During a recent conference call, Portfolio Manager David Herro shared thoughts on the previous quarter and the current market environment and participated in a Q&A. Below is a recap of the call on April 13, 2020.
Unfortunately, this was a very difficult quarter for the strategies, global equities and a number of asset classes. Oakmark International and Oakmark International Small Cap declined just over 38% and significantly underperformed their various benchmarks, which were also down in the -20s. We’ve been keeping the portfolios forward positioned and keeping our sell prices current.
The most important thing, first and foremost, we have to do is make sure our sell prices are reflective of the economic reality around us. Despite today’s extreme economic circumstances, recall that the value of any business is the present value of all future cash flow streams rather than the next couple quarters or months.
We have to make adjustments and have done so from conducting research, talking to management and doing industry work along with whatever it takes to be, in our view, as accurate as possible as to the new valuations of our businesses. In general, business values have probably declined anywhere from the mid-single digits to the low-double digits. We’ve spent a lot of time doing management meetings. As I wrote in this quarter’s commentary, it’s been very inspiring that the managements, for the most part, have been very open and proactive.
Despite working from home for well over a month, we’ve been extremely busy to make sure we anchor our investment decisions and that the valuations of our business are as up to date as possible – that’s number one.
Given the volatility, this means that from a portfolio management perspective, we have to be very proactive to make sure our portfolio remains forward looking. If a company’s gap between price and our measurement of its value opens at a greater rate than other names, then that’s a name we want to stay involved with at a healthy weight. If there are companies whose price in value may have narrowed or gone down less, then we also have to make adjustments.
Given the volatility we’ve seen, I’ve spoken in the past about one stock we own with a two-day volatility price movement of over 30%, so this was not so atypical back in the days of March 18, 19 and the week before when things were really wild. We believe that investors were no longer looking a couple quarters ahead but rather a couple weeks or days. You saw extremely volatile trading and you will see that our portfolio turnover is going to increase over the next couple of quarters to keep the portfolio positioned.
Theoretically, our turnover is normally 25-35%, but coming out of this period, you will see a bit higher portfolio turnover as we’ve had to continually reposition. If you look at the top 15 or 20 names, you will see a lot of the same familiar ones, but there might be different positions or ranks as a result of price movement.
We’ve added to some of the companies that were smaller positions as a result of the steep share price declines. Think of a company, like Prudential, Brambles or Trip.com, to which we’ve added significantly. The adjustments we’ve made in companies really vary by the type of industry they’re in, market exposure and the type of balance sheet they have. There’s really no rule of thumb.
There will be lost sales. Some companies, if they’re more discretionary purchases, might get some back. It all depends on having the balance sheet strength to make it through. This period is something important for us to look at and analyze companies and the kind of business models they have, how they will be able to recover when we start seeing some of this dissipate.
We’re starting to see a few signs of countries beginning to talk about slowly reopening. We can’t keep these economies closed forever and the authorities need time to prepare health care systems. We do feel that the fiscal stimulus that has been injected into the global economy should help ease the recovery in most of these areas. Even in the U.S., you see almost 10% of GDP is being spent, which should help us recover from what has been a relatively nasty economic wake as a result of this shutdown of about 30% of global GDP over the last four to six weeks.
New idea flow has been strong in the last two or three weeks, which is probably at a near record date for us if you look at year to date.
The last thing I want to say is that there is a good essay, “The Value of Value,” written by Danny Nicholas, client portfolio manager, as it pertains to this devaluation of value. If you look where the portfolios are trading today, they’re around 42 to 43 cents on the dollar. Their previous lows were around 40 cents on the dollar, which was March 9, 2009. We hit a new all-time low on March 18 when it was about 34, 35 cents on the dollar. Remember the range typically had been in the high 40s to high 70s. The outlier cases were the 40 and the new outlier case, 34 cents, wasn’t there long as the next day it spiked up pretty strong. Certain weeks you never forget and the week of St. Patrick’s Day is one. We’re still bouncing around near the outlier lows, last visited in March 2009, 11 years ago almost to the date.
You think it’s never going to end, but these things do. We’ll have to deal with the economic malaise that surrounds it, but this will have an endpoint. We believe the amount of fiscal and monetary stimulus and the speed at which it was deployed will be helpful in making this wake more palatable.
We appreciate your patience. We know it’s been painful. We’re among the biggest shareholders of these Funds. We feel your pain. We’re in this together and we’ll get out of this together. We’re very enthused about the types of businesses we’re able to buy at the prices we’re able to pay for them. Thank you for your patience and sticking with us. We promise to keep working and doing what it takes to keep the portfolio attractive and forward positioned.
QUESTIONS & ANSWERS
What do you expect going forward from the developed world versus emerging markets? Do they have the financial resources to carry themselves through this? Do you see U.S. or international outperforming over the next year or so?
It’s hard to make a blanket statement for developed versus emerging because each area is so different. For instance, take Germany from Italy versus the U.K. versus the U.S. versus Japan. Each one has a different situation. The same is with emerging markets with some in much better shape than others, such as Korea or Taiwan. Having said that, we’ve been able to gently increase some of our emerging market exposure. We’ve added a new position in Trip.com, which is the biggest online travel agent in China, and Alibaba. We’ve been able to tap into some of this as a result of the market instability. With Trip.com, we waited and held in there for a long time, but it finally sunk so low that it became attractive for us to buy again. It really is a case-by-case basis on these emerging markets.
The valuations of some of the blue-chip companies in the developed world have really been creamed during the first half of March. There has been little recovery since then, but we think there’s a huge valuation differential.
For the most part, non-U.S. emerging markets versus emerging and the U.S. outside of Japan, which remains a rather expensive market from our perspective, it’s been harder for us, even though you’ve seen in of our strategies that we’ve added a new Japanese name. We’ve always thought the U.S. deserves to sell at a premium today whereas we’ll call non-Japan developed ex U.S. But we think some of these prices have gotten so beat up, especially in the areas of consumer discretionary, industrials and financials. European financials, for instance, trade at a significant discount to U.S. financials – and the U.S. financials have been hit pretty hard.
We think right now the valuation is so compelling in some of these names. You don’t want to get excited during a period like this because it’s gloom and doom. But on the other hand, when else could you buy quality at such a low price? In a period of time, you’ll look back and say that you could have bought BMW for an enterprise value of $15 billion, which is quite extraordinary for a company, especially since it’s sitting on $16-17 billion in net cash on its balance sheet and it profitably sells 2 million cars a year and is a great worldwide brand name. We try to look ahead rather than at just today. You have to look through time and how it will look buying a company at one and a half or two times cash flow. We think this is where you have these really low valuations basically in developed Europe, which is kind of where they were before this started and the last three months only amplified this.
Health care is not really a large holding in your Funds. Why are those companies not attractive to you?
There have been periods of time where we’ve owned a bit more health care, but today we don’t. It’s all based on valuation. These are things that have held up really well in the last 24 months or so, especially in this recent downturn. They’ve become relatively less attractive because the prices have not declined much. Our belief is that yes, they are stable. We would apply a decent multiple to them but even with this, they’re not attractively priced. They’re kind of insurance, but you’re only going to pay a certain premium for insurance. It is our belief that where these prices are today that you are overpaying.
The last time we saw such a bifurcation in values was at the end of 2008. Health care, utilities and consumer staples were richly priced while financials, consumer discretionary and industrials were cheaply priced, which flip flopped by the end of 2009.
We almost saw a mini cycle of this in 2016 where during the front half of the year you saw the same bifurcation and it kind of flipped by the end of 2016. We believe similar conditions in terms of valuation dispersion exist today between some of these sectors.
It’s just a matter of price, but we would own health care companies. If we measured good value there, we would certainly own some of these stocks. In the past, we’ve had heavy exposure to some of the European pharmaceuticals along with medical device instrument companies. But today, there’s not enough to meet our value criteria.
Are gold miners or royalty companies something you’d be willing to consider for your Funds?
Gold is a funny thing. A lot of the demand doesn’t come from industrial demand, so it’s difficult to come up with what you believe to be a normal price. To price a gold miner, we would have to come up with what we believe is a normal price of gold. Because so much of the demand is speculative, it’s hard to get a good read and be accurate and use the mathematics of finance to come up with a good price, so this is why you see an absence of gold exposure in the portfolio.
The Global Fund has more than 1/3 in autos and financials. Are those companies that you think may bend but not break? Do you still think they offer attractive value despite the challenges they may be considered to have?
We gravitate toward those sectors because it kind of started with the last trade wars and instability in the EU, in particular, which really hammered these prices. As a result of this crisis, you’ve seen a further deterioration in prices and underperformance, which we don’t think is justified, despite a sluggish economy. The European financials, in particular, have demonstrated the ability to earn good money in the last two to three years with narrow spreads and slow growth. This time around, we believe they’re significantly stronger so we think they’re in really good shape. Despite this, the market reaction was quite abrupt – well over at a low, over 40-50% in a couple months. We don’t think the business value is anywhere near there, though, so names we initially considered to be attractive have become even more so.
The real estate sector may be challenged as banks make a lot of commercial real estate loans. What do you anticipate needing to review the loan books for banks, in particular, any collateral from real estate more regularly?
We certainly have to stay on top of loan books. We have to look for places of stress. If fact, when we adjusted our banks’ valuations, we gave a pretty good increase to credit losses, so we assume some credit losses. But again, we have to be very careful because in each jurisdiction, the state is guaranteeing some of the new loans being written. With each holding, we have to go through each bank and stress test each loan book and make judgements and take hits. The new sell prices we have are reflective of the information we have and where we think these loan books are going. Real estate has been kind of stressed for awhile now mainly because of what’s happening in the retail sector.
Looking at Oakmark International and the five-year peer rankings, it looks like there were two other timeframes where the Fund had similar performance: September 1998 and June 2008. Can you compare and contrast those timeframes to now? In both instances, it looks like the Fund had a pretty strong peer ranking within four quarters, so can you provide a sense of where that rebound came from?
The worst period still might be 1998-99, which was during the Asian financial crisis, which bled into other emerging markets as well. As value investors, when we find quality companies that are dropping, we begin to get involved and we saw Asia extremely compelling. It was an opportunity to get exposure to good businesses that were in freefall. But when you have that kind of volatility, you can’t pick the bottom.
One of the lessons learned was to be slower at nibbling. We buy in much smaller pieces today, so you don’t get so excited and buy it all up. As the prices drop and the spread between price and value increases, you slowly increase exposure.
The causes of the shock in 1998 versus this one are very different. But they have one thing in common – there was a huge shock to price compared to what we believe to be a relatively much smaller shock to the intrinsic value of the business. It seems that no two shocks are caused by the same thing, especially this one, which has been more unique than any. The result, however, is the same with the diminution in price being far greater than the decline in underlying value. This gives us an opportunity to buy quality at a low price. The third quarter of 1997 and the third quarter of 1998 were atrocious and then we did quite well the next two, three, four years. All of those companies didn’t just come back.
This is the point I’m trying to emphasize about staying forward positioned. You never know when the catalyst happens. But what we do know is that the greater the spread gets, the more unsustainable it becomes. This catalyst was different, but the price action was somewhat similar.
That period in 2008, which we underperformed, believe it or not, was mostly due to our underexposure to the commodity super cycle. Oil, minerals, mining and metals were booming and we were on the sidelines. We could underperform when we’re not participating in a sector that is doing well or we’re slowly getting involved in a sector that is dropping. And mid-2007 to mid-2008 began a period of strong underperformance due to not being involved in the super cycle names and even then we were starting probably too early to buy some of the financials that were getting killed going into the crisis. It was only 13 years ago when a Goldman analyst was saying oil could be trading at $200-$300 a barrel, so it goes to show that predictions sometimes don’t come true and this one has not. But that was one of the reasons why, especially in the second half of 2007 going into 2008, that we didn’t have any exposure to oil or natural resources.
Is it common to go four or five years without much turnover in top names, such as European financials and autos? If it’s uncommon, what does that say about the opportunity set and research process? If you still hold those names in two to five years, would you consider it a sign that something went wrong or are you not concerned about the holding periods?
We believe European financials have performed pretty well from a business perspective in the last two or three years. Last year, they outperformed their sector and the market.
Autos faced two exogenous factors that hurt their situation. The trade war hit China, in particular, which hurt the Chinese auto market and slowed the growth of its premium auto sector. It also created a period of uncertainty for where they could export. Even though it wasn’t a big part of their business, both BMW and Mercedes exported profitable SUVs from the U.S. into China, which did not help that situation.
Emission rules, especially in Europe, changed quite dramatically, which created some exogenous shocks to the businesses. The companies have had to prepare and spend more on alternative drive trains, which they have been doing now for three to five years. Today, we believe these companies are going to be more than ready in the next two or three years to have a full slate of electrified and hybrid and plug-in hybrids that will satisfy the regulator and the market because they’ll still be selling internal combustion engines.
This year was looking to be good for auto producers as the worst appeared to be behind them. They were somewhat caught up on the emissions game and the trade war was looking better – and then the coronavirus hit. The good news about these companies, particularly the three OEMs we own (Toyota, BMW and Daimler), is that they have strong balance sheets: Toyota with 70 billion in net cash, BWM with 15, 16, 17 billion in net cash and Daimler in 10 or 11 billion in net cash. We believe they have the financial strength to get through and are solid brands with good exposure to growth markets.
In the meanwhile, the price you are paying for these businesses, while looking at free cash flow yields or any kind of conventional valuations metrics, are almost at all-time lows. We think they’re prepared for the future.
In the case of autos, there was a situation with Daimler. We thought we would have given up last year if they hadn’t made such a change in management. We think they will come out of this much stronger than the way they went into it.
The financials showed good signs of life in the last year and added good performance to the Funds whereas the autos did not, but we think they’re in a position to do so going forward.
If we don’t see improvement in cash flow streams, lack of income or operating performance, then something went wrong. When we sell a stock, a few things may happen:
- Price hits our estimate of intrinsic value
- Price comes pretty close to it and there are other compelling ideas
- We’re wrong with our thesis
A few years ago in Japan, we thought that their financials, brokerage firms and asset management companies were not capable of generating value – and if they can’t do that, then price and value won’t converge. The key to what we look for is not necessarily the price curve of the stock but the value per share through time. If that value per share stagnates or if we believe they will not have the ability to generate and create a positive slope of that curve, then we’ll sell the stock.
Average Annual Total Returns (as of 03/31/2020)
|Fund||3 Month||1 Year||3 Year||5 Year||10 Year||Inception|
|MSCI World ex U.S. Index||-23.26%||-14.89%||-2.07%||-0.76%||2.43%||5.00%|
Gross Expense Ratio (as of 09/30/2019): 1.03%
Net Expense Ratio (as of 09/30/2019): 0.98%
Fund Inception: 09/30/1992
|Fund||3 Month||1 Year||3 Year||5 Year||10 Year||Inception|
|MSCI World ex U.S. Small Cap Index||-28.39%||-19.04%||-3.60%||0.39%||3.95%||n/a|
Gross Expense Ratio (as of 09/30/2019): 1.38%
Net Expense Ratio (as of 09/30/2019): 1.38%
Fund Inception: 11/01/1995
Past performance is no guarantee of future results. The performance data quoted represents past performance. Current performance may be lower or higher than the performance data quoted. Total return includes change in share prices and, in each case, includes reinvestment of dividends and capital gain distributions. The investment return and principal value vary so that an investor’s shares, when redeemed, may be worth more or less than the original cost.
The net expense ratio reflects a contractual advisory fee waiver agreement through January 27, 2021.
The holdings mentioned comprise the following percentages of total net assets as of 03/31/20:
|Security Title||Oakmark International Fund||Oakmark International Small Cap Fund|
|Alibaba Group ADR||0.2%||0%|
|Trip.com Group ADR||0.6%||0%|
Portfolio holdings are not intended as recommendations of individual stocks and are subject to change. The Funds disclaim any obligation to advise shareholders of such changes. Information about portfolio holdings does not represent a recommendation or an endorsement to Fund shareholders or other members of the public to buy or sell any security contained in the Funds’ portfolios. Portfolio holdings are current to the date listed but are subject to change any time. There are no assurances that the securities will remain in the Funds’ portfolios after the date listed or that the securities that were previously sold may not be repurchased.
Access the full list of holdings for the Oakmark International Fund as of the most recent quarter-end.
Access the full list of holdings for the Oakmark International Small Cap Fund as of the most recent quarter-end.
The MSCI World ex U.S. Index (Net) is a free float-adjusted, market capitalization-weighted index that is designed to measure international developed market equity performance, excluding the U.S. The index covers approximately 85% of the free float-adjusted market capitalization in each country. This benchmark calculates reinvested dividends net of withholding taxes. This index is unmanaged and investors cannot invest directly in this index.
Investing in value stocks presents the risk that value stocks ay fall out of favor with investors and underperform growth stocks during given periods.
The MSCI World ex U.S. Small Cap Index (Net) is designed to measure performance of small-cap stocks across 22 of 23 Developed Markets (excluding the United States). The index covers approximately 14% of the free float-adjusted market capitalization in each country. This benchmark calculates reinvested dividends net of withholding taxes. This index is unmanaged and investors cannot invest directly in this index.
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.
The Oakmark International Small Cap 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.
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.
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.
Investing in value stocks presents the risk that value stocks ay fall out of favor with investors and underperform growth stocks during given periods.
The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change and may change based on market and other conditions and without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.
Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.