During a recent conference call, Portfolio Manager David Herro shared thoughts on the previous quarter and current market environment and participated in a Q&A. Below is a recap of that call from July 13, 2020.
Thankfully, the news for the second quarter was a little bit better than the very dismal first quarter. We made back some, but not all, of the losses of the first quarter, but all the strategies have performed well on an absolute and relative basis. The International Fund, in particular, outperformed by almost nine percentage points. It doesn’t tell the whole story, though, because of how poorly we did in the first quarter and how hard markets were hit, especially as the dichotomy between stocks with value characteristics and those without continues to be wide, despite our recovery. One of the reasons we’re enthusiastic about the portfolio is because the valuation of it is still extremely attractive and we are starting to see businesses slowly resume.
The last point I’ll make is that you may recall that during the first quarter’s conference call I mentioned that the team has been busy doing three things:
- Making sure the valuations of our companies are as reflective of the new reality as possible, which means updating the valuations of the names on our approved list.
- Working hard to make sure that positions are correctly placed within the portfolio. Those positions, of course, are primarily a function of the spread between our measurement of intrinsic value and market price.
- As a result of so much price displacement, we’re very busy working on new ideas. Last quarter, we added three new names in the International Strategy and four new names in the International Small Cap Strategy. The research team has been doing a good job at maintaining reality in terms of valuations, but also looking for new ideas, including those seven new ideas between the two strategies in the last three months.
QUESTIONS & ANSWERS
Can you share your take on the recent Daimler agreement with NVIDIA? Are a lot of the European car companies going to have to play catch up with what’s going on with the rest of the world and automated driving/self-driving vehicles?
All of the automobile companies have basically chosen selected dance partners to help them move forward in things, such as alternative drive trains and autonomous driving.
The partnership you mentioned has to do with autonomous driving. Daimler has selected a technology partner with a strong, deep expertise in this field, so we view this as a positive.
As far as alternative driving vehicles/drive trains, the European companies, in particular, are moving rather rapidly into hybrids and electrification. We’re starting to see these cars launched in Europe primarily because of the regulatory requirements. You will see in the next year or two rather than three, four or five years, a flood of electric cars coming from Mercedes and BMW and already, Porsche, which launched the Taycan in the U.S. and I believe they’re completely sold out. I think as people begin to get comfortable with electrification and as technology becomes more affordable, you’ll probably see this spread more.
With respect to intrinsic value, in one of your recent quarter-end calls, you were in the sort of high 50s percentage of intrinsic value. Can you give an update of where that is? Can you comment on any changes with how you are calculating intrinsic value given all of the implications of the COVID pandemic?
In the first quarter, we hit a low of the portfolio. It was basically trading somewhere around $0.35 on the dollar. By the end of the quarter, because it bounced around a bit at the end, it was probably at about $0.40, $0.41, $0.42 on the dollar. Today, we’re about $0.50 on the dollar and this is the range where the portfolios tend to trade, high 40s, lows 50, basically low to high 70s, like in the old market downturns.
There were two exceptions. March 2020 was where we traded at the mid-30s and March 2009 through the great financial crisis was where we traded around the low 40s. We’re just a bit of a hair above where the previous lows were and today both Funds are trading at somewhere around $0.50 on the dollar.
We’re always revisiting individual company’s values, so we assign a value to every stock in our portfolio. Usually it’s a steady and continuing process because the economy moves on and companies generate business value. Hopefully they compound business value by a high single-digit or low double-digit. When we have a very volatile economic period, we have to refresh these and sometimes it has a bigger impact. As an example, I would say that as a result of the pandemic, the average stock in the portfolio is worth 5% to 10-12% less, probably 85-90% of the companies are worth mid-single digits to low double-digits less. We had to reflect that, which shows in that portfolio valuation characteristic. Of course there are some outliers on both sides, some that didn’t drop as much and some that dropped more. But really, the number I recite is a weighted average composite of all the companies we own.
It seems like there are more industries that are winner take all that are software or platform based. Do you think COVID has accelerated that? And as a long-term investor, do you have any thoughts to provide on that?
There are companies that are advantaged as a result of our progress and technological development and waves of innovation. As such, we look at these businesses and try to price them because to us a business is still worth the present value of all its cash flow streams. We used to have and still do have some of these companies in the portfolio. For instance, we had ASML and we have TSMC, which are computer semiconductor-related businesses that are structurally advantaged. But like anything else, you have to price in that advantage. The same things goes with companies that perhaps are viewed upon as old economy. At one point, everyone fled to those stocks, but you have to price slower growth for them. All of these businesses exist, some that have more uncertain futures, some that are slower growing and some that are growing faster. It is our job to price those factors when we value business, so when we have a final valuation, we can compare and contrast.
A company might be structurally advantaged, but is the market giving them too much credit for it? Is there too much optimism in the share price such that the price you’re paying for the business doesn’t justify the fundamentals even if the fundamentals are super strong? To me, the real objective of value investing is to value the businesses and you certainly have to give them credit if they’re structurally advantaged. You incorporate that into the way you price the business and this is exactly what we try to do. You generally just simplistically say that if we have a spread of a multiplier, we’re willing to put on an EBIT stream that goes from 7.5, 8 times to 16, 17, 18 times. It’s a very broad spread and the higher quality companies are given higher multiples.
Would there be a significant advantage on the International Fund versus the International Small Cap Fund?
They’re not priced too differently right now. It’s $0.53 on the dollar for International Small Cap and $0.50 for International, which is really right within measurement error.
How do you keep your sanity during times like this when you have the obvious stocks out there that people like to point to and are on some free platforms where individuals are trading and outperforming people like us in the near term? Is there a group of people you talk to, portfolio managers you respect, along with your co-portfolio manager? How do you check your thesis and make sure you’re not owning something because you’ve already owned it? As a shareholder yourself, how do you check your thesis? Does the way you feel now coincide with other periods?
The psychology of investing could play all kinds of tricks for you. It’s like mirages in the dessert. We are value investors. We predicate the movements we make based on valuations we see, which are an output of our research and approval process.
You can’t rest on your laurels; you have to question yourself. To us, what really begs a question is when a company doesn’t perform not in terms of share price but in business results as we had expected. When that occurs, we really have to question. It isn’t what happens in terms of price because we do believe if a business continually builds value per share through time that price and value will converge. We have to make sure that the business continues to build value per share. If it’s not, is it because of short-term cyclical reasons or something structural? We formally review stocks in our portfolio as a group, especially if the stock might be a big position, might have a little hair on it, maybe it hasn’t been performing as well.
We talk to our colleagues inside the firm and I have relationships with other managers. Some of you may have listened to the call one of our colleague firms organized in March, which included a host of other investors, myself included. I maintain friendships with people who even no longer work at Harris and we talk stocks.
The part about value investing that can be very frustrating, because it’s almost the exact antithesis of momentum investing, because if something is becoming a lot more expensive unless the valuation is going up at the same rate as the share price, it is less attractive to us. But if you own a stock like that, you feel really good, which is the psychological aspect, and the reverse is true for a stock that’s falling. As long as the intrinsic business value isn’t falling, you should feel excited about it. But, in fact, most people feel depressed about it and then sell their stock. Look at the pricing behavior of Tesla, which continues to go up. I think the more it goes up, the more the man on the street likes it. But it’s a financial asset and, like everything, it has a price and a value. As a value investor, you have to stay disciplined and stick to it because ultimately what can happen is that you give in at the wrong time. Look what happened to people in 1999 and early 2000 when they did so. This is the trap that we at Harris have luckily never fallen into. The psychology of investing and being a patient value investor is important, but it has to be predicated on the adherence to a fundamental investment process, style and philosophy.
There’s been a sharp rebound in prices, but the economic future is still pretty uncertain. How are you and the team managing the Funds’ cyclical exposure, primarily through some of these multinational European companies?
We had to really re-price everything given this uncertainty. For example, we gave the autos a very strong haircut to what we believed would be light vehicle production globally in sales. You have to do this on a case-by-case basis because different companies, even though they might be in the same industry, have different end market exposures. The premium German automakers, for instance, have seen an extremely strong rebound in Chinese sales, which some of the local or even foreign mass-produced companies haven’t. We have to look at each company and where they’re exposed and make adjustments.
If I look at our numbers, I think we probably tend to err a touch more on the conservative side and some of these cyclicals may do a little better than we had thought in March and April but that remains to be seen. There is less uncertainty than March and April but there is still always uncertainty. This is not a clear vision of the next six months. In certain industries we could see some bounce back. We see things getting better but with other ones, such as hospitality and tourism, there are still questions out there. If it’s an open question, we have to incorporate it. We have to cut their order books and cash flow. We have to revalue the businesses based on what we see and estimate. You’re never going to be perfect, but you have to be somewhere in the neighborhood.
Can you share your thoughts on the difference in how you are thinking about value investing compared to how some of your colleagues at Oakmark are thinking about it for the other Funds? In particular, when you look at the Oakmark Fund, you see a bunch of stocks that at the headline level seem to be significantly higher valuation multiples and stronger growth trends, like Alphabet, Facebook, Netflex and to a lesser extent Booking, along with some others that fit that category. You don’t tend to see companies with similar sorts of factor exposures in the International Fund. How are you two thinking so differently–is it solely the nature of the type of companies that are available in international-domiciled markets compared to the U.S.? In theory, would you like to hold companies like those in your Fund?
I think part of the answer has to do with what I mentioned a few questions ago about how you have to make sure a company has a strong tailwind, strong moat or way to defend and grow its cash flow stream going forward. You have to apply a correct multiple to that. If you take a company like Alphabet, this is exactly what our domestic analysts and portfolio managers see. We hold it in the global funds as well. When you price the businesses, they’re having incubators and you give them credit for the cash. It actually trades below a market multiple, which is a fair value given the quality of the business.
There is some regional bias to this because the U.S. is kind of an innovative tech leader. The only thing that kind of comes close to it is Alibaba, which we added to the portfolio in the second quarter. This is a company to which we apply a somewhat generous multiple. By the way, there is a higher cost of capital, higher cost of equity, because this is a Chinese company, but to the businesses themselves we apply a high multiple given their leadership in ecommerce and financial services and hopefully leadership in cloud computing.
When we do come across these companies, we will apply a higher multiple. We did the same thing with ASML when we held it. But outside the U.S. there are just not as many—and I think the U.S. research team has done a very good job of this. The rationale behind Netflix is that you can’t price the business on today’s revenue per head. You have to look at the growth and the heads and the ability to price through time in normal periods. When you do that, it looks more attractively priced than it seems from a distance.
Looking at the performance of your Fund and value investing in general, what’s been the catalyst for the turnaround? Can you point to other periods?
We had a very poor third quarter of 1997 or third quarter of 1998 because of the emerging markets. But then when emerging markets bounced back, we enjoyed it. As a value investor who reprices a business and then acts upon it, when the bounce back comes, you can enjoy it. But you have to stay exposed to those areas. You have to reprice them. If there is still value, you have to stay exposed or you might not experience the bounce back when it comes. This is why I think you saw us bounce back, especially with the International Fund. Now, sadly, it wasn’t enough to make up for the first quarter, but if you go back and look at the names that have outperformed in in the second quarter, those are the names that killed us in the first quarter. But because we kind of maintained our presence, we felt the strong bounce back.
This also gets to the psychology of investing. You have to have the courage of your conviction or you won’t enjoy that bounce back. I continue to believe this. Think of a spring. You keep pushing the spring down and I don’t think it has fully sprung yet. If you consider how much of the investment committee is underexposed in these areas, when the bounce back does come—and who knows when it will—it will be very strong. That’s like what we saw in 2009 following the emerging market troubles in the International Fund.
When you look at the five-year return of the portfolio, and International in general, and if you send it back even nine years, it seems to overlay pretty well with a strengthening of the dollar, not that it’s 100% of the differential, but it seems to be a factor. I know you only hedge from time to time, but what are some of the economic or political traits that tend to coincide with currency strength and weakness? Can you see a scenario or certain data points that show a relative weakening of the dollar because that could provide an additional tailwind to International?
One of the reasons, which I think is measurable, that has caused the International Fund to underperform is when the dollar turned in 2014. The dollar was weak and then it became strong over the next five to six years. When we own a foreign stock, we own the currency it’s domiciled in—and that has been a factor. Some of the many variables that impact exchange rates are relative levels of economic growth, interest rate differentials, etc. Take those two factors and what we’ve seen is that Europe has grown more slowly and has had low rates for longer and that has partially explained the relative strength of the dollar. However, we look at currencies like a pendulum. You could measure currency value by purchasing power parity. What exchange rate creates the equivalent basket of goods between two trading nations. Through time, there is pressure to move toward parity, but the pendulum swings. It wasn’t too long ago, in 2012 and 2013, when everyone was saying that the euro was going to go to two and two or three years later it went to 1.25, 1.30 and continued to weaken and it’s remained relatively weak today. The point I’m trying to make is that if you look at currency valuations today, the pendulum has swung the other direction such that these currencies are fundamentally undervalued. When I talk about being able to buy cheap foreign stocks, you also have to add that you’re buying cheap foreign currencies at the same time. On the one hand, it was very painful because these things became cheap somehow and we held these things. But on the other hand, if you look at valuations today, especially as it pertains to Europe and not so much Japan, you’re able to buy undervalued companies using undervalued exchange rates. One of the reasons I’m somewhat positive for the next three, five or so years is because of these valuations, not only the spread of business value, the whole value versus non-value dichotomy, but the currencies are also attractively priced, in my opinion.
How do you view the recent very coordinated effort by the EU to address the COVID crisis in terms of bond buybacks, potentially mutualized debt, the corona bonds. How do you see that affecting European economic prospects going forward? I’ve heard a few analysts refer to it as a game changer, but I wonder whether you have a perspective on that.
It’s possible it may be a game changer, but I wouldn’t hold my breath on the European community issuing bonds in particular because don’t forget that the European community still isn’t as united as you think. I believe they’ve done a good job stimulating from a monetary policy and the countries individually have done a great job at fiscal stimulus, but questions remain as to whether the EU and maybe this crisis will demonstrate that they have an ability to coordinate as a single body. Even if it does happen, it won’t occur in the short term but rather over the next six to 12 months. I think there is some desire to do this, but it remains to be seen.
In the meantime, individual countries have responded from a fiscal perspective with all kinds of job-supporting schemes, tax cuts—and I think this is one lesson that maybe we learn from the global financial crisis. Even in the U.S. we’ve seen very rapid responses considering how governments usually act very slowly. Now granted, they shut everything down, but they were also quick to stimulate, so I think Europe has been quick to do so. By the way, for Europe, for the most part, it appears that the worst of this crisis is behind them if you look at all the data, mortality numbers, hard-hit areas. Schools started in Germany I believe in April and I think in France in late April/early May. You see tourism going to Italy, Spain and Portugal. The U.K. has been the slowest to come back, perhaps it’s because their prime minister had COVID and is a bit more wary. Europe seems to be coming back pretty solidly and that might help economic growth as well.
On the banks, I’m assume there’s another one that you gave a haircut because interest rates are going even lower. I was on the call you did with Ariel Investments and during your commentary there was a lot of mention of these banks doing a lot more fee-oriented as opposed to spread business. It seems like a lot of them will still do a lot of spread business and be hurt with the extremely low interest rates in Europe right now. How much haircut are you having?
We have had to haircut not only because of lower but longer interest rates. Keep in mind that over the last decade these rates have been very low and most companies have been able to grow earnings regardless. Negative interest rates have been around Europe for quite some time so they’ve been able to grow despite this. We also had to make adjustments because you have to increase credit provisions and loan losses. Even when you do those things, which are the negatives, and then incorporate the positives, you end up with lower levels. When you look at the spread between even the lower value, and don’t forget the prices at least go through early April, many of these were down 50% or 60% whereas our adjustments weren’t even close to that, so that is what kind of provided opportunity.
When you look at valuations today, not only do they trade at a significant discount to their peers, in my opinion, but even when you lower their earnings power such that they only have high single-digit or low double-digit returns, you have price-to-book values of somewhere around 40% to 50%. It still represents a good value to us because as you mentioned, all these fee businesses are doing well.
Can you share your thoughts on how you think the U.S. and the rest of the world’s interactions with China are going to be following the coronavirus pandemic? Do you think there are going to be repercussions for potentially falsifying data at the onset of this?
I fear that China has picked a lot of fights with not just the U.S. but India, Taiwan, Hong Kong, everyone. I think China has to be cautious that the global community is slowly drifting away from them and they could either continue on or come to a realization that they want to coexist with trading partners, foreign direct investment, all these things.
I believe that for them to attract that, as they have in the past, there might have to be a change in behavior. If not, you’re seeing the West becoming kind of unified and even many in the East are becoming unified, from Australia to Japan. It’s my personal opinion that it’s better that they’re a productive happy partner to the global economy than be the one that’s aggravating everyone.
I tend to believe that through time people would rather be more cooperative than not. But in the short term, you could go through periods of stress and strain of global relationships. For a long time, the Chinese were given the benefit of the doubt and I think that is no longer theirs to take like it had in the past. It could impact foreign direct investment into China and trade flows; it could have some economic impact. It’s something to watch very carefully because I think it’s a very important and big question. China is an important player in the global economy. I think the global economy is better off if everyone is cooperating and following the rule book as much as possible.
Thank you to everyone for joining us on the call today and for your continued patience. Clearly, these are unique times. Remember, our job is to deploy your capital into assets we deem as attractive to generate long-term returns. When you have inefficiency in prices, sometimes it takes awhile for the inefficiency to work its way up. We try to use these inefficiencies to better our portfolios and enhance future returns, so we want to express our gratitude for the patience you all have had as clients going through this period with us. I look forward to our next call in October. Until then, everyone enjoy the rest of your summer.
Average Annual Total Returns (as of 06/30/2020)
|Fund||3 Month||1 Year||3 Year||5 Year||10 Year||Inception|
|MSCI World ex U.S. Index||15.34%||-5.42%||0.84%||2.01%||5.43%||5.50%|
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||21.66%||-3.20%||0.53%||3.56%||7.26%||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 06/30/20:
|Security Title||Oakmark International Fund||Oakmark International Small Cap Fund|
|Alibaba Group ADR||0.3%||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.