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A Fine Foreign Small-Cap Fund For the Patient

Bronze-rated Oakmark International Small Cap's results may be streaky, but its merits are significant for long-term investors.

The following is our latest Fund Analyst Report for Oakmark International Small Cap Fund (OAKEX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

It hasn't generated consistent relative results, but a disciplined approach and an accomplished team earn Oakmark International Small Cap a Morningstar Analyst Rating of Bronze.

This fund often looks streaky relative to its foreign small/mid-blend Morningstar Category peers. It ranked in the category's middle or below in six of the past seven calendar years, and in 2017 it lagged 80% of peers through October.

The fund's lumpy returns are an outcome of the patient and, at times, deeply contrarian approach plied by its managers. They only buy companies selling at steep discounts to their estimate of intrinsic value and will allow picks to cluster in certain sectors and countries. (They also prefer shareholder-aligned management teams that are solid capital allocators.) For example, relatively large stakes in tech and in Australia dented returns in 2014, and scooping up industrial stocks that were hurt by their energy exposure weighed on performance in 2015. (The industrial picks rebounded in 2016, when the fund beat nearly 80% of peers.) The fund is also capable of blowout years when a number of picks pay off at once--witness its 67% gain in 2009, and a 13% gain in 2001 that topped all peers. Thus, even its long-term trailing performance rankings can change quickly.

While performance has bounced around, David Herro has been a constant, managing the fund since its 1995 inception. But Herro is gradually allowing Mike Manelli, a comanager since 2011, to take the lead on buy and sell decisions. Herro may step off the fund in a few years, but we remain confident in the team. Herro has no plans to leave the firm and remains the lead on the highly successful  Oakmark International (OAKIX). In addition, he, Manelli, and Justin Hance (a comanager since late 2016) constitute the committee that chooses all non-U.S. stocks that may be purchased by Oakmark's funds. They're also backed by a team of seven managers and analysts, most of whom are highly experienced.

Another point in the fund's favor: Management has helped preserve flexibility by closing it at times, though the fund is now open to all investors. It is a fine holding for the patient.

Process Pillar: Positive | Greg Carlson 11/10/2017
Like all Oakmark stock-pickers, managers David Herro, Mike Manelli, and Justin Hance seek companies trading at deep discounts to their assessment of intrinsic value. (This fund typically invests in companies with market capitalizations under $5 billion.) Their estimates of a business' worth are based on multiple valuation models and, depending on the company under consideration, may focus primarily on a firm's likely private-market acquisition price, its tangible book value, or its discounted cash flows normalized over a cycle.

That's not unusual, but the degree to which Oakmark focuses on steep discounts on an absolute basis sets the shop and its firmwide process apart. Companies that appear attractively valued relative to industry peers only garner attention if they seem cheap relative to their own stringently vetted prospects.

The managers favor companies with shareholder-aligned managements with solid track records as capital allocators. Stock-repurchase programs, dividend hikes, and sensible acquisitions that are accretive to earnings are often regarded favorably, but as with all aspects of the team's bottom-up process, the managers make judgments on a company-by-company basis. They aim for long holding periods, but volatility can force their hand. Portfolio turnover typically ranges from 35% to 50%. This distinctive and disciplined approach earns a Positive Process rating.

Deviations from value-investing norms aren't unusual at this fund. The managers invest with a stringent valuation discipline trained on the gap they perceive between share price and a business' true worth. As a result, any company in any sector can be a bargain and, therefore, a potential candidate for this fund's portfolio. For example, three years ago the fund's stake in technology comprised more than a fourth of its assets, far above the foreign small/mid-blend category norm. (That weighting has since been pared back to 12% as of September 2017.)

For the past two years, the fund has sported an outsize stake in industrial stocks, some of which were scooped up by the contrarian-minded managers when the stocks were hurt by their exposure to the energy sector's 2015 woes. The fund's stake in industrials has ballooned to 43.2% of assets, nearly double the 22.7% category norm.

Regional and country allocations are a result of the team's bottom-up, wide-ranging approach to value investing and can diverge widely from the norm, too. The fund's stake in Europe, for example, was 14 percentage points higher than the foreign small/mid-blend norm at the end of September, and its combined weighting in Finland, Norway, and Switzerland was 26.0%, more than triple the 7.7% category average. The fund also held a 10.3% combined stake in Australia and New Zealand that was nearly double the group norm.

Performance Pillar: Neutral | Greg Carlson 11/10/2017
This fund's long-term record no longer merits a Positive Performance rating; it's being downgraded to Neutral.

The relative performance of this fund has always been lumpy, but it's been distinctly subpar lately--it placed in the foreign small/mid-blend category's bottom half in five of the previous seven calendar years, and barely landed in the top half in another. The fund also trailed more than 80% of its peers in 2017 through October. Thanks in part to a huge gain in 2009, the fund's 10-year record through October 2017 is still solid, beating 82% of its peers and its MSCI World ex USA Small Cap benchmark on total returns, and roughly two thirds of peers and the index on a risk-adjusted basis. But the fund looks pretty average over the trailing 15 years relative to peers, though it matched the benchmark.

As for very long-term performance, the fund only has two category peers that have been around since it was launched in November 1995. But it lands in the middle of the pack when compared with all foreign small/mid-cap funds since inception. Its benchmark didn't exist then, but the fund did handily outperform the most relevant benchmark, the MSCI ACWI ex USA Small Value Index, over that span.

The fund tends to favor value stocks more than its typical peer, but when it's compared with that category, the fund's record is only slightly above average over both 10 and 15 years.

People Pillar: Positive | Greg Carlson 11/10/2017 
David Herro joined Oakmark Funds' advisor Harris Associates in 1992 and has led this offering since its inception in November 1995. He serves as the firm's chief investment officer for international equities and has been the lead manager on Oakmark International since its 1992 inception. With fellow Oakmark veteran Bill Nygren, Herro also comanages  Oakmark Global Select (OAKWX), and he was also named a comanager of  Oakmark Global (OAKGX) in July 2016.

Increasingly, however, Herro says he's letting Mike Manelli, who has comanaged this fund since 2011, take the lead here (though all decisions are made with Herro's knowledge). Herro, who will be 57 at the end of 2017, may step off the fund altogether in a few years, though he has no plans to leave the firm.

This shift doesn't decrease our confidence in the team. Manelli, who joined Harris Associates in 2005 and was named a comanager of Oakmark International in November 2016, has impressed us with his knowledge of the fund's holdings. He's also backed by a deep team beyond Herro. Justin Hance, director of international research, was named a comanager of this fund in 2016; he, Manelli, and Herro steer the firm's international stock-selection committee. And the managers are supported by seven managers and analysts with an average of 5.6 years' tenure at Harris and 11 years of investment experience. The team continues to earn a Positive rating for People.

Parent Pillar: Neutral | 08/03/2017
Paris-based Natixis Global Asset Management is the parent to a number of different asset managers globally, including Natixis AM in France and Loomis Sayles and Harris Associates in the United States. These affiliated companies have maintained a large degree of autonomy, both in operational terms and in terms of their investment philosophies. The quality of investment culture varies significantly from one subsidiary to another. The results of the teams at Loomis Sayles and Harris Associates, manager for the U.S. Oakmark funds, for example, are excellent, communications with investors are of high quality, and fund launches have been minimal. NGAM’s latest acquisition, DNCA, has also begun improving its funds’ fee structures.

On the other hand, the results obtained by Natixis AM are more mixed, and its teams are less stable. Furthermore, in July 2017, the French financial regulator Autorité des Marchés Financiers imposed a EUR 35 million fine on Natixis AM for failings relative to its range of formula-based funds, arguing that the firm had overcharged investors and had failed to adequately disclose charges in the funds’ filings. The sanction on Natixis AM thus weighs negatively on our assessment of the group’s stewardship, but we recognize that strengths in other parts of the organization, particularly in the U.S.-based affiliates, partly compensate for this weakness, resulting in a Neutral Parent Pillar rating.

Price Pillar: Neutral | Greg Carlson 11/10/2017
At 1.38%, the expense ratio of this fund's Investor shares (which hold 60% of the assets) earns a Morningstar Fee Level of Average compared with other foreign small/mid-cap no-load funds. The Institutional shares hold 28% of the assets, charge 1.17%, and earn an Above Average fee level. The Advisor shares hold 12% of the assets, charge 1.29% and also earn an Above Average. All told, the fund earns a Neutral rating for Price.

To Oakmark's credit, the fund charges a redemption fee of 2% on sales of shares sold within 90 days of purchase. Those proceeds flow back to the fund, not the fund shop, helping to offset the costs associated with short-term trading. Those costs can be particularly high in the part of the market this fund primarily targets.

Greg Carlson has a position in the following securities mentioned above: OAKIX. Find out about Morningstar’s editorial policies.