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By Jason Stipp | 09-13-2011 05:10 PM

Herro: Quality Has Been Trampled Upon

The Oakmark manager says the fund is able to pick up quality names at 60% to 70% discounts amid a market that's selling first and asking questions later.

Jason Stipp: So, I wanted to talk to you about volatility, because it does seem, as you're saying, that we've seen a lot of the markets moving in lockstep and a lot of indiscriminate selling in some cases.

... I know it's kind of hard to get a handle on what's causing it, but it seems like especially in August we saw so many days of triple-digit up and down on the Dow Jones, for example.

What do you think is the big concern here behind some of these sell-offs and then some of the quick corrections and then some of the sell-offs again?

What is it that the people are most worried about, and is there a valid concern right now?

David Herro: I think the biggest worry, and I heard this from one of my friends who is in the hedge fund business in New York, the biggest worry is people don't want to get caught like they were in 2008 and perhaps '09. So they are extrapolating what was the situation in 2008 and 2009, and they are selling first and they are asking questions later.

Despite the fact, what we are seeing in the real economy, despite all these fears, despite all this volatility and market instability in the financial markets, in the real economy we're not yet seeing what we saw in '08 or '09--nothing like it.

In fact, in August, BMW reported their best August monthly sales ever. And this is after the August we had in the financial markets. So what we are seeing in the financial world is not transferring to the real economy at this stage, and market participants are behaving like the real economy has already adjusted downward 16 notches, when that is not the case. So you have that going on.

Number two, this volatility I think was caused by ... instantaneous information, instantaneous, and people respond and react instantaneously. Now, I think eventually we are going to get to the "boy who cried wolf" syndrome, where people are going to quit instantly responding because they are going to realize that it is erroneous to do so. So maybe this is why BMW sold more cars in August than ever before, because the consumer says, "oh, yeah, that's the financial markets again."

So ... as investors, how do we utilize this environment? What can we do with the volatile environment? We try to take advantage of it. As an example, besides the financials that have been destroyed in August and early September, lot of the industrials in Europe. You take a company like Daimler. Daimler going into August--and this is one of the largest producers of trucks and commercial vehicles as well as Mercedes automobiles--was trading at nine times earnings and had a dividend yield of about 5%, payout ratio of about a third. So, plenty of room on the dividend, still yielding 5%. Today, the dividend yield of Daimler is probably closer to 6% or 7%, and its P/E is about 6. That is, the stock dropped over 35% in one month. Now, is Daimler worth 30% or 35% or 40% less today than it was in the middle of July? Our view is no, but the markets are so scared they just wanted out of any European industrial, and you could see it across the board. A company like Akzo, which is Dutch company that makes paints and coatings, same thing.

So, we try to take advantage of that. Again, our view is the value of the business is not the next couple of quarters of free cash flow and earnings. It's the next three, five, 10, 15 and into perpetuity, discounted to the present value. That's what makes the business valuable. Mr. Market, unfortunately or fortunately, fortunately because we like to take advantage of it, is concerned about the next couple of weeks, months, and quarters. However, value is derived from today to perpetuity, and that is where a patient long-term investor could profit.

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