Tue, 22 Apr 2014
Japanese and European equities drove returns for Oakmark International last year, but manager David Herro says it's a long-term positive to have exposure to emerging-markets consumers.
Jason Stipp: I'm Jason Stipp for Morningstar. It's Beat the Market Week on Morningstar.com, and today we are checking in with Oakmark's David Herro to get his take on where we are in the global markets and where he is seeing opportunities today.
David, thanks for being here.
David Herro: Thank you for having me.
Stipp: Your fund had a really stellar 2013. In a year when a lot of equity funds did quite well, what were some of the drivers of your success at your fund, Oakmark International, last year? What led you to do so well?
Herro: We were overweight two areas, two geographic regions, and subindustry sectors in those regions that did quite well. One is, we were overweight Japanese equities and we had been significantly overweight since post-earthquake in 2011. And, of course, last year in 2013, starting at the end of 2012, Japanese equities from the low point to the high point rose almost 90%. So we are overweight catching that market pretty much at its bottom. Though, of course, we didn't catch it perfectly at the bottom because we had to wait for a while.
Number two is Europe and European financials and European consumer discretionary stocks. Europe was another area that was out-of-favor. It's an area where we found very good value, and we exposed ourselves into some of these sectors, like the financials, the luxury-goods companies, the consumer discretionary stocks that we thought were good, well-run business franchises selling at low prices for short-term reasons.
Stipp: You have zeroed in on two very interesting parts of the global market right now. Let's start with Japan, and I'd like to get your take on the extraordinary stimulus efforts that we've seen from Japan contributing to that market's performance. What's your view of the market right now, given those efforts and the valuations on the shares of the Japanese companies that you own?
Herro: Clearly, the market has experienced a very, very strong rebound, and I would argue that share prices moved up at a quite more rapid pace than value creation. So the value gap shrank in Japanese equities. And as a result, our weighting from our peak is probably half of where we were. So there is still some companies we like. We are still exposed to Japan, but that extreme value doesn't exist as much as we have seen today.
So the first part of the performance of the market was based on the fact that the Japanese monetary authority was finally taking a serious approach to ending deflation. Now, if there is one country that should have had quantitative easing, it's that one because they have been in deflation for such a long time, almost two decades. And with that serious attempt to end deflation came a weaker yen and a better stock market environment.
Now there has to be a follow-through on structural reform, and we are still kind of waiting for that.
Stipp: Let's swing over and talk about Europe. Greece recently showed some ability to sell some long-term bonds in the market. Do you feel like the crisis that was causing such volatility in Europe, we can say pretty much we're through it at this point and we are in the clear as far as the systemic issues that we were seeing there?
Herro: I think we are certainly through the worst of it. The worst of it having to do with the fears of the European Union, the monetary union breaking up with massive sovereign-debt defaults. There were people who thought that Portugal was going to default; Ireland was going to default; Italy, Spain, maybe even France.
Of course, the only one technically that defaulted and even maybe it's not a technical default was Greece, and the rest of the countries were saved and the European monetary union lives. So that part is behind us.
The second part is structural reform, and been able to get some of these periphery countries growing again, especially since you don't have the exchange rate tool to work with. Now, Ireland was able to do it, and they did it through deflation. They did it through lowering their prices and thereby making them more competitive. Spain to some degree did the same thing as well as loosening labor rules. Italy is now trying to do that, and of course, France doesn't want to budge, but they may be forced to. So we're beyond the worst, but now what we need to see is follow-through. And that follow-through must come from structural reform leading to increased competitiveness, thereby allowing Europe to grow.
Stipp: We've seen the activities in Japan with the stimulus measures there. We've seem to be getting past some of the big crisis points in Europe. Both of these markets have responded to some of those issues in the improvement there. So, when you're looking for opportunities, whether it's Japan, whether it's Europe, or elsewhere, what does your opportunity set look like now that we've seen some of these markets get past some tough times or have some stimulus kick in and we've seen some good appreciation in those markets?
Herro: Clearly the markets aren't as rich and abundant of opportunities as they were a year and a half or two years ago. But we are entering a time period now of better economic growth, even though share prices aren't quite as low, better economic growth, better earnings growth. So valuations are still OK. They are still pretty good, given the fact that we've had such movements in share prices.
I think it's accountable because, A, prices were way low and valuations were way too low; and B, we got a pickup in earnings coming. So even with that share-price movement, we're still seeing some opportunities. As I said, not as much in Japan, but you know one of the areas that people have been avoiding, which to us has started to look attractive, are those companies which have exposure in emerging markets.
Western or Asian companies that have direct exposure selling to emerging-markets consumers have really been forgotten by this market rally. Companies like Diageo and Danone and even the luxury good companies like Ridgemont and BMW are selling at very reasonable valuations, and we believe it's a medium- and long-term positive to have this exposure.
There are still places where we can find value. It's just not as widespread as it was a year or two ago.
Stipp: You mentioned the emerging markets there, and that has been an area where there have been a lot more worries. I think it's not a secret or it's not a surprise that you might be looking to places that have exposure to emerging markets. One thing with the emerging markets that came up earlier this year was, as the Fed said it was going to continue its tapering, we saw some currencies really start to get upset because of the capital that was leaving some of those markets. So when you're thinking about currency and currency risk as an international investor, how does that factor into your process?
Herro: We kind of look at it in two ways. First, is when we buy a foreign stock, we're buying a foreign currency. We have to decide yes or no, do we want to hold the foreign-currency exposure? And whether we hold it or not is dependent on kind of its valuation, its purchasing power parity valuation. So if that currency is more than 20% overvalued, we will hedge some of that currency risk out of the question, out of the formula here to make sure we're not exposed to overvalued currencies. We never hedge for more than we own. We don't want to take a naked currency bet, but if it's an overvalued currency, we will try to ensure against some of that depreciation.
Stipp: Last question for you. As you look at across the global markets today, are there any risks that you think are underappreciated, that are on your radar as worry signs for you as a fundamental investor, that maybe we should be paying a little bit more attention to.
Herro: I think one of the biggest risks is as investors and companies, we are capitalists, we are owning part of capital. There seems to be more hostility toward owners of capital. Look around the world at companies getting fined, whether it would be here in the United States or it's in Europe, companies are kind of being harassed. So there seems to be this new view by governments who need money, "We'll get it from the shareholders; we'll get it from the companies." That's one risk.
And I think the other risk that's always something we have to watch for: If goods and services and capital are prevented from freely flowing across the globe and across borders, that's not a good thing. Because we want to be able to make sure that we could get in and out, that goods could get in and out, that capital could get in and out in an easily fashion. It's always something we have to watch for, and we have to be mindful of countries that are making it hard and governments that are making it hard for the free flow of goods and services.
Stipp: David Herro, it's always fascinating to get your insights on the global markets. Thanks for coming in and joining us today.
Herro: Thank you for having me.
Stipp: For Morningstar. I'm Jason Stipp. Thanks for watching.