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Herro's Macro Issues to Watch: Trade Wars, China

Greg Carlson

Greg Carlson: My name's Greg Carlson and I'm here today with Morningstar's fund manager of the year for international equity, David Herro, who runs Oakmark International. David, thanks for joining me today.

David Herro: Thank you for having me and for the honor. 

Carlson: Absolutely, it's well deserved. Let's talk about the drivers and performance for 2016. Obviously Glencore was a big driver of performance for the fund. Can you talk about how you first invested in that, in mid-2015?

Herro: It was really a large driver. It led to a great deal of outperformance for the fund in 2016. You're right; we started investing in it in 2015, probably the middle of the year. We put it into the International fund. Commodity prices were coming off, people were a bit worried about the balance sheet. But we really believed that the management team, a very proactive management team, would find a way to strengthen the balance sheet, which they announced in September of 2015, and that they would continue to excel at the commodity exposures that they were involved in, such that when prices begin to turn around that they would benefit. By the time we got to 2016, the balance sheet was repaired. It was a textbook recovery, a little bit of everything. They raised some stock, they raised some equity, they cut capex, they sold some assets, and they got debt down to the right level. That's what really gave us the confidence to keep investing in the business, knowing that the balance sheet was repaired, and then we started to see recovery in some of the commodity prices.

In the meantime, 30% to 40% of their business, their trading operation, maintained its good operating profitability. When you put all those things together, despite the share price falling quite aggressively towards the end of 2015/early 2016, our estimate of intrinsic value of that business did not change that much. As a result, we've added a lot to our position and it became a huge driver for 2016. 

Carlson: Right, and it was still your top holding at the end of 2016. Even though the stock was up about 150% in 2016, you see more value there?

Herro: Yeah, it shows how undervalued it was and how out of favor it was. I think it kind of became the poster boy for hedge funds and aggressive commodity funds to short. There was a lot of short interest, and if people thought commodities were going to drop they shorted stocks like Glencore. Again, to us it was being removed from the fundamentals of the business. I think this is what we at Harris Associates--we're bottom-up stock-pickers--we focus on the business and pricing that business and ignore those short-term market fluctuations that often give us opportunities such as what we saw last year with Glencore.

Carlson: Is your thesis for that stock reliant at all on a further rise in the prices of the metals that Glencore deals with?

Herro: It's funny, there's four key metals they deal with. In order of importance: copper, coal, zinc, and then nickel. Two of those four metals are above what we think is the normal price and two are below. The most important one, copper, is still trading a bit below what we think is normal and for it to hit our valuation we would need higher copper prices. Some of the other metals prices, our normal price for those commodities is actually below. I think we're actually in pretty good shape with the valuation today.

Carlson: Continuing to look forward, perhaps we could talk about some of the other top holdings of fund. I know you've got several European banks among the top holdings, including BNP Paribas; Lloyd's Banking of the U.K.; Credit Suisse, which had a pretty poor 2016 in particular; and Intesa Sanpaolo of Italy. Can you talk about those perhaps as a group and maybe we can drill down a little bit?

Herro: What we've seen starting really at the end of 2015, early 2016, was this huge fear that went over the banking sector, European in particular. The lower negative interest rates, the low economic growth of Europe, the fear of energy losses, all these things combined created a very, very bleak environment for banks. What we actually saw, despite some of those headwinds, what we actually saw were the banks performed all right. They were selling at extremely low valuations and they were still able to grow, albeit it a very slow level or hold steady, their earnings. So, these very, very low prices were not verified by a collapse in earnings as those low prices would've projected. 

As we go into 2017 we still think there's good opportunity, especially helped, at least in the U.S., by we're starting to see interest rates rise, which is good for banks. We're starting to see lending growth pick up in Europe, economic growth pick up in Europe, which is also good for banks because you make more loans and you have lower loan losses. So actually, I think the earnings growth for banks should actually begin to pick up. They've had a little bit of a rally the second half of the year, but we still think there's a lot more to go given where we are from a valuation perspective.

Carlson: Also in your top 10, a few other stocks that didn't do particularly well in 2016, automakers Daimler and Honda and also outside of the top 10, Toyota. You've owned those for a bit. Can you talk about your outlook for those?

Herro: These industrials also, I think if you were to look at 2016, industrials such as the automakers, selling at very, very low valuations. At one point Daimler was at 6.5, 7 times earnings, and with a safe dividend yield in excess of 5%. Again, it's rallied a little bit, but these automakers perhaps for fear of the U.S. market being kind of topsy, perhaps for fear of what's happening with autonomous driving and new regulations as far as emissions and the whole Volkswagen scandal, gave us an opportunity to buy what we thought were the good ones with rising profitability, with very, very strong balance sheets. If anything in the case of both Daimler and Toyota, they have too much cash. 

Honda, of course, is still recovering from some of their mistakes a year or two ago. It's more of a recovery story. Of those three names, only Toyota's a pure automaker. Daimler's very strong. They're the number-one maker of trucks and commercial vehicles. Of course Honda has a very profitable and growing motorcycle and scooters [business] now. We kind of chuckle at that, but in places like India and Indonesia, huge motorcycle and scooter market, so it gives them some diversification away from just plain automobiles.

Carlson: Finally, going forward are there any particular macro or economic concerns or are there things that intrigue you?

Herro: When we look at macroeconomics we really want to understand how changes in the macroeconomy, the geopolitical scene will impact our company's ability to generate cash profits over the long haul. I'd say there's probably two things to watch out for in the macro environment. One we've all been talking about, the possibility of trade wars and anything that prevents the free movement across borders of capital, of people, of goods and services. This is something to watch out for because all else being equal, it's the economist's hat in me, the free movement of goods, services, tradespeople, this is a positive thing for economic growth and for corporate profitability. That's one thing to watch out for. 

I think the second thing is China. China all of a sudden is off everyone's radar. There seems to be a clampdown more and more and more on certain political rights. How does this dial into the global economy? If you want to be an innovative economy, especially in the tech sector, you need the freedom to express yourself, you need the freedom to exchange ideas. China seems to want to restrict some of that. When you combine that with some of their oversupply issues and some of the real estate bubble issues, I think China might have some short-term challenges. 

The medium and long term they should be able to navigate them. There's still a lot of growth to be had there, but in the short term there might be some bumps in China.

Carlson: One last question: You've had significant investments in emerging markets in the past, although not recently. Obviously EM in general had a pretty nice run last year. Are you finding anything particularly interesting there now?

Herro: Yeah, we've added in particular to a Mexican broadcasting media company called Televisa. We do have some Samsung. That's considered emerging market. It's certainly an emerging-market economy in South Korea. It is called an emerging-market stock. We have a little bit of an Indian Infosys. We have been able to find some names. I would say there's no fire sale in EM. You look at some markets like Brazil. After the political events of last year the market kind of went through the roof. We would say it's overvalued. Yes, we are starting to find more opportunity in EM, but I would say it's not as easy as you would think given that they have been soft over the last couple years.

Carlson: Great. David, thanks for joining me today, and congratulations.

Herro: Thank you very much.