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Value Investor Insight_Found in Translation_Herro_103009

Value Investor Insight_Found in Translation_Herro_103009

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05/03/2014

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D
 
INVESTOR INSIGHT:
David Herro
Value Investor Insight 
2
Investor Insight: David Herro
Oakmark Funds' David Herro describes the “biggest reason quality companies sell at discounts,” why his directemerging-market exposure is currently so low, the best advice he'd give someone looking to invest outside the UnitedStates, and why he sees significant upside potential in Rohm, Adecco, Ansell, Allianz and Carpetright.
You’re not that old, but you’ve been run-ning international equity portfolios foralmost 23 years. Has your strategyevolved in any key ways over that time?David Herro:
As a value investor, I wasinitially almost exclusively focused oncompanies with good balance sheets sell-ing at low valuation multiples. There’snothing inherently wrong with that, butI’ve learned from experience that whencheapness blinds you to not-so-hot busi-nesses or poor management, it’s a recipefor disaster. We still only buy bargains,but we pay a lot more attention to thingslike whether the company’s returns oncapital are as good as they should be andat how adept and disciplined manage-ment is at allocating cash flow. Whenreturns are inadequate or capital is allo-cated recklessly, equity value is usuallydestroyed.Another thing that’s been particularlyimportant in analyzing foreign companiesis to rely far more on cash flow thanreported earnings. This always madesense to me. When I was in graduateschool, my brother-in-law hired me to dosome temporary work at a canning com-pany. One project was to go through apile of invoices and pull out anything thatlooked at all like a capital purchase, evenfor things like tires and other pretty basicrecurring expenses. I finally asked why Iwas doing that, and he said the CFOwanted to capitalize anything thatremotely looked like capital spending sothey could write it off over time.The lesson in that for me was that aclever accountant can make financialstatements say whatever he wants in theshort term. That conclusion has only beenreinforced over time, especially as the dif-fering tax regimes and accounting con-ventions you see overseas can make com-parisons based on reported net incomeeven more meaningless.
What is the market often missing in thesituations that attract you?DH:
I would assert the biggest reasonquality companies sell at discounts tointrinsic value is time horizon. Withoutshort-term visibility, most investors don’thave the conviction or courage to hold astock that’s facing some sort of challenge,either internally or externally generated.It seems kind of ridiculous, but what mostpeople in the market miss is that intrinsicvalue is the sum of 
all 
future cash flowsdiscounted back to the present. It’s notjust the next six months’ earnings or thenext year’s earnings. To truly invest forthe long term, you have to be able towithstand underperformance in the shortterm, and the fact of the matter is thatmost people can’t.If you look at some of the newer par-ticipants in global equity markets, likehedge funds, think about how they getpaid. Their financial incentives are heavi-ly weighted to one-year performance, sowhat are they going to go after: compa-nies they think will have a big share-pricespike in the short term. Having moretrading driven by investors with a com-pletely different time horizon than wehave can be very helpful in creatingopportunity.
Is this inefficiency more or less pro-nounced in non-U.S. markets?DH:
It’s everywhere – animal spirits areanimal spirits. What may be somewhatmore common outside the United States,especially in smaller companies, are ideasfor which fewer people seem to be payingattention, leading to something trulyinteresting going unrecognized. Even assome of our funds have gotten so large interms of assets, we still prospect for thosetypes of overlooked small- and mid-capideas.
David Herro
Accidental Tourist
It says something about the prominence ofnon-U.S. investing at the time that DavidHerro was chosen in 1986 to create aninternational equity product for what isnow the Principal Financial Group in DesMoines, Iowa. He had just earned aMasters degree in Economics from theUniversity of Wisconsin, but at 25, he hadno actual investing experience. He startedout reporting to the head of fixed-incomeprivate placements. Until he took the job,he hadn't even been outside the U.S. “Youcould say there was no grand plan that Iwas destined to be an internationalinvestor,”Herro says.After successfully launching the newproduct for Principal and then doing thesame for the State of WisconsinInvestment Board, by 1992 Herro was indemand as an experienced internationalinvestor. That year he joined HarrisAssociates to launch and manage itsOakmark International Fund. Today he’sresponsible for some $14 billion in non-U.S. equity assets for Harris. “I stumbledinto this side of the business, but it waslove at first sight,he says. “There's anadded dimension and excitement to it thatI feel as much today as I did 23 years ago.It's funny how things work out.”
 
Value Investor Insight 
3
INVESTOR INSIGHT:
David Herro
We assume taking a longer-term perspec-tive has proven painful at times over thepast year.DH:
Of course. We were early into finan-cials as we thought valuations got so farremoved from what we expected “nor-mal” to eventually be, but as you know,the gap got painfully wider before it start-ed to turn the other way. We spoke withyou about Credit Suisse [CSGN:VX] in January [
VII 
, January 30, 2009] and thestock proceeded to fall another 30% byMarch, to less than 22 Swiss francs. Sincethen it’s up more than 150% [to a recent56.65 Swiss francs].Another similar example is Allianz[ALV:GR], the giant German insurer andfinancial services company which manyU.S. investors know as the parent compa-ny of Pimco. We’ve always considered itwell-managed, but it got painted with thesame brush as all financial companies asthe crisis unfolded and its stock gotcrushed. But we saw them taking steps tofocus on their core strengths in propertyand casualty insurance, life insurance andasset management, while getting out of businesses like commercial banking. Wealso saw them benefiting over time fromthe extreme distress of one of their largestglobal competitors, AIG.Our feeling then – which hasn’tchanged – was that Allianz would be verywell positioned to come out of the crisisin a strong competitive position with alot of earnings leverage. Of course, themarket couldn’t have cared less aboutany of that in November of last year or inMarch of this year, when the shares wentbelow
 €
50. The stock has come back toaround
 €
80, but we still have a big posi-tion because we believe the intrinsicvalue based on normalized earnings iscloser to
 €
150.
Do you still consider Credit Suisse sharesattractive?DH:
Yes. Its tier-one capital ratio is over15%, its private-banking franchise goesfrom strength to strength and its invest-ment bank has survived relatively intactin a business in which a lot of big com-petitors have disappeared. We sold someshares as the price increased – maintain-ing around a 3% portfolio position – butwe still believe the sum-of-the-parts valueis closer to 115 Swiss francs.
Talk about one financial that didn’t workout so well, the U.K.’s Lloyds.DH:
One of the more common unhappyreasons we sell is if management provesnot to be the worthy steward of our cap-ital that we thought. Lloyd’s did some-thing colossally stupid in buying a finan-cial train-wreck called HBOS lastSeptember. Lloyds was a company thatcould have come through the crisis almostunscathed, but they stole defeat from thejaws of victory by buying HBOS. We lostmoney on it, but the only consolation isthat we got out when the shares werearound £1.20 and it’s now trading under£0.90. You have to be able to take a lossin this business – we ended up puttingthat money mostly in other financials likeCredit Suisse or BNP Paribas, which havedone very well.
How do you organize your researcheffort?DH:
We have eight people focused oninternational research, with seven of ouranalysts responsible for at least two dis-tinct geographic regions. We’re abso-lutists, so we don’t want people to saythings like “this is cheap for a Germancompany,” but instead focus on whetherit’s an attractive international idea.We do some regular quantitativescreening for what looks cheap and of good quality – say, looking at enterprisevalue to EBITDA relative to return onequity. For things that look attractive, ournext step is to interview management andtry to fully understand the return charac-teristics of the business and how manage-ment makes capital-allocation decisions.
Is interaction with management more dif-ficult outside the U.S.?DH:
There are still language barriers,particularly in Japan, but that’s gottenbetter over the years as English hasbecome firmly entrenched as the interna-tional language of business. Culturally, insome parts of the world we’re up againsta kind of social-democracy attitude, thatsays shareholders are equal constituentswith employees and customers and sup-pliers and banks. I don’t ascribe to that atall, so in some cases we have some con-vincing to do. Most often, if that attitudeis too prevalent we just won’t be veryactive.
Your portfolio is heavily weighted toestablished rather than emergingeconomies. Why?DH:
For our type of investing, whichinvolves buying big stakes in companiesand investing for the long term, we needtransparency and a firmly established ruleof law. If we can’t believe the financialstatements or we see too much risk of therules being changed after the game starts,the whole exercise is pointless. As aresult, we won’t invest in Russia. We’vealso never owned a mainland Chinesecompany, because most of them are con-trolled by the state and there’s too muchpotential conflict between shareholderand state interests. Say the governmentwants independence in inter-coastal ship-ping, so directs a shipping company tobuy ships that might produce lousyreturns. That’s terrible for shareholders.Our emerging-markets exposure hasbeen as high as 25%, but is now for bothour large- and small-cap funds in the 4-6% range, with most of that in Mexico,South Korea, Israel and Malaysia. Themost-asked question I get in the past threeor four months is, “Why aren’t you moreheavily in emerging markets, don’t you
ON CHINA:
We’ve never owned a mainlandChinese company – there’s toomuch potential conflict betweenshareholders and the state.

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