Tue, 24 Jun 2014
Unless a fragile market triggers outflows, the Oakmark International fund is likely to remain closed to retain its flexibility and concentrated portfolio, says manager David Herro.
Gregg Wolper: Hello, I'm Gregg Wolper, senior fund analyst at Morningstar.
I'm here at the Morningstar Investment Conference in Chicago with David Herro, manager of Oakmark International, Oakmark International Small Cap, and Oakmark Global Select Fund. We have a few questions for David, and I'd like to start off with the question of the closing of the fund itself.
Oakmark International Fund grew in assets over recent years, tremendously, bringing in assets from interested investors. Last year you decided to close it to new investors. What was your reasoning there, and what would it take to reopen the fund?
David Herro: The reasoning was, we are an extremely performance-driven organization. And at times if you grow too fast too quickly it may limit your ability to perform as we want to; it might limit that flexibility.
We're bounded by two conditions. One is we want to stay concentrated. We want to keep the portfolio at 50-55 stocks, the top 10 names perhaps being around 30%. And we don't want to own more than 10% of a large group of companies. So those are the two things that bind us. And as money was coming in, we wanted to slow those flows of new assets so as not to limit our flexibility, not to limit our ability to stay concentrated without having to hold large positions in companies. So that's why we did it; we want to remain flexible. We want to still be able to achieve the types of numbers we have in the past.
Wolper: And what sort of signs would you be looking for to think about reopening to new investors.
Herro: I think if the markets became extremely fragile, and we started to see outflows, and size of the fund shrunk, then we would consider reopening, but without those things happening--and by the way, I don't think they are going to happens because I think the fundamentals are pretty good. So don't look for us to open soon, but if for some reason, we had a situation like '08 and '09, in a situation like that we'd reopen the fund.
Wolper: You do a lot of traveling, a lot of talking to managements of companies, and that's something that shareholders and outside investors can't really get a handle on--what really goes on in those discussions? So could you tell us, what are you looking for in these discussions? What do you find out?
Herro: I have to tell you, Gregg, that is one of the most enjoyable, if not the most enjoyable aspect of my job--sitting down with management teams and trying to learn and understand what makes them tick.
More importantly, since we're interested in companies that could grow value per share, does that management team have the tools and the desire to be committed to value creation? That means, how and why are they earning appropriate returns, and capital allocation. What are their plans for their free cash once it's generated? And better yet, to go back and question them. We have a clear idea on what they did with the money in the past. And for the things that worked and didn't, we like to question them, understand how they think and try to get an idea about what their priorities are going forward.
Because really ultimately, what we're looking for are managements that do what we want them to do, and that's build this value per share. And in order for us to get comfortable with that company, we have to sit down and meet the managements.
So we're not interested in short-term performance, or what does their business look like for the next couple of quarters? What we are interested in is, how are you going to get good returns? How are you going to maintain good returns, and how are you going to allocate the free cash which your business generates.
Wolper: Some of the companies that you own and seem to like the most are ones that are based in developed markets, such as Europe, but get a lot of their revenues from emerging markets. Now in the past that seemed an obvious play, because emerging markets were growing so fast and everyone wanted to get in on them. The only question was, how? But in the past couple of years, some of the emerging market economies have slowed down. People are getting concerned. So, is there still the same attraction for you for these European or Japanese companies that have emerging-markets exposure?
Herro: Even more so. We're more attracted today than we were. Why? Because the prices have dropped as a result of some of these fears that you have mentioned. People see that some of the emerging-markets countries are going through a cyclical, not structural, but cyclical downturn. At the same time they've had weakened currencies. Basically, these are two headwinds to doing business in the EM, both of which we think are unnatural and unsustainable. Over time you'll continue to see good medium- and longer-term structural growth in EM. And at the same time, some of these currencies which have become almost undervalued now should go back to fair valuation.
So the two headwinds to doing business in EM, we believe, are temporary. They are cyclical and not structural. In the meanwhile, the market has seen that and just kind of freaked out and has sold down shares in companies that do business in EM, and we think ultimately it's a good thing and not a bad thing.
Wolper: You mentioned currencies. A lot of international fund managers just let their foreign currency exposure ride; they don't hedge that exposure back into the dollar. You have done that over time, and currently you are hedging some currencies. I'm curious why you've made the decision to engage in some currency hedging, and how you go about making those decisions.
Herro: When you buy a foreign stock, you automatically buy the currency that company is domiciled in. So you own it, you hold that currency, and you have to decide: Do I like the currency, do I not like the currency? Our view is, unless that currency is significantly overvalued, more than 20% overvalued as measured by purchasing power parity, we'll just hold the currency.
So if it's undervalued, we want to hold it. If it's fairly valued, that's fine. If it's a little bit overvalued, we'll still hold it, but if it's significantly overvalued to us, than it becomes risky holding it, and as such we will then hedge some of that exposure back into U.S. dollars. So the barometer we use is purchasing power parity as a level of value for that currency. But it's extremely inexact, and as such, we only use it when there is a significant overvaluation.
Wolper: And is that primarily your decision? Some firms have a currency desk or a currency team that helps out. How are those decisions made?
Herro: I developed the methodology and a discipline, and I used it in my previous two employers, and so I have just carried it on. It's a decision tree that I've developed, but our team reviews it together formally twice a month to see where we're exposed, where currency values are, and then we'll take the necessary steps.
Wolper: Let's talk about one stock in particular to wrap this up. Your largest holding is Credit Suisse. You've had that for quite some time and sometimes that has been getting in the news with some controversial issues. But it's also one of the most prominent financial firms in Europe. What is it that you like about Credit Suisse, and do you still like it as much as you always did?
Herro: Yes. Credit Suisse has two parts to its business. One is a private bank, which is basically an asset gatherer and managing money in these funds for high-net-worth individuals. In fact that was where they really got in a little bit of trouble, because some of their clients were putting deposits into overseas funds without reporting them.
Now in Switzerland, it's against the law to disclose the names of your clients. In the United States, the Justice Department wanted to know those names. So Credit Suisse was caught between a rock and hard place, and ultimately it had to pay a big fine.
But generally speaking, that wealth management business … they are one of the largest wealth managers in the world. Revenues and profits grow mid-single-digits consistently through time. They get get net new money and then there's the appreciation of those assets. So that is a really good business.
The second of part of their business is investment bank. Now their investment bank, after learning hard lessons around the TMT bubble, has de-risked itself. You didn't see huge write-downs and huge losses on all the CMOs and these things at the other investment banks. So they did a very good job at preserving value there.
When you combine the two entities, you see a combined business that generates good cash flow streams that sells, in our belief, under 10 times normal earnings and less than one times book. So we think this is a very good dynamic for a company that, from here, should be growing cash flows by at least mid-single-digits over the medium and long term.
Wolper: Thank you very much David, and thank you for appearing at the Morningstar Investment Conference on a major panel. For Morningstar at the Morningstar Investment Conference, this is Gregg Wolper.