For much of the last decade, investors have avoided the overseas markets like the chicken pox. But David Herro is one international fund manager who has been impossible to ignore.
As co-manager of the (OAKIX)Oakmark International and (OAKEX)Oakmark International Small Cap funds, Herro has produced outstanding long-term records on both of his charges.
The Oakmark International fund's five-year annualized return of 7.3% beats more than 90% of other foreign-stock funds. The Oakmark International Small Cap fund is even more impressive, with a five-year annualized return of 8.7%, which is better than 94% of its peers. Actually, such returns are so enticing that the fund recently closed its doors to new investors.
To produce these gains, Herro follows Oakmark's deep-value style. He'll buy a stock only if it's trading at a discount of at least 40% of his estimate of the company's intrinsic value. And there are still plenty of bargains to be found overseas.
Those attractive valuations, the weakening dollar and this country's accounting scandals are three reasons that investors are finally moving some money into the international markets. But Herro isn't just dipping his toe into these waters. He's there all the time and can tell you what looks good and what looks like a trap.
1. How are the overseas markets valued?
By the most basic measure you can use, price-to-cash-flow, EAFE [Morgan Stanley Capital International's benchmark Europe, Australasia, Far East index] has a price-to-cash-flow of just over 10 times. The U.S. market has a price-to-cash-flow ratio of around 16 times. That kind of basic measure of valuation indicates that the overseas markets are selling at a significant discount. We have come across similar discounts looking at stocks on a company-by-company basis.
2. Why are the markets selling at a discount overseas?
There has been a wave of money that has flowed into the United States capital markets over the last five or six years. And that meant less money has gone into the overseas markets. We can see this by fund flow statistics. Some of it may be related to currency: the strong dollar. And some of it may be related to the big bull market in the United States.
For those reasons, the U.S. got a disproportionate amount of fund flows. The U.S. does deserve some premium. Notwithstanding Enron
, the U.S. still has the biggest economy in the world. It has the best corporate governance in the world, again even given Enron. The one big disadvantage the U.S. has over the rest of the world is our legal system, which sometimes makes it difficult for companies to do business here. But other than that, the U.S. does deserve a premium of maybe 10% to 15%. But it does not deserve a 50% or 60% premium, where it's currently trading.
3. Is performance turning around overseas?
Yes, especially when you look at Pacific Rim. Japan is up double digits this year. The emerging markets and the Pacific Rim have definitely done better. Hong Kong is even up. South Korea is up [almost] 20%, after being up strongly last year. Little places like New Zealand are up. The marginal areas, which always tend to lead these things, are definitely doing much better.
A, they were oversold. And B, these places are experiencing good increases of profitability from a microeconomic perspective. Also, these economies either have recovered or appear to be recovering.
The last place that has really started to move is mid- and large-cap Europe. I am sure that will kind of be the next sector that takes off.
4. What about the weakening dollar? Will that drive the international markets to do better, and do you think the dollar will continue to weaken?
I do think the dollar is overpriced. Whether it will continue to weaken in the short term is beyond me. But in the medium and long term, clearly the dollar's valuation today is unsustainable from any kind of a fundamental perspective. The weakening dollar will have positive impact on foreign stock markets because of what I mentioned about the tremendous flow of money from overseas into U.S. A lot of that was because they were able to get a currency kicker. Now that is working in reverse.
On the other hand, United States institutional investors and the consulting community -- the opinion leaders -- have been very negative on foreign investing. That's all kind of bottom-speak. People look in the rearview mirror and say, "For three or five years it's been bad. I am going to stay out."
You can't look at it that way. You have to look at valuation. You have to look at expected return. You have to make your judgments looking ahead, not looking backward.
And especially with these fund flows starting to turn -- that bodes very well for the asset class.
5. As a value investor, which markets look the most attractive right now?
We have surprisingly found good value in European mid- and large-cap names. We haven't had such heavy weighting in Europe since we started the fund in '92 and '93 -- between the valuation gap and the fact that the equity culture that has long been talked about and anticipated is finally happening in Europe.
For instance, the pension schemes in most European countries were not private. They were government-oriented with the exception of the United Kingdom. Today, everywhere either has or is about to have some form of private pension scheme, which means much more active equity market involvement.
No. 2 is taxes. If you take Germany and France as good examples, tax rates have been or will be lowered to make corporate restructuring more attractive.
The final straw that still needs to happen in Europe is labor market reform. If that ever happens, that would be just marvelous for company profitability -- for microeconomic success of companies. And that would make me a super bull on Europe. Now there's still hesitation. There have been some changes on the margin. If you look at Italy, for instance, Mr. Berlusconi is working very hard to drive labor market reform. Jacques Chirac in France is bringing up that maybe this 35-hour work week was a wrong thing.
It is very important for European businessmen to be able to control expenses. And labor is one of their biggest expenses. And until recently there's been a cultural taboo on this. And to me, that's the last remaining straw that needs to happen to propel the European capital markets. It sounds like a funny thing: labor market reform. But it would be a huge change, and it would be a very strong signal.
6. Is it time for Japan?
We're still overweight everywhere but Japan. Japan is 12% of the index. We're 9%. That means we're overweight in places such as Australia and Scandinavia. We have a couple of tech names in the portfolio. In our top 15 names, we have two technology stocks. We own Ericsson (ERICY)
, which is one of our top positions today, and we own an Israeli-based maker of semiconductor testing equipment called Orbotech (ORBK)
There has been no structural change in Japan. However, there has been value in Japan. Oh, excuse me. I must correct that. There are low prices in Japan. That does not mean low value. We define value as the combination of price and quality. One half of the value equation is there. And if you can find a quality business, yes, you can find investment opportunity.
We're only at 9% in Japan. However, that's vs. 0% three years ago. So for us it's actually a lot. But compared to the index and probably our peers, who I imagine are 15% to 16% in Japan, we're underweight.
7. Why aren't you more bullish on Japan?
They have some deep cultural changes to make. You cannot run businesses for anything other than the owners. And in Japan the owners tend to be third or fourth on the list. You just can't do it. You cannot be an investor in a private enterprise where the managers of that enterprise are not running the company for you. They're running for the management. They're running it for their creditors. They're running it for their employees. They're running it for their customers.
Until that culture of profitability and until that culture of building shareholder value gets embedded in the Japanese mindset, it's a place that's going to be kind of a greater fool's market. Yeah, you could trade the rallies. But of course, we're long-term investors.
Now, having said that, we have been able to find some good quality businesses which do pay attention to the owners and do focus on profitability. One of them is called Meitec. This company does outplacement for engineering companies. It's like a temporary-help company. They have high return on equity [one measure of profitability], good profitability and allocate cash flow well. The average ROE of Japanese company is 7%. And this company has a double-digit ROE of 15% to 16%. It has operating margins of close to 20%. And it has a lot of cash and, when it can't use it, it's buying back stock.
We don't think stock buybacks are by any means the end-alls and be-alls. However, if you've got half of your market cap in cash at three-quarters of a percent interest and your stock trades at five times cash flow, there's nothing for you to do with it. There's no reason for you not to buy back stock.
We still think Japan needs structural change. Unlike Brazil and South Korea, which have undergone fundamental changes in the last decade, Japan has not.
8. You're underweight Japan. Are there any markets you're staying away from altogether?
There are some places, if they don't have adequate corporate governance standards, like Russia, or political stability, like Indonesia. We won't invest in markets like that.
We feel, as bottom-up value investors, we need an environment that's accepting of the type of research we do. We think China is where everything is happening. However, we still don't think we could buy stock in a Chinese company. Their boards are basically made up of government bureaucrats, because the government still owns large parts of these private companies.
9. What about Latin America?
We do own some stocks in Latin America. We have decent weightings in Mexico and Brazil, especially Mexico. Again, it's kind of based on value. Companies like Televisa (TV)
and Femsa (FMX)
, when we first bought into them a year and a half or two years ago, were selling at almost all-time lows -- at crisis lows from a valuation perspective. And these are wonderful businesses. Well-run in growth markets.
Televisa is one of the leaders in both content and broadcasting. And Femsa does beverages. Two very solid blue-chip companies that have made money through thick and thin. We still own them. They were 60% to 70% undervalued. Now they're 30% to 40% unvalued. They have moved, but we still like the stocks.
In Brazil we own a bank called Unibanco (UBB)
. It's a great financial institution, very profitable and very well-run. It's in Brazil, so it's low right now.
10. What stocks do you like? You mentioned Ericsson earlier.
Ericsson has a fairly strong balance sheet and is the industry leader in wireless equipment and fixed-line equipment. The industry is in complete disarray, and we see them getting more and more market share. They've cut costs and finally shed their lousy handset business. Plus, the stock is 70% off its highs and selling at one times revenue. So we think once orders do pick up and they return to profitability, the company will have a bigger share of the market. They've taken a lot of costs out, so a lot more of the revenues will drop to the bottom line.
And in thelast four or five months, we've added Henkel, a German company. Henkel makes soaps, adhesives and detergents. It's a good example of a European company that's actually focusing on the bottom line. Compared to Procter & Gamble, Henkel trades at nine times price-to-cash flow. Procter & Gamble sells at 16.5 times. Now Procter & Gamble should probably sell at a premium. Should it sell at a 60% premium for a very similar business?