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Where the Hunt for Value Begins

John Coumarianos

John Coumarianos: Hi, this is John Coumarianos, senior mutual fund analyst at Morningstar, coming to you today from our studio in Chicago. And I'm delighted to have David Herro with us. David is, of course, the winner of our International Manager of the Decade award. And we awarded David this prize based on his work on three funds: Oakmark International, Oakmark International Small Cap, and Oakmark Global Select.

The first two funds have 10-year records. Oakmark International has produced a 119% cumulative return from January 1, 2000, through the end of 2009, while Oakmark International Small Cap has produced a 162% cumulative return over that time. And all that while, the MSCI EAFE Value Index has produced a 41% cumulative return.

David, congratulations on such an outstanding performance, and thanks so much for joining us today.

David Herro: Thank you, and thank you for giving me such an outstanding honor.

Coumarianos: You're very welcome. You've really earned it.

Before we jump into the portfolios, I wanted, for the benefit of the viewers, to basically tell us how you begin your research efforts as a value investor. Many value investors, of course, begin by simple screening on price-to-value metrics, and I was curious how you began.

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Herro: Well, what we try to do is look for companies that really fit our investment criteria, which is value, but which is further divided into companies which are low in price but high in quality. And "high in quality" is somewhat subjective. It's somewhat qualitative. So, yes, to first unearth value, you often need to do some quantitative screening, or sometimes these names just come up because of the frequent company visits we do.

So though a company may be cheap on paper, that may have been the original indication that perhaps there's value. And note, I'm distinguishing between cheapness and value, because the two, in our eyes, are very different things. So the first step is sometimes quantitative screening, but that's certainly just the first step.

Coumarianos: OK. Tell us, also, how many analysts you have working with you at Oakmark and how many are dedicated to the international effort.

Herro: Well, of the international group, there's, including myself--and I still do a lot of analytical work--nine analysts. Now, the whole global research team at Oakmark, the Harris Associates, the advisor, is 22 or 23 analysts, of which a little less than half do segregated into the international sector.

Coumarianos: And do the analysts typically build models for a variety of companies and have them ready when a company maybe misses earnings? Or if something comes across a screen or misses earnings and captures your attention, then the real work begins and the models start being built?

Herro: That's a great question, because it's actually both of the above. For instance, an analyst may have spent a lot of time doing work on a company, but for some reason, something just wasn't right. Maybe the management team was viewed as less than satisfactory to us. Maybe the price wasn't right. There was just something wrong. But maybe they really liked the business.

So if the management ever changed or if the price ever got cheaper, they would set it aside and keep an eye on it. And that's, I think, your first example of all of the sudden something happened, and we could spring back in action, freshen up numbers, do work again.

And in other times it is just that it's something you're watching. It missed. It was too expensive. But now it's no longer expensive because of a very, very short-term prospect. That is, if something non-structural happened that caused the price to drop, that is something that is perhaps actionable on our part. Again, the key there is "non-structural." And the opposite of that would probably be cyclical. So for some short-term reason, the stock is out of favor and gives us a reason to spring into action.

Coumarianos: And of course that's really how most value investors make their money: the fact that the rest of the market is so short-term-oriented. If you see a temporary problem, the stock drops, but the overall business value, over the long term, doesn't really drop.

Herro: That is exactly right. To most value investors, that's is what we live and breathe and survive on is the short-term-ism in the marketplace, and exploiting the fact that markets move based on very short-term occurrences within a company, when in fact the value of a business is determined by all cash flows, discounted to the present value, not just the cash flows of the next couple quarters.