European Stocks on Sale
Investors frightened of a rerun of 2008’s market meltdown have pummeled the shares of many great European companies. That makes the stocks more attractive than they’ve been in almost two decades (save for the end of the 2007–09 bear market), argues David Herro, co-manager of Oakmark International Fund (symbol OAKIX). “The market is creating cheap valuations because of unrealistic fears.”
He describes the current selloff and volatility in global markets as “an aftershock,” not another earthquake. The credit markets shut down in 2008 largely because no one knew the nature and amount of highly leveraged collateralized debt obligations held by banks. “What we’re talking about now is sovereign debt instead of the leveraged CDOs, and it’s not nearly as dangerous,” Herro says.
Herro thinks that Greece could eventually default on its debt and that Portugal might also, but those two countries account for just 3% of the euro zone’s gross domestic product. Ireland, Italy and Spain are the countries many investors fear will run into trouble next. But, Herro says, “I would be shocked if they defaulted.” Maybe so, but in my view, Europe faces major troubles ahead.
Herro is putting his money where his mouth is. When the euro was worth about $1.50 in late 2009, he hedged about half of his fund’s exposure to the currency. With the euro trading at $1.24 in late May, he had only 15% of the fund’s euro exposure hedged.
A weak euro, Herro says, is a boon to European multinational exporters, and it makes U.S. multinational companies less competitive. But U.S. investors in European stocks and funds have been hurt so far this year by the plunging euro (when the dollar strengthens against another currency, money Americans have in that currency gets translated into fewer dollars).
To be sure, Herro didn’t make any great big-picture calls before the 2008 collapse. Oakmark International plunged 41% that year. But partly because Herro slashed his holdings in financial stocks in 2007 from 34% of assets to 20%, Oakmark beat almost two-thirds of other foreign funds and bested the MSCI EAFE index, the leading barometer of developed-markets stocks, by two percentage points.
The fund’s performance has been much better in other periods. Over the past 12 months through May 21, Oakmark International returned 24% -- 17 percentage points more than the MSCI EAFE index. Over the past ten years, the fund returned an annualized 8% -- an average of six percentage points per year ahead of the index. Over that period, Oakmark International was in the top 1% of foreign funds, Morningstar reports.
What Oakmark International likes now
Herro sees analogies between the European stock market today and in 1992, his first year running the fund. In that year, hedge-fund manager George Soros mounted an assault, ultimately successful, to force the devaluation of the British pound. “It was a wonderful time to invest,” recalls Herro.
Today, he says his stock portfolio is trading at 55% less than what he and his team consider to be fair value. He, co-manager Robert Taylor and their nine analysts use a variety of tools to estimate a stock’s fair value. Aside from the situation in late 2008 and early 2009, Herro says, his stocks have never been this cheap.
Herro has 66% of the fund’s assets in Europe. He and his colleagues are focusing on high-quality companies that have been roughed up in the current selloff. “A year from now, people are going to realize that companies like Banco Santander SA (STD), Danone (DANOY) and Diageo (DEO) are good companies that shouldn’t be trading at about ten times free cash flow.” (Free cash flow is money left over each year that can be used to pay dividends, buy back shares, make acquisitions and so on.) By investing in Spain’s Banco Santander, which trades at book value, and to a lesser degree, in Credit Suisse Group (CS), trading at 1.5 times book value, Herro shows he’s unafraid of euro contagion. (All the stocks in this article trade in the U.S. as American depositary receipts.)
Emerging markets make up a scant 6% of the fund’s portfolio. Herro says that’s a 15-year low for his fund. Emerging markets remain “a good long-term story,” and “undoubtedly will continue to keep the world growing,” he says. But he finds the stocks pricey and thinks Europe is more attractive. His biggest holdings in emerging markets are South Korea’s Samsung (no ADR available) and Mexico’s Grupo Televisa SA (TV).
Herro says it could be a year before his European stock bets pay off. Over the years, he says, he’s learned to buy slowly into falling markets. I think Herro will be proven right in his bullish call, but I expect a lot more volatility before the markets in Europe and elsewhere begin rising again. No way this will be a repeat of the 2008 financial collapse, but Europe needs to do a lot more to heal its weaker economies. So far, it has hardly begun.
Steven T. Goldberg (bio) is an investment adviser.