Market Missing the Value in Asset Managers

John Coumarianos: One can't help but notice that when one looks at Oakmark International, you have a fair amount of financial exposure, particularly to European and Japanese banks. I think Allianz, Daiwa, UBS, and Credit Suisse are among your top positions. How are you assessing the balance sheets of those firms now?

David Herro: Well, you have to very carefully. Because the balance sheet risk, of course, is the biggest risk in analyzing these financials or certainly has become the biggest risk in the last year or two. And to some degree, we've been very successful at it, but to another degree, we made a few mistakes.

Because there's less-than-perfect transparency in looking at the balance sheet of financial institutions, because they're loans and loans are something dynamic. They could be good one day and sour the next. It's not like a steel plant or an oil field or any other form of asset a company may have.

So, loan is a different type of an asset, and we have to make sure, when analyzing these banks, that we do have enough transparency that we could come close enough to have an accurate evaluation.

That's only one part of the story, though. Many of these financials which we own are asset managers, and this is a business we like a lot. Now, this is something we can easily measure.

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Asset managers grow in one of two ways. One, the values of the assets, whether they're stock managers or bond managers, go up. And so their assets under management increase. Or they could get net new inflows. So that compounded, those two things together, tend to give asset management companies good, normal levels of growth.

So, I think what the market misses, it lumps a lot of these companies as just being pure banks or pure brokerage firms or pure insurance companies, when in fact they have this asset management component to it, which is very, very good business.

If you look at Credit Suisse, UBS, Daiwa... Even an Allianz, which of course owns PIMCO, has a huge amount of this asset management next to it. And that's one of the things we feel the market isn't correctly pricing.

Coumarianos: And of course, as you say, asset managers are typically very good businesses with operating margins upward of 30 or 40 percent. So, very good.

Let's talk about Daiwa in particular; I know we've talked about that on the phone before. Talk about what's going on in Japan and how people are saving and why you think there's potential with Daiwa.

Herro: We have to back up a little bit. It was December 30, 1989, when the Japanese market peaked at nearly 40,000. Here, we're sitting at just above 10,000. So the market, for over 20 years, has basically done nothing but head down. Now, one could say, "Well, that must mean stocks are cheap." But, remember our definition of value, cheap is just half of it. The other half is quality.

First that market started at a very, very expensive valuation, and second, we always argue that Japanese companies deserve lower valuations, because they had lower return on equities. So, there should be a relationship between the price of the book and the return on that book which one earns.

Finally, what we're starting to see after 20 years plus of a bear market--we're starting to see some life percolating on this whole notion of shareholder friendliness, shareholder returns, and running companies for value. And it's really that factor which has got us to invest more and more in Japanese companies.

The fact that we're starting to see better capital allocation, the fact that we're starting to see higher return structures in Japanese companies--that brings us to Daiwa. Daiwa has both an asset management business, which five or six years ago was almost zero percent of its business. And today, it's pushing 35 or 40 percent of its EBIT.

And number two, it's one of the majors... It's the second-largest brokerage firm in Japan. So, we think that the Japanese market is underpriced and we're going to start seeing a lot more activity, which should benefit Daiwa. And in the meantime, and you alluded to this, Japanese people have a very high savings rate.

And traditionally, all this money was put in the postal savings, earning a quarter percent or a half a percent. And we're seeing more and more of this money leaving the postal savings and going into equity-like products, bond products, mutual funds, unit trust, which again Daiwa is a huge beneficiary of.

So, there's a structural change happening, and the way Japanese people save, one, that's positive for Daiwa. And two, the Japanese market is sitting at the bottom at a period of time which we think the market has never looked so attractive, which should also be good for Daiwa.

And then, the third part, it's a very sound and stable financial institution, very conservatively leveraged. They made very few investment mistakes in their own holdings, unlike what we've seen many of the other global financials. So, it's...

Coumarianos: So, there not AIG or something like that.

Herro: Yes. Here even Nomura which had a take, large write-downs and raise money. Daiwa did raise money, but it's because they made an acquisition.

Coumarianos: Mm-hmm. OK. Great.