Oakmark Funds Sturdy Despite Outsized Japan Exposure

David Herro, Morningstar's International Stock Manager of the Decade, has become the financial media's go-to guy for assessing the implications of the Japanese catastrophe for U.S. fund investors. That's for good reason. At the close of 2010, the four international funds in the lineup of Oakmark--the Chicago-based fund shop where Herro is a principal--had roughly 22.4% of their combined assets invested in Japan.

Each fund's stake is higher than the respective peer group's norms--a function of Herro's longstanding, contrarian embrace of Japanese equities. While investor sentiment about the country long ago calcified into more or less permanent pessimism, Oakmark's contrarian manager--who also serves as its chief investment officer of international equities--has perceived opportunity aplenty amid what he considers an increasingly shareholder-friendly culture.

On the Mark
We don't yet know how (or if) Oakmark's Japan allocations have changed as a result of the crisis. Given Herro's recent comments, though, it seems probable that any substantial downtick would owe not to the manager selling stocks but to price depreciation. Indeed, Herro has indicated that, if the disconnect between the stock prices and the fundamental value of his Japanese holdings persists, he'll likely buy additional shares.

That's no surprise. Herro has long been an intrepid investor, a value hound untethered to traditional notions of what "value" means. The price multiples of  Oakmark International's (OAKIX) latest lineup, for example, all tick higher than foreign-large-value norms. And with the exception of its modestly lower price/sales ratio, that's true of Herro's  Oakmark International Small Cap (OAKEX) charge, too.

For all of Oakmark's managers, value's where you find it. And it's a function not of conventional price multiples but of "true business value." That's Oakmark-ese for the price the shop thinks a private-market buyer would pay to purchase a company outright. If Herro perceives a large-enough gap between his private-market estimate and a company's stock price, he'll invest without undue worry (or any worry, actually) about whether the company strikes a "proper" value profile.

Reversal of Fortune?
Over the long haul, that approach has served investors remarkably well: For all trailing periods of one year of more, Oakmark International ranks in the foreign-large-value category's top decile. International Small Cap hasn't been as consistently superior, but that foreign-small/mid-value offering remains a top-flight fund, one whose trailing 10-year return resides in the peer group's top quintile.

To be sure, Herro's Japanese exposure has lately dragged on performance. With the Nikkei 225 declining some 10.2% between March 11 (the day the tsunami struck) and March 18, you'd expect funds with above-average Japan stakes to post below-average returns.

Yet among funds with comparable allocations, the Herro-led charges have outperformed. A screen for all funds in Morningstar's database with at least 20% of assets invested in Japan (203 in all) finds International and International Small Cap notching returns that, while negative, rank above that custom peer group's average for the week of March 13, the first full week following the onset of the crisis. They've both enjoyed nice snap-backs as Japan's oversold markets have begun to recover, as well.

The funds' above-average showing among like-minded rivals also comes as no surprise. Energy and utility stocks--hard-hit in the aftermath of tsunami--barely make a blip across Herro's portfolios. International Small Cap sports a well-below-average allocation to financials--and no positions in Japan's beleaguered insurers. And while International does have a sizeable overweight financials stake, it doesn't hold any Japanese insurers, either.

All told, as Herro noted in a commentary released shortly after the crisis began, Oakmark's funds "have no direct exposure to Japan's insurance, energy, or utilities sectors, which appear to be notably vulnerable in the short term."

An Investment Lesson
In addition to helping account for his funds' post-crisis performance, Herro's remarks offer broader insight too. While U.S. investors have long been accustomed to diversifying portfolios with foreign funds, many of us have perhaps been too quick to think of that diversification primarily (if not exclusively) in regional terms.

But foreign funds obviously offer exposure to more than just non-U.S. areas of the globe. As the recent (and continuing) tragedy in Japan reminds us, our international allocations come laced with all the risks that we reflexively consider when gauging our domestic fund holdings. Looking ahead, we'll be smarter investors if we aim to think more carefully about the full range of exposures--sector and industry among them--that our foreign funds provide.