Note: This video is part of Morningstar.com's November 2014 Risk Management Week special report.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by David Herro, the portfolio manager of Oakmark International Fund. We're going to talk about where he thinks investors are getting paid to take risk today in the global market, and where they aren't.
David, thanks for joining me.
David Herro: Happy to be here this morning.
Glaser: Looking at the risk environment today and the market today, do you see any opportunities where the risks or the perceived risks are being overblown, and there really is a big gap between the intrinsic value of the companies and where they are trading now?
Herro: I definitely think this is the case especially as it pertains to European equities. As of today, there are parts of Europe that are under economic distress--namely France and Italy. Other parts are doing OK, but they are not robust, for instance Germany and Benelux. And there are other parts in Europe that are growing quite acceptably--the United Kingdom, Scandinavia, perhaps even parts of the problem markets like Spain and Ireland.
But because there is this perception that Europe is going into a macroeconomic slowdown, many businesses that are based in Europe seem to be selling at extremely reasonable valuations, despite the fact that these businesses have exposure to the whole world in its entirety. They are not just European companies; they are based in Europe, but they don't just sell their products or earn profits in Europe. And this provides us with a very exploitable opportunity.
Everyone thinks just because a company is based somewhere, it's not going to do well, and in reality that company has exposure to the world on whole and provides us an opportunity to buy a good business at a very low price.
Glaser: Are there places where investors aren't getting paid for risks?
Herro: I think if you look at places in the emerging markets, still you have difficulty reconciling the price you pay for some of what I would call the higher-quality businesses in EM that are selling at extremely rich valuations and you are getting somewhat limited growth.
We have found that if you want to play growth in EM, and we do think EM is a structural growth story, at this point it's cheaper to buy, for instance, a European multinational that has a huge exposure into emerging markets, as you could get it at probably half the multiple as a company that's based right there onsite. Look at China's Brilliance [Automotive] versus the valuation of BMW--this is the perfect example--or some of the banks and financial institutions.
So, I think EM overall is still priced higher than many of the non-EM companies that have huge exposure in EM. We think the situation from a valuation perspective is better if you go for the domiciled companies that do business in EM, but are domiciled outside of EM.
Glaser: How do you think about the risks in Japan right now? There was news this week that the economy is in recession again. Do you think there is any opportunity there?
Herro: Well, the problem with the Japanese equity market is that it has moved up so strongly, it's not nearly as underpriced as it was, say, two years ago. It has finally bounced well off the bottom, making it not impossible but more difficult to find value. We probably have 10%-11% [exposure] in Japan, and that's off of a high a year and a half to two years ago of about 27%-28% in Japan. So we could still find some value; it's just not as ripe as it was.
Now, if the yen continues to weaken, this provides opportunity and a chance for some of these multinationals to be revalued up. But remember, the normal price of the yen is probably closer to 105-106; today it is at 116, close to 117.
But we are still able to find value in Japan. It's just not the extreme value that you saw in 2012. Basically the market has doubled from there.
Glaser: What do you see today as probably the biggest risk that investors are either underestimating or are misunderstanding that they should be aware of?
Herro: I think one of the things that always represents a risk factor--and this is something from outside and it goes under the category of regulatory risk--is government actions that restrict the free movement of capital goods and services, that become extremely insular, that really make it difficult for the corporate world to earn money.
We have seen in the financial-services industry extremely aggressive fines put on global financial institutions. Now, I think this is a risk that if governments become more and more proactive. We've also seen it in the automobile industry. Any little problem with an automobile today, you have an instant recall, and I think this government activism perhaps is one of the risks.
And the other problem is the transparency rules and regulations. Whether it be Dodd-Frank or some of the financial rules in Europe, they've become so convoluted and so abstract, it is difficult for businesses to follow the rules. And this becomes kind of a risk factor, because then you have to carry excess capital, you have to operate at a sub-profitable level.
I think this is something that's going on in our environment today that does represent a risk factor, because it provides a less-than-favorable environment for businesses to operate from a rules and regulatory perspective.
Glaser: David, thank you for joining me today.
Herro: Thank you for having me.