Fund Times

Global Gold

Laura Lallos

This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference. 

The final general session of the 30th Morningstar Investment Conference brought together two great minds in international investing: Diana Strandberg, director of international equity at Dodge & Cox and portfolio manager on Gold-rated Dodge & Cox International Stock and Dodge & Cox Global Stock; and David Herro, chief investment officer of international equities at Oakmark, and manager of several Morningstar Medalists, including Gold-rated Oakmark International.

Katie Reichart, a director with Morningstar Research Services, noted that both Strandberg and Herro have "proven their worth and made a lot of money for many people" over their long careers. She asked them to start the session with their assessment of how global investing has changed over time.

Strandberg started with what hasn't changed at Dodge & Cox: The management team's belief that earnings and cash flows drive fundamental value, and that "starting point matters a lot. The difference between a good company and a good investment is valuation."

What has changed, said Strandberg, is that corporate governance is better, as transparency and accountability have improved across the globe.

Herro observed that people still react emotionally, "forgetting the basic notion of investing is to buy low and sell dear." What's changed, though, is the pace at which information flows--which only exacerbates knee-jerk responses to events such as the collapse of Lehman Brothers, where "everyone collectively did the same thing without thinking, processing, digesting."

"Ultimately," Herro laughed, "that's probably good for investors like Diana and me, because we look at fundamentals."

Domicile Doesn't Dominate Analysis
Morningstar is currently developing geosegmenting analysis of portfolios, measuring geographic exposure on the sources of underlying companies' revenues, not the countries in which they are headquartered. With that in mind, Reichart asked whether domicile is important.

"Domicile doesn't tell much about risk and opportunity," said Strandberg. "We've seen some of the best corporate governance in Brazil, and been disappointed in the Netherlands." Instead, Dodge & Cox considers the global scope of the business, where it earns and owes money.

"We are not a big fan of certain countries, particularly Russia," said Herro. "We can deal with economic instability, but rule of law and ownership rights must be there. That said, domicile is one of the most overrated factors … companies based in Europe make their money all over the world."

Meanwhile, macroeconomics might obscure opportunity. Take Brazil, where concerns about the possible election of a candidate are knocking down stock prices. Itau Unibanco remains one of the best-run banks in the world, said Strandberg, with strong fundamentals and priced at around 10 times earnings, with a 5% to 6% dividend yield.

"There are risks, of course," noted Strandberg, "but this is an illustration of how the macro doesn’t always signal where underlying value is."

Similarly, while Herro is cautious about China because of government intervention in corporate affairs, he holds Baidu, which is growing strongly and is a leader in artificial intelligence. The hurdle is higher for such companies, though.

"When we look at a company based in China or Brazil, or any unstable environment, we require a higher rate of return," he explained. "With Google, the cost of equity is 9% or 10%. For Baidu, it's 14%."

Overlooked Opportunities
Both Strandberg and Herro own Naspers, a South African company that owns about a third of Chinese Internet giant Tencent. Strandberg has owned it for 10 years, while Herro recently added a position.

"We've been fans of Tencent for a long time; it is perhaps the best internet property in the world. Naspers was up significantly last year, but the underlying value of Tencent increased even more so, so the value gap was strong," said Herro. "And the rest of Naspers isn't so bad, either."

"The market cap of Naspers is $100 billion," noted Strandberg, "while the market cap of its stake in Tencent is $150 billion. So the market is valuing the rest of an unparalleled array of holdings at -$40 billion. We think it is worth $20 to $30 billion. We've been trimming back over the past year or so, however, as the valuation has risen."

"That's who we’ve been buying it from!" joked Herro.

On the other hand, Herro sold his stake in Honda, while Strandberg remains positive on the company. Herro believes the core auto business is underperforming compared to peers. Strandberg pointed to the strength of Honda's motorcycle business, with operating margins in the low teens, and believes that skepticism is priced into the stock.

They agreed that corporate governance is an issue for Honda and other companies in Japan, pointing to companies' tendencies to stockpile cash. 

"We are underweight in Japan largely because of capital allocation," said Strandberg. "We write letters to boards and engage with management in a friendly way to try to improve capital allocation and have seen modest success."

"Japan is ground zero of poor corporate governance," asserted Herro. "We tell them that we are investing people's savings and we have a responsibility to earn a return through our investments, and they should be working to generate earnings!"

Filtering Out Background Noise
Reichart wondered how issues such as Eurozone turmoil and U.S. trade belligerence might affect the managers' portfolios.

"You have to look company by company," said Strandberg. "We pay attention to the macro, but we view it through the lens of what's priced into valuation. Banks are down 30% to 40%, almost at financial crisis levels. But their fundamentals are vastly stronger, their asset quality is better, earnings are going up. Higher interest rates would be fantastic, but our investment thesis doesn't rely on interest rates. Macro concerns are obscuring improving fundamentals."

"Ultimately, a long-term investor should consider how a headline impacts cash flows," said Herro. "If it would have little meaningful long-term impact, then you can take on advantage of the noise."