2Q14 | David Herro
June 30, 2014
The Oakmark International Fund and Oakmark International Small Cap Fund experienced a soft quarter in a very quiet market environment. I am pleased to say that both Funds delivered positive returns, though they performed a bit below their respective indices. Other than the price of oil spiking, market volatility has remained extremely low, despite some macro noise surrounding the conflict between Russia and Ukraine, as well as the ISIS invasion of Iraq.
Two factors negatively impacted our Funds’ weak comparative quarterly performance: 1) being under-exposed in direct emerging market stocks, which experienced a strong rebound, and 2) being overweight in Europe, especially within the financial sector, which had a weak quarter. We are happy to report, however, that our medium- and long-term results remain extremely strong.
Holdings in European Companies
For some time now, we have been quite heavily exposed to European equities. There is nothing special about Europe that we like or dislike; we are simply bottom-up investors who focus on the business fundamentals of the companies in which we are invested, as opposed to the postal code of their corporate headquarters. What really matters to us are the durability, velocity and quality of a particular company’s free cash flow stream over time.
Many market watchers are frequently distracted by macro, geopolitical and regulatory events that often influence sentiment or allude to a more “cyclical” impact, but do not structurally affect a company’s future stream of free cash. As such, these events often do not have long-term fundamental impacts on business value. For example, Russia’s annexation of Crimea certainly has unsettled and weakened European markets, but it has not rattled our view on our holdings of European-based companies.
As we look at the last quarter, two of our larger holdings, Credit Suisse and BNP, fell under intense regulatory pressure from U.S.-based regulatory bodies. Both pleaded guilty to various charges and will pay large fines (see the Oakmark International letter for further discussion of Credit Suisse). Though this is unfortunate and points to lapses by some of their employees, we believe that the fundamental business value of each company, based on the present value of all future cash flow streams, does not align with the declines in these two companies’ share prices. Additionally, we believe that both companies are structurally intact, have strong business models, are well-capitalized and should be able to recover, post legal settlements.
Positive Reforms in Japan
Though the Japanese stock market has been the worst-performing developed market to date in 2014, there seem to be some positive reforms worth commenting on. You may recall that roughly two years ago, when the Japanese market was selling at extremely low valuation multiples, both of our international Funds were significantly overweight in what we believed to be excessively attractive Japanese equities. As the market rose nearly 80% from bottom to top, we trimmed some of our holdings, as business value certainly didn’t rise as quickly as share prices. In 2014, the situation is a bit different. Share prices have been weak and business value has gently increased, again opening the “value gap.”
The positive reforms in Japan involve government policy that aims to significantly improve corporate governance and lower corporate tax rates. We are especially pleased that the Japanese government is committed to using the clout of its $1.4 trillion pension fund to enact changes in corporate behavior, urging such factors as better capital allocation, as well as more independent corporate board composition. Though the Abe administration initially appeared to be slow in implementing a structural and corporate reform agenda, it seems to have acquired a “second wind.”
In closing, we remain enthused with the positioning of our portfolios. Though valuations aren’t as acutely cheap as in the past few years, we believe they are attractively valued, especially when one considers that the global corporate earnings cycle seems to have bottomed.
As always, thanks for your continued support.
David G. Herro, CFA
View other commentary and letters from David here.
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. 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 performance of the Oakmark International Small Cap Fund does not reflect the 2% redemption fee imposed on shares redeemed within 90 days of purchase. To obtain the most recent month-end performance data, view it here.
As of 06/30/14, Credit Suisse Group represented 4.9% and 0%, and BNP Paribas 3.3% and 0% of the Oakmark International Fund and the Oakmark International Small Cap Fund’s respective total net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Click here to access the full list of holdings for The Oakmark International Fund as of the most recent quarter-end.
Click here to access the full list of holdings for The Oakmark International Small Cap Fund as of the most recent quarter-end.
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.
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.
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 discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.