2Q16 | David Herro
June 30, 2016
Our two international Funds experienced disappointing quarters, both in absolute and relative terms as European geopolitical events strongly impacted share prices. The negative deviation, especially in the Oakmark International Fund, was in part due to our exposure to the European Financials sector, which was the one of the larger contributors to the negative relative underperformance. For the Oakmark International Small Cap Fund, the cause for underperformance was mainly due to exposure to businesses involved in the U.K. real estate market.
I Will Only Use This Word One Time: Brexit
On June 23, voters in the United Kingdom chose to exit the European Union. This vote to leave, known as “Brexit,” caused an extreme reaction in the global financial markets. European and Japanese stocks weakened in general and, as mentioned, stock prices in the Financial sector, as well as those relating to the U.K. housing market, were aggressively marked down. Oddly, the Japanese yen is seen as a “safe haven currency,” and as such, it strengthened abruptly, hitting the share prices in their export sector where our Funds have notable exposure.
The outcome of the U.K. referendum came as a shock to most, as the global “establishment” heavily campaigned for a “remain” vote and warned of dire consequences if the U.K. voted to leave. In the wake of the exit vote, it is uncertain as to what the actual economic impact will be. The “remain” campaigners certainly made their disaster scenario well known leading up to the vote, but perhaps these same parties were oblivious to the reasoning of the “leave” supporters, who argued that the EU was the real disaster and that the rules, regulations and mandates for the entire EU were often made by unelected officials in Brussels irrespective of the desires of local citizens.
My guess is that markets and the economy will adjust to this new reality, and though some negative side effects will result, there may be more than a few positives. First, weak sterling will likely have a stimulative effect on the U.K. economy. Second, perhaps the U.K. government will use this newly found freedom to legislate pro-growth policies. Lastly, maybe the EU will view this vote as a wake-up call and undertake real reform.
During the first two days after the vote, the European stock index dropped just under 15%, with the European financials dropping even more. I would assert that, as often is the case, the underlying intrinsic value of the corresponding businesses did not change as drastically as the market price. In fact, this is usually the case as fearful traders and investors often sell in a knee-jerk reaction in response to any geopolitical disturbance. We believe that for real investors, it provides an opportunity. Our process is to first try to measure the true impact these events may have, if any, on the intrinsic value of the businesses we own and then to respond in a way that takes advantage of the market’s short-term fears. Again I stress the point we often make: Volatility is opportunity!
Recent events have further reduced the prices of European banks, insurance companies and asset managers. Often we get questions as to what the value arguments are for us to be relatively overweight in this sector. The market is concerned with the impact that low and negative interest rates have on earnings as well as the balance sheet strength of the companies in this sector. We believe the market is ignoring the following:
- Earnings can be enhanced by lending growth, increases in fees, and cuts in costs and loan losses. The lending spread, though an important factor in any bank’s profitability, is not the only determinant of success.
- Low and negative interest rates are unlikely to be a permanent condition.
- Capital levels and balance sheet safety have rapidly improved since the 2008-2009 global financial crises. Today, the amount of required capital European banks have is nearly double where it was in 2008. Loan-to-deposit ratios, a measure of funding stability, are at 104% vs. 125%; leverage ratios, another measure of bank safety, are at 5.1% vs. 1.8% according to Autonomous research. Given the financial strength of banks and insurance companies today, as well as with most companies, there is the ability to withstand periods of economic slowdown and uncertainty.
- The global consumer is in an extremely strong economic position given low interest rates, low energy costs and low unemployment rates in most of the developed world.
- Price: European financials sell at extremely attractive valuations no matter what metric is used. When looking at fundamental value measurements, they sell at measurable discounts. The MSCI Europe Financials Index shows price-earnings ratio of 13, price-book ratio of 1 and dividend yield of 6%, compared to the MSCI World Index with P/E of 20, P/B of 2 and dividend yield of 3%.
All in all, we believe there is a strong value case to be made for the European Financials sector, and this exposure should have a positive impact on our long-term performance.
We continue to believe that strong investment performance requires discipline and patience, and that the opportunities are quite positive for long-term investment success. We appreciate your support and confidence, and we will continue to work hard to stay disciplined and patient to achieve welcome results.
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.
The MSCI Europe Financials Index captures large and mid-cap representation across 15 developed markets countries in Europe including Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. All securities in the index are classified in the Financials sector as per the Global Industry Classification Standard (GICS®). This index is unmanaged and investors cannot invest directly in this index.
The MSCI World Index (Net) is a free float-adjusted market capitalization weighted index that is designed to measure the global equity market performance of developed markets. This benchmark calculates reinvested dividends net of withholding taxes using Luxembourg tax rates. This index is unmanaged and investors cannot invest directly in this index.
The Price-Earnings Ratio (“P/E”) is the most common measure of the expensiveness of a stock.
The Price-Book Ratio (“P/B”) is a measure of the market value of a stock compared to its book value.
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.
Oakmark International Small Cap Fund: 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.
Oakmark International and Oakmark International Small Cap Funds: The Funds’ portfolios tend to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held will have a greater impact on the Funds’ net asset value than it would if the Funds invest in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Funds’ 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.