013

Beating the Market for 20 Years

By SARANYA KAPUR | MORE ARTICLES BY AUTHOR

David Herro of Oakmark International scours the globe for undervalued, unloved stocks.. Here are his best investment ideas in Japan, Australia, and, of all places, Europe.

A few money managers manage to beat their benchmark in any given year, and a select group string together longer periods of outperformance, but not many have taken the index out into the woods and thrashed it as severely – over two decades – as David Herro. A $10,000 investment in his fund, Oakmark International (ticker: OAKIX), in 1992 is now worth about $88,000, versus $34,000 for the MSCI EAFE index. Over the past year, his 43% return has doubled that of the index. His performance has not gone unnoticed: In 2010, Morningstar named him manager of the decade, and Barron’s has written about Herro’s market-beating returns (see Interview, “Driven by a Vision of Global Growth,” Feb. 19, 2007). Despite running an international fund, Herro eschews a geography-specific approach and focuses instead on company’s valuation and quality. His favored measures are free cash flow yield, business structure, and how efficiently management allocates capital. Sometimes Herro’s bottom-up approach looks a lot like a great macro call. Late last year he started loading up on Japanese stocks right before they began a furious rally that took the Nikkei 80% higher in six months. In keeping with his value orientation, he was already dialing back his exposure before the rally faded in late spring.We caught up with Herro recently to hear about what he’s buying – and what he’s avoiding – today. Our discussion is excerpted below.

Barron’s: What is your view of the market right now?

Herro: I think that stocks have had this slow rally and now they are at record levels, but they’re not too far from where they were 10 years ago. People forget that. The bond market is still overpriced. We have a 10-Year Treasury [yielding] under 2.5% and inflation is at 1.5% or 2%, so you barely even have a real yield. People are still clinging to safety, but it’s starting to change, and I think whether on an absolute or relative basis, global equities is the place to put your money over the medium and long term.

Manager’s Bio

Name: David G. Herro 
Age: 52 
Title: Chief investment officer for international equities, Harris Associates 
Education: B.S in economics and business, University of Wisconsin-Platteville; M.A in economics, University of Wisconsin-Milwaukee 
Hobbies: Cycling, education promotion and Green Bay Packer football

Q: After the big run in Japan, are you still finding value there?

We still think that Japan is a good investment, but the market has gone up 80% from the bottom, so we have trimmed back. Today just under 15% [of the fund is invested in Japan] so we still have a significant amount invested there, just not as much as it was. We think the macro situation will continue to improve.

Q: What Japanese stocks would you recommend?

Canon (CAJ)* for example, is one of the better blue-chip companies and will be a big beneficiary of the weaker yen, especially versus the euro, and they’ve been one that has been consistently profitable despite some headwinds as far as their base business is concerned. Canon’s main headwind is their weak camera business, as demand has been slow in Europe and the emerging markets. But we believe they are an innovation leader, and their management team is very shareholder-focused, as evinced by their frequent stock buybacks and dividend issues.

Q: You have trimmed your positions in Toyota (TM) and Daiwa Securities(8601.Japan).

When we buy a company, we determine what we believe it is worth, and as price gets closer to value we’ll trim a little bit, because we want the position size to be a function of the discount of price from value. After Daiwa dropped significantly, we actually added to our position again.

Q: Nearly three-quarters of your portfolio is invested in Europe.

What has attracted us to the region is its core valuation. During the European crisis people just dumped European equities, we think mindlessly because where a company is domiciled doesn’t necessarily have a major impact on its value; it’s where they sell their goods and make their profits.

Daimler (DAI), for instance, is one of our larger positions. It has operations all over the world and has good exposure to emerging markets and the United States. It has a truck business, a bus business, Mercedes car business, and just because it was a European stock, people sold this stock down to the $30s. Now it’s back up in the $50s. It was sold so low that the price-to-earnings ratio was actually below the dividend yield, which tells you something from a valuation perspective.

Fund Facts

(as of Aug. 7, 2013)

Fund Name: Oakmark International Fund (OAKIX)

Assets:	$20.7 billion
Expense Ratio:	1.06%  (Net expense ratio as of June 17, 2013)
Front Load:	None
Annual Portfolio Turnover:	38%
Yield:	1.78%

Source: Morningstar.com

Q: You’ve also invested heavily in European financials.

During the crisis everyone thought that France, Italy and Spain were going to default. Our view was there might be trouble on the extreme periphery, i.e., Greece and Portugal, but that the core countries will make it through. These bank stocks dropped 50%-60%-70%, which we thought was completely unwarranted, as the governments weren’t going to default on their bonds.

The best-performing financial we have is Lloyd’s Banking Group (LYG). It is a U.K. financial institution that we started buying in the low to mid-$20s and now it’s at $69. It is still a top 10 holding. And if you look at a couple of the European commercial banks, like BNP Paribas (BNP.France) and Intesa Sanpaolo (ISP.Italy), these are two really well-run, well-capitalized financial institutions that are in less than robust countries. If you put up with a little short-term pain, they are selling at very attractive valuation levels. Intesa for instance, is a leading bank in northern Italy, and it trades at less than 10 times next year’s earnings, 44% of book value, yields 4.7%. This is a bank that operates in northern Italy, which is almost like Switzerland or Germany. It is a good place to be located.

Our biggest position is in Credit Suisse (CS), and I continue to believe that it’s a hit, because I think people confuse it with a typical European financial, and they don’t realize that it is really an asset-management company, what we call a de-risked investment bank. They’ve been increasing their capital position, and are in very good shape. This is a company that should begin to grow earnings in the mid- to high-single digits as they get net new money in and as people start to move money out of bonds, and as the Swiss franc continues to weaken. It currently trades at under 10 times earnings and below one times book value. It’s just got two strikes against it: It’s in Europe and it’s a financial.

Q: You’ve recently added AMP Ltd . (AMP.Australia), the Australian financial company.

This is a company that’s suffered. It’s got a lot of exposure to Australian asset management, pensions and investment products, and the Australian stock market has been weak. But it isn’t going to be weak forever. When the Australian economy comes back, AMP will be a huge beneficiary. Australia has had some of the highest interest rates in the developed world and an overly strong currency. Now we’ve seen the currency weaken, which will help the economy. Meanwhile, AMP is in a superannuation market, which means they have a mandated private pension, and AMP is the biggest manager of pensions in Australia.

Top 10 Holdings

(as of June 30, 2013)

Credit Suisse Group	(CS)
Daimler	(DAI)
Intesa Sanpaolo	(ISP.Italy)
BNP Paribas	(BNP.France)
Lloyds Banking Group	(LYG)
Allianz	(ALV.Germany)
Fiat Industrial	(FI.Italy)
Orica	(ORI.Australia)
Daiwa Securities	(8601.Japan)
Bayerische Motoren Werke	(BMW.Germany)

Source: Morningstar.com

Q: You are also the largest outside owner of Orica (ORI.Australia), the Australian mining company.

Mining has been soft over the last year or so, and Orica’s been hit quite hard. But Orica makes explosive materials, so it doesn’t matter whether mines are necessarily expanding, it just matters that they are producing. Coal and iron ore need explosive material to move ore bodies, and Orica is the world leader. The industry has high barriers to entry. These things are very difficult to make, very difficult to get licenses for, very difficult to ship and it’s a necessary part of the mining sector. It’s a timely profitable business that is not booming and the share price is down significantly, so we think this is a good, safe way to play exposure over the medium and long term to mining services.

Q: You’ve avoided emerging markets in the last quarter, what would entice you back?

What would entice us back is lower emerging-market stock prices, because the problem for us, in the last two or three years, is that relative to the developed markets, they’re just selling at higher valuations. In the late ’90s we were over 20% emerging markets, and as they spiked up and all the money poured in, stocks became less and less attractive there, so as a result we’ve trimmed back.

Q: Do you see any opportunities in U.S. stocks?

Looking at the big positions we have here, I think you can find value in some of the U.S. financial names, like Bank of America (BAC), and AIG (AIG). I think those are two companies that are misunderstood, and they offer extremely good business value. The other sector I would add is the technology sector, companies like Intel (INTC) andOracle (ORCL), which everyone loved 10 years ago, when they were selling at significantly higher multiples. Now there’s been a little lull in that tech cycle so people don’t like them.

Q: Thanks, David.