February 2016 Interview
David Herro is a partner and the chief investment officer of international equities at Harris Associates, based in Chicago. Herro has managed a portion of the Litman Gregory Masters International Fund since the fund's inception in 1997.
As part of your investment process, one of the many things you look at is how sensitive a company's cash flow generation is to changes in the macro environment. What is your perspective on the current and future economic and investment landscape? What does the current investment environment remind you of as you look back on your decades of investing in international markets?
Clearly, today, as a bottom-up stock-picker, we observe a wide divergence between the movement in share prices and the movement in underlying intrinsic value of a company.
This is what happens when the market becomes obsessed with geopolitical events, as opposed to company fundamentals. What I mean by this is, we're all pouring over what's happening in China. Is it going to devalue? Are loan losses building up? Or what's happening in Japan with negative interest rates. In the past, it was a slowdown in Europe. The lack of strong recovery in the U.S. So on and so forth. What is the Federal Reserve going to do? We're all worrying about that.
And we're manifesting this worry via our decisions to buy and sell stocks. However, the value of businesses rarely is determined over time based on these factors. These factors have a short-term influence, generally speaking, on a company's ability to generate earnings and free cash. For us, as people who consider ourselves investment fundamentalists that make decisions based on the medium- and long-term viability of a company's cash flow streams and price companies based on that, the fact that these shorter-term factors move share prices up and down—sometimes in violent fashion—is really a good thing.
The negative, of course, is that it just takes a lot of explaining to clients. Because clients, of course, during this period are extremely uncomfortable. As an example, three or four years ago, the big concern in the international equity market arena was Greece and the eurozone. Now we seem to have forgotten about Greece.
Remember, everyone was obsessed positively with something called the BRICs (Brazil, Russia, India, China, South Africa). And everyone was obsessed negatively with countries called the PIIGS (Portugal, Italy, Ireland, Greece, Spain). And we got lots of questions on why were we investing in PIIGS banks.
Let's fast-forward three or four years. Even despite what's happening today, many of these investments were very sound investments in Europe. This is because, again, people focused on macro noise and not company fundamentals.
This is exactly what we try to do as investors. I think clearly today, especially when you look at certain areas like the European financials and like any company that might have exposure to economic sensitivity, you see what I believe is an extreme over-reaction in share prices and therefore is an opportunity for the long-term investors.
In your Masters’ portfolio, we ask you to own no more than 15 stocks, with the primary objective of generating superior long-term returns and not worrying about short-term volatility and tracking error.
Can you talk about the process you use in picking your highest-conviction names for our portfolio?
Generally speaking at Harris Associates, when we construct portfolios, it's off an approved list of securities—securities that have gone through the vetting and approval process that are eligible to be used in portfolios.
Really, the output of this process is coming up with what we believe is the intrinsic value of a company. Say it's a company like Allianz or Credit Suisse. We think a company's worth, say, $100. If it's at $50, then that company has 100% upside. So every stock that's on the approved list is measured this way: its intrinsic value, its price, and its upside.
What we try to do is, in these concentrated portfolios, all else being equal, just pick those names that are the most attractive based on this measurement. Those are the companies that have the biggest spread between intrinsic value and price, which is the upside.
Now we do want to remain somewhat diversified even though we realize we're part of a sleeve. Still, it is a portfolio. We don't just have 100% in the same industry. But, generally speaking, the biggest independent variable for a stock making it into this portfolio is its expected rate of return or its upside.
Determining the potential upside is certainly useful, but in which part of your process do you factor in the potential downside?
When we're pricing a business, we have to use certain parameters. We assign a multiple, for instance, to what we believe is the terminal level of EBIT (earnings before interest expense and taxes). That multiple that we apply to the EBIT is really the barometer of risk.
All else being equal, a riskier business will have a much lower multiple applied to it. A less-risky business, all else equal, will have a higher multiple. Therefore, when the valuation process is completed, the final price incorporates our view of risk already. So we can compare companies on an apples-to-apples basis when using them in portfolios.
In your earlier comments, you said European financials, in general, are an attractive opportunity. Could you share more detail on that view?
In general, what we've seen happen is extreme price weakness. Year to date, most banks are down—most financials are down—15% to 25% in five weeks. Annualize that, and it's not pretty.
We've seen a number of these banks report. For instance, BNP Paribas is held in the portfolio. Credit Suisse is held.
What we've seen is very, very little—if any—earnings deterioration. We've seen improving credits. We've seen expenses being cut. We've seen dividends being increased. Very, very inconsistent with share price activity.
Now one of the fears is that with the flat yield curve, lending spreads will shrink. Again, all else being equal, this is true. All else being equal, a flat curve is not good for banks.
However, all else is not equal, as I mentioned. Fee-based income is increasing. Costs are going down. Credit expansion is picking up. And loan losses are dropping.
So, yes. There is a negative. But we don't think that negative—especially when you blend it with some of the positives—at all warrants the share price movement of what we've seen in European financials.
The last thing I will say is, as a group, last time there was this just widespread destruction in value—well, there were two times: The first time was in '08/'09, during the financial crisis. The second time was around 2012 or 2013, during what was a sovereign debt fear.
Now during the financial crisis, the average European bank probably had a Tier-1 capital—this is a measurement of financial strength—of around 5% or 6%. When you look at those numbers today, they're at 11% or 12% or 13%. And the definition of "capital" has become a lot more conservative.
So banks are better capitalized today than they were during '08/'09. That gives them the ability to absorb losses, despite the fact that there aren't widespread losses.
Yes, there are some losses in the energy sector and high-yield's been dinged. But you don't see these widespread losses. And even if there were, their balance sheets are much stronger today than they were eight years ago.
During the second crisis for European banks, there was a belief that the PIIGS would default and that these banks, which held a lot of sovereign debt, would in fact have to take huge hits in their portfolios.
Well, what has happened? Well, let's see. The Italian 10-year bond used to trade at—three or four years ago—believe this or not, close to 8%. Today the Italian 10-year is at 1.63%, which is below that of the U.S. So right now, according to Mr. Market, and I actually don't believe this, but according to Mr. Market, Italy's a better credit risk than the United States.
This is what I'm saying: Do not let current markets and pricing jade your picture. Because often, as was the case of 2012/2013, Mr. Market is wrong.
That's the general European financial prognosis.
The same thing with Japan—it's gotten hit even worse with the negative interest rates. Again, based on this notion that a flat yield curve will make spread-lending difficult. That part is true, but we have to remember there are other things that go into banking profits.
Credit Suisse, as you mentioned, has been one of your top holdings. Can you walk us through what's been hurting the stock and the case for owning it today?
Credit Suisse consists of [primarily] two businesses: a private bank/global wealth manager and an investment bank. The investment bank made it through '08/09 far better than just about any of the other big major investment banks. They did quite well.
However, what's happened since then, and what has really impaired our thesis is that the Swiss monetary and financial authorities kind of significantly changed the capital requirements for the two—what were viewed as—too-big-to-fail banks—UBS and Credit Suisse. That meant that Credit Suisse needed more capital.
Then there were the pretty large fines that involved bank secrecy and privacy. You might remember this from the [Department of Justice] a couple of years ago. That required capital.
So all the money that was being made in the private bank—whose earnings were facing some cyclical headwinds of the strong Swiss franc and low interest rates and all these things—were being bled by paying fines and lower returns in the investment bank.
We also believe that when you look at the capital allocation between the two businesses—even though there were attempts to de-risk the investment bank—perhaps they weren't aggressive enough in getting rid of high-risk-weight assets.
A little less than a year ago, new management came in. A new CEO came in and really took a fresh look. What this new management is going to do is really [focus on] one of the key strengths of the private bank, and that's their Asian footprint. They are the top private bank in Asia.
They're going to deploy more capital to that Asian footprint. They're going to restructure the investment bank. They've been getting out of businesses, [and that] costs money. As a result, their Tier-1 capital, which should've been around 12% was probably around 11.5% by the end of the year. Not a huge but a bit of a disappointment.
We remain confident that they're doing exactly the right thing. In fact, we wish old management would've been more aggressive at doing it. Maybe we wouldn't have had the problem we had at the end of last year if they would've been more aggressive.
So, a very strong private bank. Good inflows. Good footprint in emerging markets, especially Asia. We should really start to see these returns coming through. If I look at raw valuation, in a Street consensus—not ours—this is a business that is basically trading at 7x next-year's earnings with a dividend of over 6%—next year's.
Can you give us a sense of the discount to your estimate of intrinsic value Credit Suisse trades at currently?
We view this business trading at $0.35 or $0.40 on the dollar. This is one of our highest-upside names. Therefore it's one of the biggest positions in our portfolio.
We basically priced the investment bank at a multiple below 1x its book value—85% or 90% of book value. There are different parts of it; that's why I'm being a little vague.
The wealth management business gets a multiplier of its EBIT and net income, which is in the low double digits. Double-digit net income and mid-single-digits EBIT, basically.
We value it as a sum-of-the-parts between the private bank, which is the wealth management business, and the investment bank.
Now hopefully, if they've really taken risk out of that investment bank, we're underpricing that investment bank. If they could get 12%, 13%, or 14% return on equity, valuing it at 80% or 90% of book—hopefully that will be conservative.
What about the wealth management business? How does this low double-digit multiple compare to peers or private transactions you might be seeing in that area?
Well, no two are alike. But what you typically see are these healthy and growing wealth management businesses going for 3x to 4x revenue. That's kind of consistent with how we're approaching this.
They have net new money that tends to be [growing] anywhere from 3%, 4%, 5%, or 6% a year. So it's a very healthy, net-new-money grower.
You recently stated that your team is increasingly adding names in emerging markets to your list of potential ideas to work on. Other than Samsung Electronics, you do not own any emerging-markets-domiciled name in the Masters portfolio. That said, you do own several developed-market names with exposure to emerging markets. And in some cases, that exposure is an important part of your long-term thesis for them.
Can you talk about how you view investing in emerging-markets companies in general, the hurdles you have, both qualitative and quantitative, before you'll consider investing in them?
Basically, we price them like anything else [with] one difference. We adjust the cost of equity based on whether it's an emerged or emerging market. If you're a company based in Switzerland, your cost of equity in our view is 10%. If you're a company based in Mexico or Brazil or somewhere else, your cost of equity is going to be higher. That's one way in which we account for it.
The other is, we have to be very careful that we understand ownership structure and corporate governance. Because in emerging markets, this tends to be not quite perfect—not that anywhere is perfect.
In that case, if we see an ownership structure we don't like, we probably won't invest in it. Or if we see a suboptimal voting structure, we will reflect that in the multiple. All else being equal, we will price the business lower if we think there are issues surrounding the company in terms of opaqueness.
Of course, if it's too opaque and if we cannot measure that risk, we won't even attempt to do so.
Russia, as an example, where there is [no] clear rule of law—you won't see us investing in Russian stocks.
We could take a company like Danone or Diageo—if there were a measurable part of their profit that came from Russia—we would put a risk factor on that stream of income.
We believed that up until about a year or two ago, for the three or four years prior to that, emerging markets were systematically overpriced. Remember, we used to get all those questions: Why are you in the PIIGS and not the BRICs? And we said, Price. We're not going to overpay for these companies.
You have to price in these factors. People just like to look at concepts. They put big multiples on concepts. We put multiples on stable, growing cash flow streams, not just on concepts.
Are you finding your hurdles to investing in emerging-markets companies (that you’ve had since the early 2000s) are coming down?
Yes. They have come down a little bit, and they should come down, as the world becomes smaller, as the global economy becomes more integrated.
There were huge lessons learned in terms of increased transparency after the last big emerging-markets crisis in the late '90s. You have a lot less foreign-currency debt.
I think we've valued them a little bit more generously. I think it's warranted.
Thanks for your time, David.