How Oakmark Puts a Currency Hedge On

John Coumarianos: I'd be remiss if I didn't ask you a question about currency, which we've discussed over the phone. But again, for the benefit of shareholders who when they own your funds are effectively exchanging their dollars for foreign currencies in some cases, how do you deal with the currency issue?

We hear from different investors, different strategies. Some foreign investors don't hedge back to the dollar at all, they just buy the foreign companies in their denominations, and then other, often value investors, like yourself, say, well we own businesses, and we don't want our returns to be affected by currency fluctuations at all. How do you fall on that?

David Herro: Well, you're exactly right. When we buy a foreign stock, we buy the underlying currency, and like the stock, the currency also has a value. It has a broad value called purchasing power parity. That is, the equivalent of each, say if we're buying euros, what is the equivalent of underlying value between a euro and a dollar.

Now, our view is quite simple. If that currency we're buying is not any more then 20 percent overvalued, so that's if it's undervalued, or just a little bit overvalued, we do absolutely nothing. If that currency goes beyond 20 percent of its intrinsic purchasing power parity value, we slowly begin to hedge back into dollars, some of that currency exposure.

So kind of think of a pendulum, but the pendulum doesn't start at parity, it starts at 20 percent, so it has to be at least 20 percent overvalued. You say, why? Why does it have to be overvalued by 20 percent? That is because currency estimation is very, very imprecise. The market doesn't move that efficiently, and we don't want to be caught hedging something that's just within white noise of valuations.

Coumarianos: Maybe in the words of Ben Graham, you'd want a margin. That's your margin of safety.

Herro: That's our margin of safety. So when it gets beyond 20 percent, we begin to hedge. The more overvalued it becomes, the more we increase the hedge, but we never hedge for more then we own. So we don't speculate. We only cover what we own. When that currency begins to come back down, we begin to unwind the hedge. So when it hits fair value, we're completely unhedged again. That's our simple policy.

Oakmark International started in 1992, and I think there have been four different instances where we employed currency hedging. At this current time, we're hedged against three currencies--the yen, the Swiss franc, and the euro.

Coumarianos: OK.