David Herro: 'We Are Not at All Afraid to Vary From an Index'
The portfolio manager of Oakmark's International funds talks about bargain-hunting during the pandemic, ESG and risk management, and why he's not complacent about inflation.
Our guest this week is David Herro. David is chief investment officer of international equities at Harris Associates and serves as deputy chairman and portfolio manager for a number of Oakmark funds, including Oakmark International. Prior to joining Harris Associates, David managed international portfolios for the State of Wisconsin Investment Board and the Principal Financial Group. Morningstar's analysts named David International-Stock Fund Manager of the Decade for 2000 to 2009 and International-Stock Fund Manager of the Year for 2016. He holds a bachelor's degree from the University of Wisconsin-Platteville and a master's from the University of Wisconsin-Milwaukee.
“Market-Beating Money Manager David Herro Says It’s Time to ‘Gently’ Buy Some Stocks,” by Jesse Pound, cnbc.com, March 16, 2020.
“The Next Generation of Would-Be Buffetts--and the Stocks They’re Buying Now,” by Reshma Kapadia, barrons.com, May 21, 2021.
“Oakmark Global Fund: Second Quarter 2021,” by David Herro, Clyde McGregor, Tony Coniaris, and Jason Long, oakmark.com, July 8, 2021.
“Oakmark Global Select Fund: Second Quarter 2021,” by David Herro, William Nygren, Tony Coniaris, and Eric Liu, oakmark.com, July 8, 2021.
“Oakmark International Fund: Second Quarter 2021,” by David Herro and Michael Manelli, oakmark.com, July 8, 2021.
“Oakmark International Small Cap Fund: Second Quarter 2021,” by David Herro, Michael Manelli, and Justin Hance, oakmark.com, July 8, 2021.
“The Case for European Financials,” by David Herro, Jason Long, and Justin Hance, oakmark.com, March 24, 2020.
“Investor Insight: David Herro,” Value Investor, Oct. 30, 2020.
“David Herro Comments on Glencore,” by Sydnee Gatewood, gurufocus.com, July 9, 2020.
“David Herro on CNBC’s ‘Closing Bell,’” oakmark.com, Jan. 1, 2021.
“David Herro on ‘Squawk on the Street,’” oakmark.com, June 24, 2021.
“Herro Holding Credit Suisse Slumps Amid Archegos Fallout,” by John Coumarianos, citywireusa.com, March 30, 2021.
“Major Credit Suisse Investor Mulling Exit?” by Katharina Bart, finews.com, April 1, 2021.
“Credit Suisse Investors Target Board Over Archegos, Greensill Failures,” by Margot Patrick, wsj.com, April 26, 2021.
“Danone Announces Appointment of New CEO; No Changes to Thesis and Fair Value Estimate,” by Ioannis Pontikis, Morningstar.com, May 18, 2021.
“Manager Adopts Climate Measures After Investor Pressure,” Bloomberg.com, April 7, 2020.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer at Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.
Ptak: Our guest this week is David Herro. David is chief investment officer of international equities at Harris Associates and serves as deputy chairman and portfolio manager for a number of Oakmark funds, including Oakmark International. Prior to joining Harris Associates, David managed international portfolios for the State of Wisconsin Investment Board and the Principal Financial Group. Morningstar's analysts named David International Stock Manager of the Decade for 2000 to 2009, and International Stock Manager of the Year for 2016. He holds a bachelor’s degree from the University of Wisconsin-Platteville and a master’s from the University of Wisconsin-Milwaukee. David, welcome to The Long View.
David Herro: Thank you for having me, inviting me today.
Ptak: Well, it's our pleasure. So I wanted to start with big picture and it seems like a logical place to start, is the pandemic--as a global portfolio manager, the pandemic must have presented a challenge given how accustomed you and your colleagues are to traveling the world to meet with companies and conduct research. Were there any unexpected benefits you feel you reaped as a team from this experience? And conversely, what did you find you missed the most?
Herro: I think the benefit was the demonstration that we were able to work flexibly. We were able to improvise and adapt to the situation. And I thought, given the technology we have today versus if this were to happen 5, 10, 15, 25 years ago, I think these lockdowns would have been a lot more severe to our team, to our business, to the economy. But with technology today, with the ability to do video meetings, calls, and these types of things, I think the pandemic's impact on work was far less than it might have been without technology, which provided us with this flexibility.
As far as the negatives, I would say the biggest one is having us be unable to meet face to face with managements and even clients. It is very important for us when investing in a business as we are long-term investors, often we own a stock for more than 5 or 10 years, to really get to know the management team, the people who are running the businesses which we're investing in. And though a call works, it's much better, much better, especially on initial introductions, for us to be face to face. And I think we missed this. I think the good news was that our management teams offered extremely good access during this period. No one ever refused the call. They usually happened promptly. This was very pleasing. However, it's still, especially in new businesses and new investment ideas, it's just suboptimal. You want to see body language, you want to see facial expression, you want to see their work environment. All these things are very important to us. We've just now started doing some in-person meetings. And hopefully it will accelerate this fall. But by far, this was the biggest thing we missed.
And the second thing is the team element. We have a very open-door policy at our office. We want people discussing ideas, bouncing ideas off each other. We want people to get to know what makes each of their teammates tick. Get to know them personally, professionally, etc. And the work-from-home thing clearly was not conducive to this; it was not conducive to building even better team cohesion. For that I think you need to be in person. And so, I'm happy that in June of 2020, Harris Associates kind of reopened, not mandatory or not for everyone. But for those who could. On average, we had, I think, close to a third of our 200-ish employees on premise. But at least it was a start. At least it was a start and we were able to kind of rebuild some of that cohesion that is needed for effective teamwork.
Benz: Switching over to discuss investing, you're a bottom-up stock-picker and we know that you don't focus on trying to predict macro trends. But those trends can have an impact on your holdings. Fiscal and monetary policy has been extremely loose during this period. What implications has that had for the way that you pick stocks and manage the portfolio?
Herro: Well, to be honest, the swiftness of the actions on fiscal and monetary policy early during the pandemic, is what gave us confidence that we would have a less impactful downturn as a result of the economic lockdowns. All across the world, central banks and governments reacted swiftly, I think this has to be a record. And this gave us confidence that the valuations in our businesses, though we had to adjust downward for most of them, that in the ensuing years--in years, two, three and four, think of a discounted cash flow model--you're projecting three or four or five years out, and then you're using a perpetuity formula. And what I'm trying to emphasize is that the downturn that happened in year one, early in the pandemic, as a result of this policy would be shorter, and therefore your valuations are less impacted. And so, I think this was one of the lessons of trying to integrate the aggressive fiscal and monetary policies that were used globally. And it really gave us more confidence in our valuation numbers. There would be a backstop. And then when you add to the fact that many people were still working--albeit from home, for the reasons I stated earlier, because the ease and convenience and technology we have today--it really meant that the economic impact was shallow. And we were confident that once the worst of the pandemic got behind us, we'd get back to business as normal, which in essence has happened.
Ptak: That's a good segue, actually to another question that we wanted to ask you about, which is related to none other than Warren Buffett, who had indicated previously that a reason Berkshire hadn't done any big deals is because once the Fed intervened, it dramatically lessened the need for firms to seek capital from Berkshire. And so the question that we had teed up is whether you observed a similar effect among the non-U.S. firms you follow in whether that limited some opportunities? But based on your previous answer, it maybe sounds like that it buttressed your confidence in owning some of the more cyclical names that you had in the portfolio, knowing that that backstop was going to be there. Is that the case?
Herro: Given the fact that Mr. Buffett--often you almost call him the Grave Dancer, like Sam Zell, he looks for companies that really, really need capital and then provides it to them. And he's a very what you'd call a very active investor. And he does so at very generous terms to Berkshire Hathaway. If you recall, he did this during the great financial crisis. We have a very similar philosophy on looking for undervalued businesses and investing for the long haul. But we kind of limit ourselves to investing in companies that are already trading and aren't necessarily seeking to inject their balance sheets with fresh capital.
The beauty of what happened in March--now it was painful. But you had an extreme knee-jerk reaction, that even companies with sound balance sheets that did not need capital, saw extreme negative price reactions, especially ones that were tied to the real economy; not tech sectors, but industrials, financials, materials, in particular, were clobbered. They did not need capital. But their share prices behaved almost that they would need an emergency capital. I take the German auto companies as a perfect example. Both Daimler and BMW had net cash on their balance sheet. And yet both of them lost 70%, 80% of their value at one point at the low, maybe 60%, 70% of their value, at one point of the low in spring in 2020. So, they didn't need capital, but their prices were selling and behaving that they did need capital. And the share prices were so weak, it gave us an excellent opportunity to increase our positions in these world-class brands, these businesses with strong balance sheets, that in our view, when normalcy return, you would see a strong market reaction in terms of orders and sales.
Benz: Some of the firms that you invest in have balance-sheet issues that they're addressing. However, money remains very easy. Given this, do you think a durable, globally diversified business like, AB InBev, which you own, ought to be paying down debt the way that it has been? Or would you prefer to see them put that capital to other uses, like cap-ex or making acquisitions. In general, how do you assess decisions like these in this climate?
Herro: Christine, this is a very, very important part of what we do is analyze a management team's capital allocation policies, and judge their prowess as stewards of our capital by how well they make this decision on what to do with the free cash which they generate. You mentioned actually one of the few companies that I would say has a bit of debt that we invest in is AB InBev, the big global brewing company, the biggest global brewing company. And the reason why we're somewhat comfortable with their debt levels is because of the stability of their cash flow streams. Clearly, it was our view, and when we made the investment, that they did have a bit too much leverage, and that they were, as a priority, going to work some of this leverage down. And that's exactly what they've been doing--they've made a few asset sales, and generally speaking, had been using free cash to pay down debt.
Now they can carry more debt than typical companies because of the stability of their cash flow streams. But still, as a result of the rather aggressive M&A of the past, they had a very, very large debt position, which we thought was too high. And we invested in the business, a fairly recent investment, based on our belief, and based on their statements that they were going to delever some of that, and thankfully, they're sticking true to their word. As of now, this is exactly what they're doing. With rates this low, we don't think companies should be shy from issuing debt. In fact, there are examples of European companies that we own that in the last year issued debt at near a zero interest rate. And as long as you take that money, and you deploy it in a way which contributes to shareholder-value creation, we think it's a good thing.
In general, I will say this, though: all else being equal, I would prefer companies to err on the side of less debt and a stronger balance sheet than what the financial theories, formulas will tell you. Why do I say that? Because these theories don't take into account the qualitative costs of high debts, especially in terms of flexibility when there's a downturn. If you have too much debt on your balance sheet, and there's a downturn, just when you want to be on the offense, you can't; you have to be on the defence, because you're being strangled by the debt. And with that comes bankers, with bankers comes conditions and covenants and terms. The last thing you want to worry about in a downturn is dealing with bankers and covenants, and these sorts of restrictions on what you can and can't do. You want to use a downturn to be on the offensive. And this is why I believe that whatever the financial models say, it's too much debt. You should always have a strong enough balance sheet where you have flexibility.
Yes, interest rates are low today. But that doesn't mean you automatically pile up. If you're underleveraged, and you can take on debt while still having this flexibility, especially at these rates, I believe it's a good thing to do. But too much of a good thing is a bad thing. And you have to be careful with putting too much leverage on your balance sheet. But I think it is distortive given where rates are today. Because people have to think not just at today's rates, but especially if it's a variable rate structure, it could go higher sooner than you think.
Ptak: We'd be remiss if we didn't ask you about what's the watchword right now, which is inflation. It's on people's minds. How concerned are you about it? And has it informed any decisions you've made recently in the way you pick stocks or structure the portfolio?
Herro: Well, I am concerned about it. My emphasis in graduate school was monetary theory. And I was taught by a very strong monetarist in graduate school. And I'm a believer in Fisher's MV = PQ, money times velocity equals the price level times output. We have not had inflation in the last decade or so, despite money supply going up, because we've had a massive, massive, massive build-up in reserves in the global banking system which has caused a decline in velocity. So, the money that has been expanded has not been multiplied through the economy because banks have been forced to increase reserves. Just think about before the financial crisis, tier-one reserves were somewhere around 5% or 6%, now they are at 12%, 13%, 14%, 15%. So, reserves have more than doubled and tripled. This has been globally--this is a global phenomenon of basically banks hoarding capital.
What we're seeing today is the banks are at their capital positions after this 10- or 11-year build-up; they don't need to build up anymore. And I believe that the money that is being produced will eventually start getting multiplied through the system, and not just hoarded in terms of sterile reserves. And this will have an impact on inflation. When you add to this, the fiscal policy, especially in the United States, Europe has not been as expansionary because they've used other tools to get their people through the pandemic. But the United States has kind of spent--we've had a couple of pandemic stimulus bills that have passed. And there are a couple more proposed. Well, you just can't keep doing this without having an impact on inflation, especially since it's coming at a time when the global economy is reopening. Thankfully, the global economy is not reopening all at once. Because as we're seeing supply chains and logistics systems couldn't handle it. It's opening in stages, even within the United States, it's opening in stages. All these things are going to pressure inflation, whether it's excess monetary policy or fiscal policy, you're going to see an impact on inflation. And I do think authorities, monetary authorities, are being a bit too reserved about this. I think they're being fooled by the last 10 years of low velocity. And if that velocity of money picks up, then they're going to have to really act quicker than we think.
So, our portfolio is somewhat positioned for this because where we're finding value today are in the financials and some of the industrials and some of the materials companies, this is where we're overweight. And these are the companies that will in essence benefit from inflation. So, I guess it's not really good for the people, but it's going to be good for our portfolio if we do have a tick up of inflation. In fact, a little tick up, it won't bother anyone because, what's 1% or 2%. But if it goes to 2% or 3% or 4%, it really inflicts pain, especially on people on fixed income.
Benz: We wanted to ask, what's the biggest lesson you've learned as a portfolio manager that only experience could confer? And, do you have an example of a habit or practice that you brought into the job initially that you've shed over time, because you found it to be counterproductive?
Herro: Two good questions. And you really know the lessons that work until after you're all said and done with the business and then you can look back. But I guess one of the lessons--and I think it's a lesson that differentiates portfolio managers from being fair, to bad, to good, to average, to excellent--is you have to be able to do two things: You have to be able to use legwork and a lot of background work to execute your philosophy and process--meaning we're value investors. It's not easy coming up with what you think is a relatively accurate valuation of a business. But you have to go through the legwork and the research process to do this without taking shortcuts. But once you've established that this is the hard part, truly abiding by it, truly buying low and selling high, this really sounds simple. But it is very hard for human beings to not get excited when price goes up, and not get depressed when price goes down.
And one must differentiate. And this is the critical point. One must differentiate between changes in intrinsic value and changes in share price. Because in the short term, Mr. Market bounces all over the place. Just look at the last two or three days--the Japanese market was up 3% or 4% yesterday and down 3% or 4% the day before. Makes no sense, right? It's short-term price movement that just moves on any short-term flavor of the day. The value of those underlying businesses didn’t change by anywhere near that. The key is not to react as an investor on price movement, but to react on value movement--underlying value of the business--that should govern your actions, not the movement of price, because price is a given. So, price and value converge, of course you sell; if price goes down faster than value, then it might be an attractive investment for you to buy. The point being is, as an investor, you cannot form a judgment based on price movement of your business; the focus should be on value. To me, that is the biggest lesson that I think a successful investor has to learn and has to ingrain in their mind. And it's also the hardest, because that psychological impact of just naturally disliking something that goes down and liking something that goes up.
The second question you asked me was about a habit that maybe I'm doing less of? This is another good question, because, since I was probably an adolescent, I was a news junkie. Just loved reading the news, listening to the news, read three or four papers every day, probably starting in college and post school. However, especially given the quality of journalism today, this has almost turned into a bad habit. What I try to do now is listen to the current news of the day and then stop. I try to quit hanging on every news item. The financial channel, CNBC, Bloomberg, they just continue to reiterate and harp on the current theme of the day. To me, it becomes counterproductive.
Think of past the global financial crisis, there was the Greek crisis, every day was on Greece; and then the trade war, everything was on the trade war. And then the pandemic, everything was on the pandemic. They beat these topics to death, and I think it doesn't allow for one to look at the outside in, because you're always inside looking out. And so, one of the habits, I think, me being a news junkie, is I'm trying to be less of a news junkie. Yes, I want to stay very informed on what's happening, especially within our businesses. But today's 24/7 news coverage, I believe, is highly counterproductive. And one thing I don't even touch is social media, for I think all the obvious reasons. I’m on no social media. I was initially, but I found it to be destructive for me and for my thinking and for coming up with independent thought. And so, I quickly got off of it.
Ptak: There's lots of private equity money sloshing around, as I know you know, competing for deals. Can you talk more generally about how the competitive landscape in value investing has changed through the years? And in what ways you and your team have had to adapt?
Herro: The competitive landscape sure has changed. Because when I look when I first got into this business in 1986, it was mostly the big pools of money were pensions, defined-benefit pension plans, trust companies, insurance companies, long-only, buy-and-hold types of investors. Yes, you always had the traders on the side, stock flippers. But the big way to money it seems gradually has changed through the years to where today the big way to money is on hedge funds and people using leverage and index funds and funds that represent everything from cryptocurrencies to SPACs to whatever. So, the competitive landscape certainly has changed.
And, actually, it's brought more volatility and more imperfect price discovery, which, actually as a long-term value investor, is better for us. Because when you have more volatility and more size, chasing themes and ideas and less chasing fundamentals, for an investor who focuses on fundamentals, it actually becomes a positive. Now the negative is, in the short term, this might really cause you to look silly. You might really be out of sync, and your clients who may be impatient or have a shorter-term investment horizon may not appreciate the fact that we are trying to take advantage of these market imperfections and volatility to enhance medium- and long-term return, because they are worried that they're not going to get the short-term return. And so, it's a two-edged sword. On the one hand, it provides more opportunity--the changing nature of who's holding assets, and what's causing volume creates more opportunity for the bona fide long-term investor. But on the other hand, it might create some severe downward price dislocation, as you saw with value investors in 2018--and '98, by the way--but in 2018, and in the first quarter of 2020.
And instead of investors thinking, “My manager is a good solid long-term investor with a good track record. I'm going to give them some more money to take advantage of this situation” They often become scared and sell right at the wrong time. So, the good news, is it provides more opportunity for long-term investors. I think the bad news is sometimes this comes with more volatility, price dislocation, which, again, provides you a tool to harness to exploit market imperfection. But, on the other hand, it's painful while you're going through this. And at times, your client base doesn't appreciate the short-term negative price performance.
Benz: At Harris Associates, you have a lot of latitude to stray from the index compared with other shops where the manager might need to stay within a particular risk or tracking-error budget. Can you talk big picture about how you define risk, and how you determine whether the portfolio is striking an appropriate balance between risk and potential reward, versus perhaps running a little bit too hot and being overly risky?
Herro: Risk to us is really the possibility probability of losing principal, losing capital. And where we really instil our risk process is in valuing businesses. What do I mean by this? And the analogy I use is, if you were a life insurance underwriter, and a 70-year-old overweight person came into your office and wanted to buy a life insurance policy. And that person was a smoker and a drinker etc., etc. You wouldn't necessarily say, “Get out of my office.” You're going to say, “I'm going to give you an insurance policy, OK? But here's the cost. And I have to take into consideration all these risk factors. When I issue you your premium, I'm going to insure you, but I have to consider all these factors.”
Now, the next person that comes in, say, it's an Olympic swimmer, and she's 20 years old and 2% body fat, healthy, and doesn't smoke. They're going to come into your office, and she's going to ask for a life insurance policy. And you're going to say, “Oh, sure I'm going to insure you. And here's what your rates going to be.” And it's certainly to be a lot lower than the overweight, unhealthy person. So, you insure both people. When looking at investments and trying to price and risk, we do the exact same thing. If it's a riskier business, a business that is financially geared, operationally geared, is susceptible to swings and profits because their pricing is determined exogenously, we're going to price you a lot lower than a steady business.
Take a company like the mining operations of Glencore, to us natural resource extraction is not such a good business. It's not so terrible that we wouldn't own it. It's just that when we price a business that's involved in extraction--because we think it is a harder business, is of lower quality than other businesses--we give it a much, much lower multiple. If it's a higher-quality business with a higher-quality cash flow stream, which is less sustainable to shocks, we give it a much higher, higher multiple. So, risk to us, first and foremost, is embodied in the pricing of the investments which we make. So then after we price the business, we have an apples-to-apples-to-apples comparison with the various stocks.
That's number one. Number two, though we do believe in concentration and we are not at all afraid to vary from an index. In fact, we see no benefit looking like an index. We would be ripping off our clients if we were closet indexers because we charge an active management fee. Why would we do that if we're closet indexers, which, unfortunately, some people are. And plus, we don't think that's the way to beat the index. However, we want to stay diversified. We're not afraid to be overweight, but for instance, if financials were the most attractive sector in the world, we wouldn't have 100% financials, just because, there's an old adage: put all your eggs in one basket. We want to remain diversified. So, we do watch covariances within the portfolio, we do want to make sure that we don't have overconcentration--such a strong covariance that if one event happens, every stock in the portfolio gets hit.
We also watch our position sizes; we believe in concentration. The top 10 names are often usually more than 30%. But still, we don't want to have a stock that's a 15% or 20%, or 10% of the portfolio, we try to max it out at 7%. So, we do have steps to ensure that you diversify. But on the other hand, the real challenge to controlling risk, is to control it on the investment level, by making sure you price risk. That you have to price risk appropriately. I think one of the things that makes us different than perhaps more theoretical investors is that we don't define risk as volatility. Volatility is risk to a short-term investor, to someone who doesn't have access to credit, to someone who has to worry about when they're going to exit a position.
If you're a long-term investor, and you have cash to deploy, etc., risk really isn't volatility. I believe that academia uses it because it's a nice, easy, measurable tool. It's a nice, easy, measurable label. We can measure risk through volatility. So, we'll measure volatility and we'll call that risk. And I think, in reality, risk and volatility are only one and the same if you're a trader. If you have a short-term investment horizon, if you have to worry about having to rapidly exit a position. If you're not in that situation, risk is a special situation, a special case. Risk equals volatility is a special case.
Ptak: You mentioned financial, so it seems like that's a good place to go to next. The financial sector has been a big weighting in the international fund for years with banks, insurers, other diversified financials--think they soaked up around 29% or so of assets over the past decade or so on average, and that mirrors financials’ pretty big weightings in the major foreign value indexes. The reason they're in those value indexes, one could argue, is investors have been leery toward those names. But European financials have rallied pretty hard lately. I think they've been up more than 40% over the past year, depending on the index you choose. Yet we've seen that before the sector jumped sharply from mid-2016 through 2017 and then it faltered again. But are you seeing signs that sentiment toward banks and other financials is changing in a more durable way, and, if so, why? You mentioned the fact that they've largely mended their balance sheets. And they're fully funded, if you will. And so, do you think investors are seeing that and that's causing a change in sentiment that's a bit more permanent in nature?
Herro: You have to look back in the last 11, 12, 13 years. And a lot of this does relate to what I mentioned earlier about what banks have done to their balance sheets. As the banks have repaired their balance sheets over more than a decade, this process took more than a decade, and especially in Europe where there was also slow economic growth. And then don't forget post the global financial crisis in Europe, there was what was perceived to be a sovereign debt crisis, when there was a belief that the periphery would default, and there was the Greek crisis. And all these things had a negative impact on sentiment of European financials in particular. Despite this, by the way, these companies, generally speaking, have been able to still grow their earnings and compound book value per share growth.
Now, as a result of the investment, investors, and the investment universe exiting these things over the last decade, valuations have at one point shrunk to global financial crisis lows. So, you saw it in 2018, they rallied a little bit in 2019. And in the first quarter of 2020, they got slammed again. These companies, despite the significantly better balance sheets, were trading at valuations, price/book, price/earnings yield, that were far lower than for most of the global financial crisis. To us this was just unsustainable, especially since these businesses were able to demonstrate earnings growth, even with the headwinds, the headwinds of slow economic growth, the headwind of having to store more capital, to put more reserves with the central banks.
And the headwind of lower-for-longer interest rates. Despite these headwinds, these three very important headwinds, they were still able to grow earnings, but it didn't matter. And dividends, by the way, didn't matter. The market didn't like them, the weightings in most portfolios went to zero, maybe except for ours, because we thought there was good value here. And in this low-interest-rate environment, these things are yielding 4%, 5%, 6%, 7%, it was a nice place to catch yield. And at some point, people are going to recognize that those headwinds are permanent. And I think what we're going to start to see now in the next 10 years, is exactly just that, that interest rates, I believe, will start to slowly climb up. You will see, especially in short- to medium-term, better economic growth.
And in the same time, we're seeing low credit losses and higher credit quality. And most of these financial positions are well overcapitalized. So not only will they be able to pay out the dividends that they were paying out, they might even be able to increase dividends, they might be able to increase buybacks, you might see some M&A activity going on in Europe. So, I think just that this time now, despite the fact that it's been kind of a bad post-global financial crisis for these businesses, from a price perspective, they have been able to grow value for the most part. And I think valuations today are more attractive than ever, especially since I believe that those three main headwinds of having to keep capital and lower interest rates, and lower economic growth will soon turn into tailwinds. They're at the capital positions they need to be. They are even stronger than ever; we should start to see better economic growth and higher rates.
So, I do believe that this is one of the most attractive areas around the globe today, especially when you look at the valuation multiples and the potential for a higher-growth inflection in terms of earnings and book-value-per-share growth.
Benz: As you and your analysts go industry by industry, can you give a sense of where you think moats are narrowing the most dramatically? Do you find those types of situations where stocks in an area have sold off because barriers that perhaps once protected them against rivals are beginning to give way, have to be approached in a particular way?
Herro: Clearly, you see it in the area of media and media distribution. Let's go back to 50 years ago, maybe when I was a little kid, there were three stations and public TV: ABC, CBS, and PBS. And so, if you were a producer of content for TV, for the consumer, other than movies, you had to go to one of those three. Look at it today, of course, this has completely changed. Content could go anywhere. And by the way, the manufacturer of content no longer requires a big moat, maybe to the detriment of Hollywood and some of the Hollywood stars is that we're seeing that amateurs on TikTok could get as many views as a Tom Cruise movie. So, there are certain areas where moats are coming down. We saw it with Legacy. News media outlets is another example.
But these also then provide areas where there's opportunity. Because whereas the moats are gone in certain areas, it provides someone access to an audience, which they formerly did not have. And if they're good and if they're talented, they might be able to turn that access into dollars. If you look at advertising companies, we've had to revisit. We own two advertising companies, but the business is not good as it once was. And they had to pivot to digital rather quickly. And if they were slow, their growth in their digital business did not make up for losses in their conventional creative businesses, yet most of them have been pivoting. And because of their attachment with their customers and clients, this in itself has become a moat, and it helps them compete against the newcomers, because their moat is having a connection to a client, which an up and comer may not have.
So even if you are a legacy business that might on the one hand, be losing part of your mojo because of new technology. On the other hand, if you incorporate that new technology, either through organic incubation or from M&A, you can provide a client with these services and use your relationship with your client as a moat in itself. So, there's a lot of dynamism that's happening in the market today. And there's a lot of change. And of course, because technology and digitalization, this change happens even quicker than I think it used to happen. And it requires nimbleness from our management teams to be able to adapt because, if you don't adapt, you're going to perish probably.
Ptak: That's a good segue to another topic we wanted to explore with you, which is management and your approach to assessing management. Wanted to ask about Credit Suisse. That firm has been plagued by setbacks, I guess you could say, as I think you pointed out in your letters, that firm has a very enviable private banking franchise and other salutary attributes, but it's also experienced a number of setbacks--the latest being Greensill and Archegos. You've hung on to the name. In a situation like this if a management team seems like it's unable to put setbacks like these behind it, how do you get comfort that the value you see in that franchise can be unlocked?
Herro: If the same management team would have been in charge, we would have left the company. The fact that a major change was made at the head of the leadership in the firm, and it was someone we knew quite well from a previous investment. The new chairman came from Lloyds Bank. And we have a great deal of respect for his ability to repair situations. By the way, he repaired, in his words, Lloyds was even in a worse situation when he took it over, over a decade ago. If it weren't for that we would have sold the stock. As you know, or may recall, we had a big issue with the chairman of the company. Now, the chairman and the CEO of Credit Suisse, in early 2020, got in a big fight over things that happened in 2019. I think there are other reasons why they got in the big fight. But regardless, they got in the big fight.
Our view was, and we are one of the largest shareholders of Credit Suisse, that the CEO has been very successful at turning the business around. He should be the one who stayed. And the chairman, who presided over, over a decade of value destruction with three previous CEOs hamstringing them, with complete inability to lead an organization in a professional manner, which controlled risk etc., etc., etc. We fought quite publicly that he should go. And we lost. I think there were over 30% of the shareholders, at least who agreed with us. And the board, instead of getting rid of the chairman, agreed to get rid of the CEO, and agreed the chairman would go but not for another year.
Now, perhaps what we should have done was, when the CEO left, we shouldn't have waited. We thought, well, what could he do in a year? And so we maintained our investment based on its valuation, based on its prospects, based on the person who took over for the CEO--we thought it was a rather steady set of hands. Now, of course, in retrospect, it doesn't look like the right decision--that we should have reevaluated this given that the CEO departed and left a very incompetent chairman in his chair for another year.
If it weren't for the fact that we are so respectful of the incoming chairman--and we do believe that the core business has inherent strengths. Combine this with the valuation of the business--this gives us hope and confidence, that, of course, there'll be some growing pains as the new chairman adjusts and makes changes, but over the next two or three, four years, the strengths and the benefits of Credit Suisse, especially given that you're buying this thing at just over half book value, with a strong balance sheet, should mean that shareholders enjoy a good rebound and a good return.
There was another example of one that actually worked. We stuck with a management change. A few years back, we were very disenchanted with the management of Daimler. We thought the company was being run as a bureaucracy, and not as a profit-maximizing entity to focus on building shareholder-value creation. Despite having strong franchises, in both trucks and in Mercedes Benz automobiles, years and years of value destruction, we're getting ready to sell. A new CEO and a new CFO came in who we discussed with, we met with, we were convinced they would turn the business around. And thankfully they did. And they're even operating above our expectations. This business is now becoming competitive, they're creating value. Everywhere you look, they're succeeding in their business plan.
So, this was an example of where we were about to sell a stock if a management change didn't happen. Management change did happen. Our view was that the management team would be able to extract value, especially given the inherent strengths of the various business units that were undermanaged for so long. And that ended up being a positive result.
Benz: You've been an outspoken critic of Danone's management. You thought shareholder interests were taking a back seat to ESG matters that you viewed as secondary concerns. Yet management teams are under lots of pressure to define their stakeholders more broadly than just common stock shareholders, and to consider issues like climate risk and how they run their businesses. How do you gauge whether a management team is striking the right balance between taking these matters to heart while still committing to driving shareholder value?
Herro: It's a really good question. Because somehow, I think--and I think the Danone CEO tried stating this case--that there's a trade-off, that there's a trade-off between a good value creator and a good corporate citizen. And I don't think that trade-off exists at all. I think the two go hand in hand. So, we don't want our management teams and boards to be discriminators. We believe diversity is a positive, we want them to be good stewards of the environment. All these things and this focus on ESG are conducive to building shareholder value. It shouldn't cost money. And I don't believe it does cost money to be a good corporate citizen.
And I think a good corporate citizen is what ESG is all about. I'm a believer in this notion of when we come on this planet, we should leave it better than we found it. I am a believer that diversity, especially as it pertains to providing diversity of thought, diversity of experience leads to better decision-making; good clean corporate governance. Transparency leads to better decision-making and better wealth creation. Danone tried using ESG as an excuse not to generate shareholder wealth. By their own failings, they did not attract appropriate returns out of businesses. They were not strong at allocating the firm's free cash flow in a way which led to the perpetual value-creation machine. And he used ESG as an excuse for not performing from a corporate-performance perspective. And as I said, I think that's completely inappropriate. It's not either or; I think they go hand in hand.
Now, where you get into some cloudiness, of course, is defining this stuff. So, you have to be good stewards of the planet. Some might argue that wind farms and solar, for instance, are more destructive to the planet than nuclear power and using natural gas to generate electricity. If you look at the greatest impact on the environment. So, people are going to have different views on these things. And I think we're going to see more and more of this, which makes the ESG question even more difficult. But if ESG stands for ecological, societal and governance, and using ecological as being a good steward of the earth and not being a polluter. And utilizing resources--this is, again, as an economist, the economic question is, how do you get more from less? So being a good steward of the earth is critical for all of us.
Being a meritocracy, where we don't discriminate on sexual orientation, on skin color, on nationality, on all of this, this is good for a business, this is good for a company. Having a transparent, diverse corporate board. This is good. And so, I think ESG is very important conceptually, and I don't think it all conflicts--or should be as an excuse--for not generating values for the shareholders. First and foremost, this is the purpose of a company is to create wealth for those who invest in it. It's not a non for profit, it's not a government entity, it's not an NGO. But, of course, must do so in a way which is acceptable to society's morals and the laws of the land.
Ptak: Wanted to ask you a couple of more questions. Next one being, I suppose you could say it's another type of misunderstanding. And that's with respect to some of the businesses that you own in the portfolio where your thesis I think, turns to a certain degree, and the market maybe not fully, or correctly comprehending, what the underlying assets consist of. And so there are a couple of examples that come to mind. Fresenius is one; Naver, I think is a Korean business that you own, another one that you've written about. I suppose you could argue the same is true of Naspers. These are complicated firms to a certain degree, or maybe have weird structures, or maybe there's been a short-term setback. And I guess one could argue that maybe they deserve to trade at low multiples, because complicated businesses with weird structures or bad short-term performance, maybe aren't great assets to own. So, given that, can you talk about how, in situations like these, you're able to separate the wheat from the chaff?
Herro: It's a good question, because sometimes they don't. People at first, can't see the inherent value. And I will use another example: Exor, another kind of holding company that owned a number of businesses and it's transformed itself in an amazing way in the last 15 years. This was originally the Agnelli family holding company, where Fiat was held. Now Fiat was this huge Italian industrial organization, which had everything from newspapers to car companies to a soccer team to car parts companies to ag equipment. And John Elkann, the grandson of Gianni Agnelli took control of this thing, I think in his 30s. And he just demystified it and simplified it and sold assets and created a ton of value for the owners despite some of these challenges and opaqueness. You mentioned Naver and you mentioned Naspers. These all have kind of similar elements.
What we do when we price these companies, is we have to price the businesses, yes, for what they're worth. But then we also have to account for the fact that there is some opaqueness. For instance, we have to put a holding-company discount on these assets. Naspers is a perfect example because they are somewhat trapped in South Africa. This is a holding company that's biggest investment is almost 80% of its value is tied up in Tencent, the Chinese digital powerhouse company. But it's a South African holding company. Now they've tried to do things to relax this, we'll call it place of domicile, by splitting into another company called Prosus etc. They've taken the steps, which by the way, should help alleviate the need for a holding-company discount, if the management team actively seeks ways to narrow that discount, which we believe the Naspers management team is doing. But still, we have to account for this opaqueness, and we do so in how we price the stock.
Remember back to the life insurance. If this company didn't have some of these impediments, we would price it in a way which gave full credit for all the various divisions. But since there are potential obstructions to value realization, we have to reflect that in how we price this via discounting the asset value that we come up with. And that's basically how we tackle these situations. And even if after that discount, we see a great deal of value. And we see a management and board team that are working to alleviate these value differentials, we will invest in it if there's opportunity there.
Benz: Your strategies have been very successful long term and there's no question shareholders who have remained in the funds over the long haul have reaped the rewards. But it also appears that the average dollar invested in the international fund has significantly lagged the fund's total return reflecting inopportune timing where it appears some investors have chased performance to their detriment. We know that you're an ardent believer in active management. But could one argue that most of these investors might have been better off in an index fund?
Herro: No, those types of investors probably do the same thing with an index fund. Meaning, buy high sell low. As an example, we had a really good second half of 2016, 2017. And as a result, a wave of money comes in starting second half of 2017, early 2018--we even closed the fund. Then, of course, 2018 was an off year. It's an off year after we had all these people chasing this hot performance. What happens? By the end of 2018, early 2019, they sell out. Then we have a big recovery year in 2019. And they miss it. So, they're there for the downturn, chasing the past return, and then they miss the upturn, because they sold out at the wrong time. This gets back to what I said earlier, about investors or people wanting to like things that go up and dislike things that go down. It's one of the few things that violates the laws of supply and demand.
When Ford Motor wants to sell more cars, they put an incentive on--they cut the price and they sell more cars. If a grocery store wants to sell more apples, they cut the price, put apples on sale. And the reverse seems to happen with stocks. If stocks drop on price people want to sell them. Same with mutual funds; probably with an index fund the same thing. It's this inherent behavior of not being able to embrace a deal or a discount when stock prices fall, or mutual funds fall, and I think this is just natural human psychology. And for some reason it's different. It's different with financial assets than it is with real assets. It's a bit puzzling, but I think a lot of it has to do with the comfort of the crowd and not wanting to leave the comfort of the crowd.
Ptak: Well, David, this has been such an enlightening discussion. Thanks so much for sharing your time and perspective with our listeners. We really appreciate it.
Herro: Thank you for the opportunity and I enjoyed the discussion.
Benz: Thanks so much. Thanks for being here.
Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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