Tue, 22 Apr 2014
The Oakmark manager notes how a long-term view, with strict buying and selling discipline and preparedness for short-term weakness, has allowed his international fund to beat its peers.
Jason Stipp: I'm Jason Stipp for Morningstar. It's Beat the Market Week on Morningstar.com, and today we're going global with David Herro, manager on the Gold-rated Oakmark International as well as the Oakmark Global Select and Oakmark International Small-Cap funds. We're going to learn a little bit about his process and how he has been able to be so successful in the international-investing world.
David, thanks for coming in today.
David Herro: Thank you for inviting me.
Stipp: Let's start big picture about how you run your fund, the process that you use to select investments. What's in? What's out? How do you know that something is an investment you're going to want to hold?
Herro: We take a very bottom-up approach. That is most, if not all, decision-making is based on the underlying attractiveness of the stocks themselves. So we're looking at businesses, and we're looking for companies that meet our specific value criteria, which is really the combination of two concepts: companies that are low in price but are high in quality, where price is determined by the cash flow streams--and we have to pay for those cash flow streams--and quality is determined by the returns that the management owns and the capital-allocative proficiency of that management team.
So those investment decisions are based on companies that meet those value criteria.
Stipp: High-quality companies, but the low-end price part means that the market must not be agreeing with your assessment somehow or there is some dislocation between the price and those underlying fundamentals? What are some of the risks you might say you're taking on by buying something that, to you, looks underpriced, but to the market perhaps not so?
Herro: Yes, a lot of it does come down to timing because the market is inherently impatient. It is inherently short-term focused, and because of this we have opportunity to buy quality at low prices. If we're going into an economic slowdown, the market might want to flee all consumer discretionary stocks or all heavy industrials, whereas, we have the luxury of looking through the cycle to take advantage of it. So that's kind of one of the ways we're able to outperform.
However, if we're early, that is one of the risks--that the market still might dislike something. We like it because we're looking medium and long term. Yes, we're probably going to be right in the medium and long term, but in the short term we might cause some underperformance.
Stipp: You're really taking advantage of what some call the time-horizon arbitrage, that you can look a little longer term than the market can look. What kind of holding period would you expect to have? How long are you looking out?
Herro: I almost prefer perpetuity. So if we buy a company at a certain price and if the management team continues to build value per share and if we buy it at a discount to what we believe is that intrinsic value and the price doesn't keep up with the value creation, then I guess we could hold that forever.
In reality, that doesn't happen. Mr. Market could be very emotional, and with any good news it might spike up. So generally speaking, we model a company based on five years. Our portfolio turnover suggests a three-, four-, five-year holding period, though some stocks we've held for more than a decade.
Stipp: David, looking either at something in the recent past or more historically, is there an example of a pick that you've had that exemplifies your process, that you would hold up as a prime example of the way you look at stocks?
Herro: A couple years ago, I think we did an interview and it was during the European financial crisis, where no one wanted to invest in any banks. We identified a high-quality Italian bank called Intesa Sanpaolo. It was one of the best capitalized, it had a solid balance sheet, and it had a good business franchise in the north of Italy, which is a very wealthy, very heavily industrialized area. But because of the sovereign-debt fears in Europe, the share price went to below one third of its tangible book value.
And we thought that the sovereign debt of Italy was not going to be a bad bet. That is, banks own the sovereign debt of the country therein. U.S. banks are on Treasury securities; Italian banks are on Treasury bonds. So we thought, Italy is not defaulting, and this is a quality bank with a good business franchise. And even though it was a bank in Italy, in the financial sector, in Europe, out-of-favor, and low-price, we thought this is going to be a very good investment. Sure enough, it's more than doubled off its bottom and still at this stage we hold the investment. We still think there is upside even though it's doubled.
Stipp: I want to talk a little bit about you might call it the secret sauce of your process. A lot of people will say, "We look for great companies, and we want to buy them at a good valuation." But it's not necessarily an easy methodology to execute, and you've obviously had great success with what seems like a very simple way to look at the investing world. What is it though, when you're executing, what do you have to have to be able to do this right, and you've obviously been able to do it right for quite a while?
Herro: There are two parts of the process. So we're basing our investment decisions on valuation. A, we have to get the value right, or we have to come close. We don't have to be perfect. We're more or less within 10% or 15% of that valuation 75%-80% of the time.
And, B, if we act upon our conviction, that's the second part. That's often the hardest part. It's often people like something, but because share price falls, or because it's temporarily out-of-favor, they refuse to add to their holding. Or if it's gone up they see it going up and even though it's hit intrinsic value, they want to get all greedy. They want to keep riding the winner even though it's hit what you believe to be intrinsic value.
So, A, you got to be able to price something right; and B, you have to have the courage of your conviction. You have to be able to truly buy a quality business, that's falling for nonfundamental reasons, and you have to sell a business as it hits its price point. You have to have that discipline. I think that second aspect is what we do very well where that discipline comes in that perhaps others do not have.
Stipp: I imagine that behavioral aspect might be the answer to your next question. There are certain investment philosophies that will work for a while and then they'll stop working. Other people catch on, they'll see that there is an opportunity, and the opportunity is arbitraged away, but the process of value and being able to execute it well has worked for a very long time. It's likely to continue to work into the future. Why do you think your strategy will continue to stand the test of time? What about it will make it durable?
Herro: It's just really intuitive. It makes sense. Identify price, buy low, and sell dear. Whereas all these other things, these momentum strategies, I was listening on Bloomberg radio driving home from work, and they were talking about sector rotation and when the sector is hot, you got to ride it. And I thought, "Oh, my gosh." It is the antithesis of how we invest.
We just try to do what we can measure, where we have a reasonable chance of success. That is, we can measure intrinsic value of the business, not perfectly, but with a reasonable chance of success. But then, of course, you got to have that discipline I spoke about.
I think actually the third part is, you can't be afraid to underperform in the short period. If you're constantly trying to match short-term results, guess what, I don't think you're going to perform over the medium and long term.
So I truly believe that there is a trade-off between medium- and long-term results and short-term results, and we are more than willing to give up short-term if it means more for medium and long-term. But you have to be able to explain that to a client. That's not easy. They want it now, and we have to be able to explain to them, "Be patient; we're doing this for the medium and long term." And I think a lot of even professional investors would rather not be put in that position where they have to explain short-term underperformance. I think it's part of my job.
Stipp: That's very much related to the last question I want to ask you. As an investor, going into Oakmark International, for instance, what should I know about how that fund will perform over a full cycle over a longer period and a shorter period? When might the fund not look like such a great investment, and what do I need to ride through in order to really appreciate the longer-term results that you've had?
Herro: In our nearly 22 years of history, I found there are two types of market conditions where we underperform, and one is when there is extreme value somewhere because we will be in there picking through that value, looking for the good-quality companies, but with us not being perfect investors, we won't be able to buy them right at the bottom. When we see extreme value will be there trying to take advantage of it. But in the meantime, we might be a little early and thereby causing us underperformance.
The other extreme is true as well, when you have extreme overvaluation and when you have an overly euphoric market, we'll be on the sidelines watching, waiting for share prices to come down, staying out of what I believe is kind of a train-wreck disaster-type of scenario. And in those periods, because momentum is winning, we will be on the sidelines, and we will underperform, as well.
I think those two extremes--where there is extreme undervaluation where we'll be early, perhaps too early, and extreme overvaluation where we don't want to participate, because it's above all euphoria--those are the different kinds of periods where we don't perform in line with the market.
Stipp: David Herro of Oakmark, thanks so much for telling us a little bit more about your process and how your fund is operated so well over the years.
Herro: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.