The Anglo File: Oakmark International Fund Bets Big on Ailing U.K. Supermarket

Oakmark's fund manager tries to repeat his Giordano success by buying Somerfield.
Author:
Publish date:

LONDON -- Never mind being in deep water: Somerfield, a castaway in the U.K. supermarket sector, is nearly drowning in bearish sentiment. And that's one reason why a U.S. money manager has been snapping up shares in the grocery chain.

David Herro, who manages the $800 million

(OAKIX) - Get Report

Oakmark International fund for

Harris Associates

, can't get enough of the stock. His fund now owns 45 million shares, or 9.2% of Somerfield, which makes the stock one of his largest holdings. His buying spree has continued even as the shares collapsed to one-sixth of the value they commanded eight months ago. On Tuesday, the shares closed down 4% to 51 pence (83 cents).

Thanks to heated competition, declining margins, an acquisition that went awry, a management shakeup and a government investigation into potentially monopolistic practices among U.K. supermarkets, Somerfield is being dumped by institutions and most analysts now give the company their lowest rating.

So is Herro throwing good money after bad?

That's a question investors in his fund will want answered, since Herro's practice of betting big on out-of-favor companies has caused his fund's performance to swing widely. Such volatility has prompted fund tracker

Morningstar

to assign Oakmark International its lowest rating despite a respectable (for a value fund) five-year return of 13.9%.

For investors with an appetite for risk, the rewards can be great. In 1998, for instance, Herro bought shares of Hong Kong retailer

Giordano

just prior to the Asian crash. The stock halved in a matter of weeks. Convinced of the company's intrinsic value, he picked up more shares on the way down until the stock was one of his biggest holdings. Today with the Tiger economies on the mend, Giordano's has rebounded 10-fold. The gain on that stock was one of the main reasons Herro's fund returned 39.5% last year, outperforming the

S&P 500

index.

Now Herro believes he's spotted a similar bargain in Somerfield.

"When we think there's a unique situation, we will make a big investment," Herro says. "We know

Somerfield's business fairly well and the Street has just trampled it."

Lost Its Way

Those in The City -- The British equivalent of Wall Street -- say the shares have been savaged for good reason. Analysts argue that Somerfield, which has medium-sized stores, is neither small enough to milk the convenience store sector, nor big enough to compete with

Tesco

or

Asda

, which is owned by

Wal-Mart

(WMT) - Get Report

. With same-store sales on the decline, analysts argue Somerfield will soon be unable to generate the cash to fund store refurbishments. That's a death sentence for retailers, which depend on spruced-up stores to drive sales.

"The mountain is very steep," says Rowan Morgan, an analyst with the U.K. brokerage

Teather & Greenwood

, who rates Somerfield a sell. (His firm hasn't performed any underwriting for the company.) "If indeed this is turning, there will be an opportunity to get in much later on."

Somerfield's tortured history -- it's the kernel of a failed leveraged buyout -- merely serves to illustrate the idea that the company has lost its way. Evidence of that identity crisis is visible in its 1998 purchase of

Kwik Save

, a discount supermarket chain that departed from Somerfield's smaller, neighborhood approach.

The company was unable to achieve the expected synergies and last year it put most of the 756 stores on the block along with 87 Somerfield stores, of which it sold 46 for $207 million. When no buyers emerged for the balance, then-CEO David Simons made a bid to take the company private. The board of directors rejected that idea when they axed him last month.

Nitty-Gritty Operators

In his place, are John von Spreckelsen, chairman, and Alan Smith, group chief executive, who think they can do a better job. Both have solid track records in retail, and the former is credited with helping German grocery chain

KAFU-Wasmund

find its footing and, more recently, rescuing

Budgens

, a smaller rival to Somerfield in the U.K.

Some of the new team's handiwork was visible Tuesday when Somerfield, in an about-face from its previous strategy, said it will retain all the stores previously up for sale, including Kwik Save.

"John and I decided -- before we joined the company -- that Kwik Save, despite being under-marketed the last five years, still has a lot going for it," Smith says. He went on to outline a plan to take Kwik Save back to its roots as a discount supermarket by lowering prices on key items. He says Somerfield, with 558 stores, will benefit from its positioning as an urban chain that's more convenience-oriented than its larger competitors.

As for analysts' concerns that Somerfield's coffers may soon run dry, Smith had this to say: "Making even a pessimistic view about the next 12 months, we would have sufficient cash to invest at the level that I want to."

Herro, who liked the story even before the management changes, is even more enthusiastic now. Von Spreckelsen "is a nitty-gritty operator who knows the business," he says. "He knows how to make money selling groceries."

Should business improve, Herro figures the stock could return eightfold in two years.

That's a big reward even by today's high-growth standards. It's also a big risk for Oakmark's investors.