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Herro: Tune Out the Macro White Noise

Oakmark's David Herro encourages investors to not be paralyzed by the excessive distractions found in Asia and Europe, pointing out there's still value to be had. 

Liana Madura, 01/25/2012

As portfolio manager of Oakmark International OAKIX, David Herro joins us again for a Fund Manager Q&A feature, discussing why selling at first signs of trouble might be overreactive and that instead of focusing on the European crisis as a whole when investing, it's important to look at where companies are making their money. He also gives us some examples of companies that are currently trading at deep discounts, and tells us why the energy sector does not look promising at this time.

1. Investors moved out of Japan after the tsunami hit in March 2011, and as economic turmoil and uncertainty rises, investors are hesitant to put their money in financials stocks. Despite the general consensus, you tend to move in the opposite direction and actually increased the fund's exposure in both Japan and the financials sector. What gives you the confidence to make these moves against the trend, and what would you say to an investor who is worried about the potential increase in risk by doing so?
Our belief is that the value of any business is a function of all cash flows from the present to perpetuity. Natural disasters, such as last March's earthquake and tsunami in Japan, are short-term phenomena, and though they may hurt businesses for a quarter or two, they have only a small impact on value because only a small part of the future cash flow stream is affected. They are not indicators of structural problems, but the market tends to aggressively sell at the first sign of trouble. Japan continues to lead the world in terms of discounted valuation. In late 2011, the Japanese market was trading at less than 1 times book value, and companies were seeing rising profitability despite a very strong yen. The tsunami and, later, the prolonged flooding in Thailand really slowed corporate activity, but we expect to start seeing increased business activity and greater profitability, and perhaps even a V-shaped economic recovery for Japan.

On the financials, it is widely assumed that all financial institutions in Europe are under duress as a result of the sovereign debt crisis. But those who look past the apocalyptic headlines can find healthy, well-capitalized, and profitable companies. This is not the best of times for these companies. However, they are still making money, and their shares are selling at well below half their book value. We think those who use the daily headlines to make their portfolio decisions provide a buying opportunity for those of us interested in acquiring good-quality businesses caught up in the short-term run for the exits. We are not particularly worried about the risk of trying to buy good companies on the cheap and for the long term. As we see it, the real risk investors face is overpaying for such assets during periods of market euphoria.

2. Do you continue to hold the same view in that the market is overreacting to the current eurozone crisis and economic uncertainty in the United States? Why or why not? What's different about the current market situation compared with what you've seen in similar scenarios during the last 20 years?
As I alluded to in the previous answer, yes, there is some short-term overreaction in the market. But I'll provide a little elaboration on that theme. First, one needs to be careful when making broad statements about the economics of Europe and the eurozone because neither are homogeneous. We see Northern Europe as being relatively healthy, while most of Southern Europe is not so healthy. Conditions look to be improving in Eastern Europe, and you have a mixed bag in the western portion of the continent. All this said, there's no doubt that parts of Europe are in crisis.

But we judge businesses not by their country of domicile, but by where they make their money. Many market participants take a contrasting view, so the macroeconomic challenges scare them. Because we are concerned with cash flow streams over the long term, we believe short-term, macro-induced panic enables us to find and purchase good companies with global asset bases, global revenue, global cash flow, and global profits that just happen to have their headquarters in Europe.

Regarding the eurozone, I believe that its current troubles will strengthen the ties between the members. This has to be the outcome for Europe to remain relevant; if the eurozone doesn't become more integrated fiscally and monetarily, its position on the world stage will diminish as the U.S. and China assume a greater role in global economic policy.

3. What do you think investors should be paying close attention to in this market?
I think investors need to focus on the degree to which the so-called white noise of macroeconomic worry is hampering the market's ability to objectively analyze companies on their individual merits. It seems that an entire sector gets flushed at the slightest whiff of worry. How else can you explain what happened to Daimler DAI in the second half of 2011? The carmaker lost nearly half of its market value between late July and late November, and this was during a time that Mercedes-Benz had some of its best sales ever. BMW saw strong sales, too, and it lost one third of its market cap during the same time period.

I see a level of anxiety in the financial markets that is not fully embraced in the consumer market. And as long as that fear does not overtake the consumer, I see brighter days ahead that could help settle equity markets. Some parts of Europe appear to be heading toward recession, but the global economy is expected to grow 3%-4% this year. The U.S. is seeing accelerating growth, and Asia, including Japan, is growing at a meaningful rate. Growth at or close to 4% bodes well for increases in corporate profitability. When one combines low valuations with economic growth, it is generally positive for stock prices.

Liana Madura is an assistant site editor with Morningstar.com

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