Oakmark International Funds Annual Update

We spoke with David Herro in late December 2019. In this report, we share some observations related to the international portfolios he co-manages with other members of the Harris Associates investment team.

Market Environment

Reflecting on markets, Herro observes that since early 2018 macro factors have had a bearing on the environment. They have caused a bifurcation among sectors. He says, “I think we haven’t seen this bifurcation since the end of 2008.” For example, many consumer discretionary, financials, and materials companies are selling at single-digit cash flow multiples. On the flip side, what’s perceived as “safety,” such as health care and consumer staples, is trading at mid-20x cash flow multiples. Herro says, “Mr. Market, because of macro and geopolitical factors, [appears] to be more than willing to pay higher prices [for these businesses].” He acknowledges the cheaper names do not always deserve such high multiples because they may have greater capital intensity, but their growth is not that dissimilar and the current discount is excessive in his view. Herro says, “We believe this [bifurcation] is unsustainable. Eventually fundamentals do assert themselves. It’s taking time right now.”

To some degree macro issues, such as trade wars, slowing Chinese economic growth, and now the coronavirus, are impacting businesses’ confidence and their willingness to hire and/or invest to take risks. So, Herro is seeing relatively subdued capital expenditures generally. Offsetting that is relatively healthy consumption due to a relatively strong consumer throughout the world. Herro says this last factor is important. In the United States, Herro notes the biggest issue companies face is the availability of skilled labor. Low unemployment and a strong consumer in the United States is not a bad thing given the consumer is such an important part of the U.S. economy, which in turn influences global growth.

Portfolio Discussion

Speaking to sector-level fundamentals in Europe, Herro says one of their largest exposures, European financials, has been negatively impacted by lower-for-longer slower growth. These names, he notes, have taken a severe price hit based on the belief that negative rates will hurt their earnings. Herro says, “In most cases in our portfolio we see some earnings growth this year, and they will grow that amount next year. But we are not seeing earnings destruction.”

For many years, there have been other headwinds for European financials than just negative rates—regulatory requirements for banks to beef up their capital and general low economic growth in the region. Despite this triple headwind, the financial companies Herro owns are growing earnings. Moreover, the European Central Bank is aware of the stress on European banks and has made some changes that effectively mean that “only half the deposits are affected by negative interest rates.”

In addition, banks are much safer now than before the crisis given they have surplus capital. Banks are paying out this surplus to shareholders in the form of buybacks and dividends. Herro says, “None of our stocks have cut dividends. Most of these banks have anywhere from 12% to 14% core-equity Tier-1 capital. This is nearly double where we were in 2007 and 2008.”

Summarizing his thesis on banks, Herro says, “A lot of the headwinds are either being relieved, or they are becoming tailwinds. This is one of the great pockets of value across the globe today. To me it’s unfathomable that someone is willing to lend their government money at negative 40 bps instead of earning 800 or 900 bps by [investing] in BNP Paribas or Intesa Sanpaolo, especially given the quality of their earnings.”

Investment Philosophy & Process

Oakmark’s international funds invest most of their assets in foreign companies with market caps greater than $5 billion (for Oakmark International) and lower than $5 billion (for Oakmark International Small Cap).

The portfolio managers are looking for three criteria before considering a stock for purchase. First, it must sell at a discount of at least 30% to their estimate of intrinsic business value. Second, the underlying business value should be growing. Finally, management must think and act as owners (i.e., allocate capital efficiently). The research team conducts fundamental, bottom-up company research rather than rely on top-down macroeconomic forecasts. Consequently, the funds’ country allocations are purely a byproduct of stock selection. To assess the intrinsic value of a business, the research team focuses on a company’s ability to generate free cash flow well into the future and discounts it to the present. The funds use a long-term time horizon in evaluating a prospective investment and are largely unconcerned with short-term performance or stock price volatility. Price declines are typically viewed as creating potential buying opportunities. The manager defines risk not as volatility but as the permanent loss of capital.

The funds maintain a maximum position size in a single company of 5% at cost. To maintain diversification, the funds invest no more than 30% in a single country and no more than 25% in a single industry. Currency hedging is done for defensive purposes if the dollar appears excessively undervalued. Emerging-market equities may constitute a significant weighting in the funds.

Performance & Opinion

At the beginning of 2019 when commenting on the Oakmark International’s underperformance in 2018, we wrote:

To illustrate the importance of having patience with this fund, on prior occasions when it has underperformed its benchmark over the short term in a material way, subsequent three-year and five-year returns were significantly superior to the benchmark’s. Looking at three periods we could identify, which include a “normal” market environment as well as bear markets, the fund outperformed its benchmark by over eight percentage points on average, annualized, over the subsequent three-year and five-year periods. Considering that the team’s process and discipline has remained unchanged, we believe recent underperformance will prove to be a blip in the fund’s excellent long-term track record.

In 2019, Oakmark International rose 24.4%, outperforming the MSCI World ex USA Index (up 22.5%) and handily beating the value benchmark, MSCI World ex USA Value (up 17.0%).

Looking at long-term performance, Oakmark International has underperformed MSCI World ex USA by 23 basis points (bps), annualized, over the trailing five-year period (ending 12/31/2019). And it has outperformed the benchmark by 346 bps, annualized, over the trailing 10-year period. The fund has also beaten MSCI World ex USA Value by 160 bps and 441 bps, annualized, over the same time periods.

Since its inception in 1992 (through 12/31/19), the fund has returned 9.42%, annualized, versus 6.07% for MSCI World ex USA. Since inception, the fund has outperformed MSCI World ex USA 73% of the time for rolling three-year periods, 81% of the time for rolling five-year periods, and 100% of the time for rolling 10-year periods (through 12/31/19).

Based on our extensive due diligence and our many years of investing with Herro and his team, we are confident these funds will outperform their benchmarks over the long term. Herro is an independent thinker and an extremely disciplined investor. Over time, we believe patient shareholders will continue to be well rewarded as they have been for over two decades.

—Rajat Jain, CFA