How Has Portfolio Management Changed During the Global Pandemic?
David Herro, portfolio manager of Oakmark International, discusses the effects of loose fiscal and monetary policy, federal intervention, and inflation.
David Herro, CIO of international equities at Harris Associates and portfolio manager for Oakmark International, joined Morningstar's The Long View podcast to discuss how the coronavirus pandemic presented a challenge to global portfolio management.
Herro also outlined how the competitive landscape in value investing has changed throughout the years and the ways he and his team have adapted to these changes. While touching on environmental, social, and governance investing, risk management, and narrowing moats, Herro explained why he "sees no benefit" in looking like an index.
Here are a couple of excerpts on fiscal and monetary policy, federal intervention, inflation, and stock-picking from Herro's conversation with Morningstar's Christine Benz and Jeff Ptak:
Benz: Fiscal and monetary policy has been extremely loose during this period. What implications has that had for the way that you pick stocks and manage the portfolio?
Herro: Well, to be honest, the swiftness of the actions on fiscal and monetary policy early on during the pandemic actually gave us confidence that we would have a less impactful downturn as a result of the economic lockdowns. All across the world, central banks and governments reacted swiftly; I think it has to be a record. This efficiency made us confident in the valuations in our businesses, though we had to adjust downward for most of them. The downturn during the early days of the pandemic created shorter policy; therefore, valuations were less impacted. This was one of the lessons of trying to integrate the aggressive fiscal and monetary policies that were used globally. It gave us more confidence in our valuation numbers. We knew there would be a backstop. Considering the fact that many people were still working, too (albeit from home), this meant that the economic impact was shallow. We were also confident that once the worst of the pandemic was behind us, we'd get back to business as normal, which in essence has happened.
Ptak: Warren Buffett previously indicated that a reason Berkshire hadn't done any big deals is because once the Fed intervened, the need for firms to seek capital from Berkshire dramatically lessened. Did you observe a similar effect or limited opportunities among the non-U.S. firms you follow? It sounds like knowing that backstop was going to be there buttressed your confidence in owning some of the more cyclical names that you had in the portfolio. Is that the case?
Herro: Mr. Buffett looks for companies that really need capital and then provides it to them. He's a very active investor. And he does so at very generous terms to Berkshire Hathaway. If you recall, he did this during the great financial crisis. We have a very similar philosophy on looking for undervalued businesses and investing for the long haul. But we kind of limit ourselves to investing in companies that are already trading and aren't necessarily seeking to inject their balance sheets with fresh capital.
In March, you had an extreme knee-jerk reaction. Even companies with sound balance sheets that did not need capital saw extreme negative price reactions, especially ones that were tied to the real economy; industrials, financials, and materials, in particular, were clobbered. They did not need capital. But their share prices behaved almost as if they would need an emergency capital. I consider the German auto companies to be perfect examples. Both Daimler and BMW had net cash on their balance sheets. And yet both of them lost 60%, 70%, 80% of their value at one point in the spring of 2020. They didn't need capital, but their prices were selling and behaving like they did need capital. The share prices were so weak, which gave us an excellent opportunity to increase our positions in these world-class brands, these businesses with strong balance sheets, that, in our view, will see a strong market reaction in terms of orders and sales when normalcy returns.
Ptak: We'd be remiss if we didn't ask you about inflation. How concerned are you about it? And has it informed any decisions you've made recently in the way you pick stocks or structure the portfolio?
Herro: Well, I am concerned about it. My emphasis in graduate school was monetary theory, and I was taught by a very strong monetarist. I'm a believer in Fisher's MV = PQ--money times velocity equals the price level times output. We have not had inflation in the last decade or so, despite money supply going up, because we've had a massive, massive buildup in reserves in the global banking system, which has caused a decline in velocity. So, the money that has been expanded has not been multiplied through the economy because banks have been forced to increase reserves. Before the financial crisis, Tier 1 reserves were somewhere around 5% or 6%. Now they are at 12%, 13%, 14%, 15%. So, reserves have more than doubled and tripled. This is a global phenomenon; basically, banks are hoarding capital.
What we're seeing today is the banks are at their capital positions after this 10- or 11-year buildup; they don't need to build up anymore. And I believe that the money that is being produced will eventually start getting multiplied through the system and not just hoarded in terms of sterile reserves. And this will have an impact on inflation. Additionally, the United States has had a couple of pandemic stimulus bills that have passed and a couple more proposed. (Europe has not been as expansionary because they've used other tools to get their people through the pandemic.) Well, you can't keep doing this without impacting inflation, especially since it's coming at a time when the global economy is reopening. Thankfully, the global economy is not reopening all at once. As we're seeing, supply chains and logistics systems couldn't handle it. The economy is opening in stages, even within the U.S. All these things are going to pressure inflation. Whether it's excess monetary policy or fiscal policy, you're going to see an impact on inflation. I do think monetary authorities are being a bit too reserved about this. I think they're fooled by the past 10 years of low velocity. If that velocity of money picks up, then they're going to have to act quicker than we think.
So, our portfolio is somewhat positioned for this because, today, we're finding value in the financials and some of the industrials and some of the materials companies. This is where we're overweight, and these are the companies that will benefit from inflation. Slightly higher inflation is not really good for the people, but it's going to be good for our portfolio. In fact, a little increase won't bother anyone, because what's 1% or 2%? But if inflation increases to 2% or 3% or 4%, it really inflicts pain, especially on people on fixed income.
Benz: What is the biggest lesson you've learned as a portfolio manager that only experience could confer?
Herro: One of the lessons--and I think it's a lesson that differentiates portfolio managers from being fair, bad, good, average, or excellent--is that you have to be able to use legwork and a lot of background work to execute your philosophy and process. We're value investors. It's not easy coming up with what you think is a relatively accurate valuation of a business. But you have to go through the legwork and the research process to do this without taking shortcuts. Once you've established that this is the hard part, truly abiding by it--truly buying low and selling high--sounds simple. But it is very hard for human beings not to get excited when prices go up and depressed when prices go down.
One must differentiate. This is the critical point. One must differentiate between changes in intrinsic value and changes in share price. Because in the short term, Mr. Market bounces all over the place. Just look at the last two or three days: The Japanese market was up 3% or 4% yesterday and down 3% or 4% the day before. Makes no sense, right? It's short-term price movement that just moves on any short-term flavor of the day. The value of those underlying businesses didn't change by anywhere near that. The key is not to react as an investor on price movement, but to react on value movement; the underlying value of the business should govern your actions, not the movement of price, because price is a given. If price and value converge, of course you sell; if price goes down faster than value, then it might be an attractive investment for you to buy. The point is, as an investor you cannot form a judgment based on the price movement of your business; the focus should be on value. To me, that is the biggest lesson that I think a successful investor needs to learn and ingrain in their mind. It's also the hardest lesson, because of that psychological drive to naturally dislike something that goes down and like something that goes up.
Maya Sibul does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.