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Herro: Look to Europe for Value

Jason Stipp

Note: This video is part of Morningstar's 2015 International Investing Week special report.

Jason Stipp: I'm Jason Stipp for Morningstar. It's International Investing Week on, and today we are checking in with David Herro--manager of the medalist-rated Oakmark International (OAKIX), International Small Cap (OAKEX), and Global Select (OAKWX)--to get his take on the international markets and where he is seeing opportunity today.

David, always great to see you. Thanks for coming in today.

David Herro: Thanks for the invitation.

Stipp: I want to start out by talking about your portfolio positioning at the regional level. You recently had a letter to your investors at Oakmark International that said you have 80% in Europe, 11% in Japan--which are big weightings, especially the European one. We do know that those markets, year to date, both of them have done pretty well--up around 10%. As you are thinking about the individual securities you hold and the appreciation we've seen, you still see room to run in those regions.

Herro: Yeah, how we are positioned is really a function of where we are finding individual-company value. I think it's really important to realize that a lot of these European and Japanese multinationals have revenue streams and cash flow streams that are really sourced from all over the world. I think that is one of the anomalies that we try to take advantage of. People were scared of Europe, so they stopped buying European equities, even though many of those European companies have exposure to good areas of growth in Asia, even in Latin America, where some of the growth exists. And so, really, this is why we're positioned the way we are in some of these markets.

Japan--we're actually a bit lighter than we were a few years ago. Recall that we were over 20% at one point. The market had a substantial rally; we trimmed back. We are actually starting to see a little better value; we're slowly been building some of our Japanese positions, and you could see that if you read the reports quite closely.

And in Europe, again, to us, it's just what we get for the valuations that are listed in a lot of these European countries. The European multinationals still seem to be some of the cheapest companies in the global universe, and today the euro is what we deem as "fundamentally undervalued." If purchasing-power parity for the euro is around $1.25 or $1.28, and the euro is around $1.12, we're buying cheap currency as well as getting cheap stocks.

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Stipp: I want to circle back to you on currency in just a moment, but sticking with Europe, Greece is in the headlines again. They made a debt payment this week. There's a lot of concern over Greece. Still, it's been in the background for a while. How do you see, from a fundamental perspective as you are sizing up companies, the risk from Greece? And is this more of a fundamental story or a potential volatility story in the short term, which could create opportunities?

Herro: I do think it's more of a volatility story. This has been in the headlines now, it seems, forever. The Greeks just can't push through with real reform or a real solution to their issues; they have already taken a haircut on their debt, but there's still too much debt. They don't seem to want to negotiate with the Europeans, and maybe at some point it's time for the Europeans to say goodbye if they will not seriously negotiate.

In the past, there was fear of contagion--that if Greece left, Spain would leave, Portugal, Ireland, perhaps Italy, even maybe France. These fears, at this stage, seem way overblown because those other places are in much more sound and stable conditions. So, at this stage, if something happens to Greece, I think it would be more of a volatile situation, less of a fundamental situation--something we would be carefully watching, especially in the financial sphere, to see if we could find good values as a result of the instability in Greece.

Stipp: You mentioned financials there. Looking at your top three holdings as of March 31 in Oakmark International, in the financial sector, Credit Suisse (CS), BNP Paribas (BNP), and Allianz (ALV), can you talk a little bit about the opportunities you're seeing in financials? Are there any sector themes that are driving some of those individual-stock selections?

Herro: One of the themes in particular is that we are believers that well-run asset-management businesses are really good companies to invest in. And really a substantial part of Credit Suisse's income stream comes from their private-bank and their asset-management businesses. Of course, PIMCO has been in the news with Allianz. And 15% to 20%-ish of the valuation of Allianz comes from PIMCO, and they are actually starting to see some recovery as a result of what happened last September with Mr. Gross leaving. Outflows are still happening but at a much, much a lighter rate. So, that's one theme.

The other theme is just the valuations themselves. These companies have been hit, partially based on these Greek fears, but it should be known that none of the European financials own a lot of Greek debt anymore. This has all been flushed out of the system. So, for us, it represents a good opportunity. BNP is a very well-run universal bank in France, and they have good exposure to Italy and other parts of Europe, as well as Bank of the West in the United States, extremely well run. Don't forget they were hit last year by that [Department of Justice] fine. They are recovering from that. They have ample capital positions, all at good valuations. So, we think some of this European instability is hitting these financials, perhaps unfairly, providing us with an opportunity to make money for our shareholders.

Stipp: Lastly, you mentioned earlier your take on the euro. Just in general, as we have seen a very strong dollar--although it has been weakening recently--what's your take, as an international investor? How do you think about currency, handling currency risk, and the opportunities that currency can present for you?

Herro: Well, what we do is we value a currency like we value an equity, and we use purchasing-power parity to value a currency. However, currency valuation is an extremely inexact science. So, we only take steps to hedge and protect if we're holding a currency that is substantially overvalued, more than 20% overvalued as defined by PPP. Now, today, as a result of the dollar move, a lot less of those currencies fall under that description of being overvalued. The Swiss franc is still overvalued, the Australian dollar is still overvalued, but it's hard to find a lot of others.

Now, recall that three years ago there were situations where sterling was overvalued, where the euro was overvalued, where the Swedish krona was overvalued. So, today, in fact, as mentioned earlier, we see the euro as undervalued; the yen, which used to be substantially overvalued, is undervalued. So, that means for the dollar-based shareholder, over time, as the prices of currencies go back to normality or to fundamental PPP, there is actually a little currency tailwind that we can catch by holding those weaker currencies. For those currencies that are still overvalued by more than 20%, we protect our shareholders by hedging some of that back into U.S. dollars, and the hedge amount is really a function of how much overvalued it is. The more overvalued it is--over 20%, that is--the more we hedge.

Stipp: David Herro, one of our favorite international-equity managers, it's always good to hear your insights on the global markets. Thanks for joining me today.

Herro: Thank you for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.