David Herro is the portfolio manager for Oakmark's International Fund, International Small Cap Fund, and Global Select Fund. The global investor, who was named Morningstar's International Stock Fund Manager of the Decade for 2000-2009, recently spoke with GuruFocus for an exclusive interview.
In the next few weeks, GuruFocus will also be interviewing David Dreman, a legendary contrarian investor and author of Contrarian Investment Strategies: The Psychological Edge. Don't forget to submit your investing questions that you'd like answered.
Could you tell us how you got your start in investing and then specifically value investing?
I initially wanted to pursue a Ph.D. in economics, but after realizing that my real love was investing, I left graduate school after finishing a master’s degree. I was also disenchanted with the publish-or-perish attitude of academia, which is another reason I went into investing. The first place that hired me was the Principal Financial Group, which at the time was called the Bankers Life Association of Des Moines, Iowa, because they wanted to start an international equity investment program and thought someone with an economics background who understood currencies was the best person to hire. Now, sadly, I had to tell them that currency actually plays a relatively minor role in the long term performance of international equities, but nonetheless, I got my start.
I started in 1986, and in early 1987 they gave me a pool of money to start investing. I got into value investing because I had to come up with a plan to invest the money there, and again, with a background of a theoretical economist, I did some reading on different investment approaches. I read the Intelligent Investor and Security Analysis by Benjamin Graham, and I immediately thought that if you blend Graham's philosophy of value investing and meld it with microeconomic theory, you could come up with a really good way of investing money. This method focuses on analyzing and pricing businesses and buying low and ignoring all the macro noise. So that's how I got my start. I've been self-taught because, at my first job, I was based out of private placement fixed income department of an insurance company, where I just taught myself.
Did you have any mentors during this time when you were at your first job out of graduate school?
I think Roy Eahrle, who was the vice president in charge of investments at the Principal Group, was a very wise man. In those days in the '80s, all the desks were in the interior of the room, and the officers sat along the outside of the room. I sat right outside of Roy Earhle's office and through talking with him and listening to him, I learned a lot about the importance of being a long term investor and avoiding disasters. He was a very solid investment thinker. If you look at the Principal Group while he was at the helm, unlike most of the other insurance companies that would get caught up in developing market lending or oil patch lending and took big losses, Principal avoided all of those, and I think it's because of him.
You mention Ben Graham, which is, of course, required reading for any investor, but did any other investors have an influence on shaping your investing philosophy?
I read David Dreman's book as well. He wrote very extensively on the psychology of investing and how most people think when a stock goes up it's time to buy, and when a stock drops, it's time to sell. Of course, in most instances, that's just the opposite of how we should behave. I run a retail mutual fund, and sadly, people are the most scared and do the most withdrawals at the bottom, and the most money comes in at the top. David Dreman goes extensively into that type of investment psychology and explains why you should ignore it. I think that was instrumental in shaping my philosophy as well.
Could you tell us more about the process that you use to narrow down your search for an investment? How do you get your ideas?
First, we screen for companies that have certain value criteria. Our idea of value is companies that are high in quality and low in price. The criteria we use to judge price are free cash flow yield and enterprise value and operating cash flows. The criteria we use for quality are returns on equity and return on capital employed. So, the return structure tells us about quality and the amount of cash flow the company generates versus the price of the enterprise. We look for companies that maybe have been hit because they're in an unpopular sector, industry or region – they are cyclically out of favor, but they are not structurally impaired. So those types of businesses we'll take a look at. Now, that doesn't mean that value exists, it means we should take a look at it. If it demonstrates value characteristics or if its share prices have been hit, it gives us a reason to look. But again, just because it looks good on paper, we require ourselves to do a lot more homework before we can invest: We want to make sure that the company is high quality and is low price, with a management team that is committed to building shareholder value.
Our whole research and approval process is about trying to put the right corporate value on a business. That's what our process comes down to: answering the question of what is the company worth from a fundamental perspective?
What factors and metrics do you look when you're trying to determine a management's ability?
It's very important for us to understand or have confidence that the management teams in which we are investing are value creators. We look at their track records. We look at how they've allocated capital; we look at the historical return structure of the business. Just because a company may have had low returns doesn't mean they're going to have future low returns, and we have to understand, in that example, what management's plan is to turn the returns around so that they are positive.
When we sit down and meet with management, we're basically accessing their ability to create value. We're not there asking them how many widgets they are going to produce in the next quarter. We're not so concerned about short-term plans. What we're really concerned about is what they believe is the best route to value creation for their business, and how they will execute it. What their priorities are and why. So how, what, why – these are the types of questions we ask.
On the flip side, what are your guiding principles when you're deciding when to sell a stock?
It's actually fairly simple. We sell a stock when one of three things happen. What we're trying to accomplish in our analysis is to determine the worth of a business. Incidentally, hopefully that worth has an upward slope, but when price and our measurement of the business value coincide, then for us it's time to sell. We are value investors; we won't even invest in a business unless it trades at a discount to that intrinsic value. And so when price hits value, it's time to sell. So, that's the first and foremost reason why we sell. We consider it a victory and we sell the stock.
The second point of when we sell or trim is based on the notion that the position assigned to a stock is predicated on the distance between price and value. Those stocks where price is far away from value are big positions, and as price approaches value, it becomes a smaller position; so positioning is dynamic, since it is based on the relationship between price and value.
Our belief is that a management team creates value over time, so price and value will eventually converge. But what happens if you invest and made a mistake, and the management team doesn't create value or destroys value? In that case, we just sell the stock. We're not activist shareholders. We're not out to replace management. Our view is in an instance when we feel we've misjudged management, then we need to get out.
You seem to have a preference for investing in emerging markets indirectly, but do you have any ideas in markets like China or Latin America?
It's not really a preference; it's just how it is today given the valuation differential. Categorically, we like what's happening in the emerging world, where you have large masses of the global population moving from lower class to middle class and from middle class to upper-middle class, which is driving global economic growth. This is a very good thing. Now, that's different than "our company's cheap." Are they well managed? Are they good quality? This is a big mistake investors make: they confuse what's happening in the macro environment with the availability of company specific intrinsic value. What we'll do is look for companies and look for their valuations. Yes, we'll give them credit for higher growth rates if they, in fact, are exposed to it, but just because they're in an area of great macroeconomic growth doesn't mean they're a good value. This is a very important point because investors often confuse them. In fact, when we look at companies that have exposure to EM, many of these are priced at huge discounts. A much better way of benefiting from this macro event is to buy companies that are well exposed, as you can get that exposure at a significantly lower price. There have been times in our history when we've had over 20% in EM; if you look at the late '90s when EM prices had been hit, we had huge exposure. But at this point, the price just isn't there.
Overall, are there any companies in which you're waiting for a better price before you buy in?
Yes, many times we identify businesses we really like – they have good quality management teams, they're value creators and have good return characteristics – but the price isn't there. So what we do in that case is put it on a watch list, and we hope that maybe the price doesn't go up as much as value creation – that creates a value gap – or maybe there's a short term disappointment that creates a value gap, etc. These are the types of companies we really like but there just isn't enough upside in price for us to make the investment.
You sold out of Continental AG (XTER:CON) back in the second quarter and bought back in this past quarter. Can you explain your investment thesis there?
When we first bought it, it had the necessary upside. It's a really good quality company, a big car parts and tire maker going through restructuring, and was really starting to focus on driving returns. We established a small position, and before we could get a big position, the price spiked way up. Price got really close to value and it was a relatively small position for us, so we sold it. It's a great company and that is an example of something that if the price drops, we'd be interested in adding back in.
What do you think about the current market conditions and being able to find bargains?
If you look through time, there are certain periods of time where entry points are clearly better. In March 2009, we saw stocks selling at a huge discount, and then again in the summer of 2012, whenever everyone thought for the first time that the euro was going to fall apart, there were huge opportunities. I would say today we don't have such extreme opportunity, but especially looking around the world, we still see good opportunities in certain businesses. I mentioned that some European multinationals have good exposure to EM, and also some of the Japanese exporters like Toyota (TSE:7203) and Honda (TSE:7267) are huge beneficiaries to EM. They continue to get good exposure in EM, so we do see good pockets of opportunity, but we'd say we're not at a place like ‘09 or 2012 where there were fire sale prices. I would say we're at a place in the cycle where we're only able to find select opportunities. By no means are we shut down to opportunities, but it just isn't as widespread as it was two or three years ago.
What regions do you find to be most interesting right now?
If you look at where our equity weightings are, you do see an overexposure to continental Europe, as all the fears that people had about the euro and the Eurozone imploding caused people to leave the share markets of Europe and the prices to drop. Again, these are global businesses, and this is one of the mistakes people make: They don't judge a company by what they earn, they judge companies by where they're located. To us, that makes no sense; what's important is the money they earn, not where they're located. So, we found good value in European financials, consumer discretionary, consumer staples, and a number of industry classes.
Other than the Ben Graham books and David Dreman's, do you have any recommended books for other value investors?
Peter Lynch's (One Up On Wall Street and Beating the Street). And Seth Klarman’s (Margin of Safety), even though it is out of print. These are just really good investors and thinkers that are the types of people investors could learn from.
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Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
The Oakmark International Fund’s portfolio tends to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Fund’s volatility.
Oakmark International, Oakmark International Small Cap, and Oakmark Global Select Funds: Investing in foreign securities presents risks that in some ways may be greater than U.S. investments. Those risks include: currency fluctuation; different regulation, accounting standards, trading practices and levels of available information; generally higher transaction costs; and political risks.
Oakmark International Small Cap Fund: The stocks of smaller companies often involve more risk than the stocks of larger companies. Stocks of small companies tend to be more volatile and have a smaller public market than stocks of larger companies. Small companies may have a shorter history of operations than larger companies, may not have as great an ability to raise additional capital and may have a less diversified product line, making them more susceptible to market pressure.
Because the Oakmark Global Select Fund is non-diversified, the performance of each holding will have a greater impact on the Fund's total return, and may make the Fund's returns more volatile than a more diversified fund.
The discussion of the Fund’s investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Fund’s investments and the views of the portfolio managers and Harris Associates L.P., the Fund’s investment adviser, at the time of this letter, and are subject to change without notice.
According to Morningstar, the Fund Manager of the Decade award, which is a new award from Morningstar, recognizes fund managers who have achieved superior risk-adjusted results over the past 10 years and have an established record of serving shareholders well. While the awards focus on performance over the past decade, Morningstar takes into consideration other factors, including the fund manager’s strategy, approach to risk, size of the fund, and stewardship. Both individual fund managers and management teams are eligible, and being a previous winner of the Morningstar Fund Manager of the Year award isn’t a prerequisite. Morningstar’s fund analysts select the Fund Manager of the Decade award winners based on Morningstar’s proprietary research and in-depth evaluation.
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