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Herro: Risk Must Be Priced Right

Jeremy Glaser

Note: This video is part of's November 2014 Risk Management Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by David Herro, the portfolio manager of Oakmark International Fund. We're going to talk about how he thinks about risk when selecting individual securities in his portfolio.

David, thank you so much for joining me today.

David Herro: Happy to be here this morning.

Glaser: I wanted to talk about how you think about risk when selecting individual securities. Are you worried about volatility? Are you worried about capital impairment? How do you think about it? How does that play into your process?

Herro: It really has more to do with the probability or improbability of the company performing as we expect. To us, that is risk. So when we price a business, it's really based on the strength of the cash flow stream, the consistency of the cash flow stream, the ability of the company's cash flow stream to withstand shocks, etc.

Risk, of course, is always with us. The important aspect of risk is that it must be priced. That if a company is subject to risk, we must price in those risk factors, so we can properly have a balance between risk/reward. So, the biggest area where we may encounter risk is if we misprice risk in these company-specific factors.

Glaser: Are you worried about short-term risks, or is it really only a long-term view?

Herro: When you look at the duration of a company's cash flow streams, and the duration of a company's viability in general, it's very, very long term. So to us, it would be a mistake to look at it from a short-term perspective.

Yes, we have a client base where we may have to explain short-term deviations and short-term variations. But generally speaking, we're looking at a business that has long-term assets, long-term cash-flow streams, so we like to stay focused on the long term.

Glaser: The risks that you're looking at are mainly internal to the company--for instance, are they going to have a product launch that's successful? Are there more external factors, maybe geopolitical or some sort of other macroeconomic factor?

Herro: First and foremost, it's company-specific factors. We are looking at a company's ability to continue to generate cash flow for its owners. So if they do have a new product flop, if they do mismanage a contract, to us that is risk, because it means that the cash flow streams, which the business should be generating and eventually distributing to the owners, don't happen.

However, we must keep in mind that companies are not immune to macro influences. That is, such things as economic slowdowns or natural disasters may impact the company's ability to generate profits and cash. As such, we have to price those probabilities into that cash flow stream.

For instance, if a company is highly leveraged and has a lot of fixed assets, one small change in revenues will have a big change in the bottom line. In that type of a situation, we must apply a proper price for those company's assets and that company's value. So yes, … mostly we focus on internal risks, but we cannot ignore macro risks. And if a company is exposed to macro risks, we hope that they have a balance sheet and a management team that is able to withstand it, and that's how we counterbalance and that's how we price in and incorporate the macro risks to companies.

Glaser: How do you weigh if a macro factor is going to be more fleeting, something you shouldn't worry about, or if it is something that could be a serious systemic risk?

Herro: When you look in the past 20 or 30 years, or maybe from the history of equity markets, we've always been exposed to "macro risk," "macro uncertainty," "macro volatility."

So generally speaking, these things come and go. Imagine it like weather. Today in Chicago we're having a mostly sunny day, but it's 15 or 20 degrees. Tomorrow it could be cloudy with frozen rain. Weather patterns come all the time. And when we look at businesses, businesses are exposed to changes in the macro environment all the time. We have to make sure through our analysis that the company is prepared to deal with these macro storms.

So it's not a weak, rickety ship that as soon as it rains two inches, it sinks. We want to make sure it's a ship that it could sail through the storm without sinking. This is how we have to integrate this notion of macro risk. Yes, they happen, and they don't just come once and go away; it's a flow. You constantly have macro issues. And our job is to make sure the companies in which we are invested have properly planned how they are going to get through these macro situations.

Often these macro disturbances are more opportunistic for long-term investors than anything else. They enable you to take advantage of share prices that may get hit as a result of the macro disturbance, even though the intrinsic value of the business barely moves. That difference between share price and movement of value provides opportunity.

Glaser: Are there any risks that you won't take, no matter how attractive the price of the security may be?

Herro: There are situations where, as bottom-up value investors, if we don't have assurances that the company in which we are investing is domiciled in a place that has a rule of law, that has a clear and transparent financial system, financial markets, without excess burdens and government controls, we will not invest in that company.

For example, we've never invested in a Russian company, as we have felt that the domicile, Russia, just is not conducive to owners of businesses. We don't have the transparency. We don't have the legal system. We don't have a government that is adequately on the sidelines and not interfering to key industries. So as such, places that do not demonstrate those kinds of characteristics--strong legal systems, strong regulatory systems, etc.--we will not invest in those businesses.