Hunt: Value in Large-Cap European Stocks

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Global markets have sold off sharply during the past month and a half, but at least one bargain hunter says he is seeing some opportunities. He is James Hunt. He is portfolio manager for Tocqueville International Value.

James, thanks so much for being here.

James Hunt: It's great to be here. Thank you.

Benz: So, James, it has been a bruising sell-off since late July, but you say that you're actually finding some pockets of opportunity in the market, in international stocks on which you focus. Can you talk about what those are?

Hunt: Well, moments like these are really attractive to us because moments of fear and moments of volatility tend to create the greatest pricing dislocations, and they present us with opportunities to find diamonds in the rough. So, we actually do think it's an interesting time. We think that the markets have clearly begun to discount a recessionary scenario, and some stocks, particularly economically sensitive stocks, have declined 40% or 50% in price from their recent highs. And we think those look like very good values compared with their cash flows over the course of an economic cycle.

So, in moments like this, particularly, when markets are moving very fast, the first place we look for ideas is in our existing portfolio. These are companies that we've already made the decision to invest in, that we like qualitatively, where we understand extremely well the business and the cash-generation capabilities.

So, for example, one stock that we have owned, which we've added to recently is AkzoNobel, which is a Dutch chemical maker, which makes chemicals that go primary into paints and coatings. It's a mid-cap stock. The company has generated returns on capital in the double digits during the last 10 years. Its free cash flow generation has been around 9% of market cap on average for the last 10 years. It's a very attractive company, with a 4%-plus dividend yield. It's been marked down in this sell-off to levels that reflect a significant fall back in business activity. So, that's one example.

Benz: So, in terms of the banks. The banks have obviously been under a huge cloud, especially in Europe. Have you been looking at the banks and do you think that things are cheap enough and attractive enough currently or are you staying away?

Hunt: So, that's a really good question. It's a very relevant question because we are first and foremost contrarians and then value investors. As contrarians, things like a steep decline in an industry get us really excited. So, the European banks are example of something to which we would typically be very attracted.

Having said that, part of our investment discipline is to buy businesses that we understand, that are transparent, and that are not highly leveraged. And so, we also typically have an aversion to financials and we're typically very underweighted financials relative to the indexes. 

To answer your question specifically, the way we're trying to take advantage of this extremely negative sentiment toward the European financials is to find businesses that are down and out-of-favor because of those fears, but from an economics of business standpoint, don't have the same vulnerabilities as the banks.

So, one example of a company that we've actually taken a toehold in recently is, Aflac, which is sort of an odd creature. Aflac is a U.S.-listed company that has most of its business in Japan, and has a very large bond portfolio as an insurance provider. And the reason the stock is down is because of its exposure to the European bond market. So, those are the same forces that are affecting the banks. The stock is down around 50%. It's selling at around 6 times earnings and is a fantastic business. And we have a strong view that once the European bond market normalizes, which should happen as fears about the banks are alleviated, the stock should recover.

Benz: So, James, you mentioned Japan, and you were very active in buying there during the natural disaster and subsequent nuclear accident earlier this year. Have things played out in Japan as you thought they would, and do you still think there is upside for your holdings in Japan right now?

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Hunt: So, we were active in buying. There was moment of great fear, and we added to our existing positions. So far it has worked out as we had hoped. The Japanese in characteristically, uniquely Japanese fashion pulled up their boots and pulled the economy together I think much faster than most people expected, and that's been good for some of our stocks. This is in addition to which some of our stocks actually had exposure to the construction sector and that's been fundamentally positive dynamic that's come out of the rebuilding efforts. So far, so good.

We track very carefully the intrinsic value of all the positions that we've got on the portfolio, and if I look at the Japanese positions specifically, the average discount that they are trading at is around 34%. So, that implies that today if they were to trade at fair value, you'd automatically have a 50% increase. So, the answer is yes. I see a lot of opportunity, and we've also been finding new positions in Japan during the recent sell-off. One example is Hoya, which is an electro-optics maker. It's down about 50% from its recent high. It's a great cash flow generator, and we've put that into the portfolio recently.

Benz: One thing we've been hearing from value-oriented portfolio managers for more than a year now is that quality is cheap. So, when the market was even more richly valued, we were hearing that quality is a good place to be. Do you concur with that general sentiment?

Hunt: So, it's very hard for me as a bottom-up stock-picker to discuss broad swaths of the stock market in general terms like that. As a contrarian I guess I would say, if everybody is saying that, it makes me a little bit nervous. But having said all of that, we are clearly finding value in quality stocks. Our discipline is to buy good businesses, add a deep discount to intrinsic value when they are out of favor, and we are finding opportunities that meet our criteria. So, there's certainly some quality.

Benz: Right. It also appears that you're an all-cap portfolio, but you have graduated up into some larger names than you owned before recently?

Hunt: We were finding a lot of good value in large-cap stocks, particularly in Europe, where some of the large caps have enormous free cash flow generation, which is one of our key investment criteria when we're looking at financials.

Benz: Right. So, finally, James I want to ask you about emerging markets. There's been so much excitement about emerging markets for several years now, but especially now that developed markets seem to be hitting a period of slowdown, people are saying, "Well, emerging markets will be OK." But your portfolio is pretty light on those markets, what's your thinking there?

Hunt: So, we currently have around 8% of the portfolio in companies that are domiciled in emerging markets, but if I actually look at the cash flow of the portfolio...

Benz: That's how you think about it?

Hunt: That's how we think about it. It's probably 25%-30% exposure to emerging markets. You're right, we care a lot about the quality of financial reporting; we care a lot about transparency. We care a lot about management quality, and we're looking at companies with 10 years of financial history. So, that naturally draws us to more mature companies and mature economies, but as you correctly implied, there is a lot of businesses in developed economies that have very large emerging-markets exposure.

So, our low exposure today really is a question where we're finding the values. Typically our investment dollars follow where we're finding the best risk/reward. Today that's in more developed economies. But if the emerging markets were to experience a real sell-off, you'd probably see us finding more opportunities directly there.

Benz: Well, thank you so much for sharing your insights. We really appreciate you coming in today and also sharing some information about the fund.

Hunt: It's great to be here. Thank you.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.