David Herro, CIO of International Equities at Harris Associates and Portfolio Manager for Oakmark International, joined Morningstar The long view podcast to discuss how the coronavirus pandemic has presented a challenge for global portfolio management.
Herro also spoke about how the competitive landscape of value investing has changed over the years and how he and his team have adapted to those changes. While discussing environmental, social and governance investments, risk management and moat narrowing, Herro explained why he “sees no benefit” in looking like a clue.
Here are some excerpts on fiscal and monetary policy, federal intervention, inflation and stock picking from Herro’s conversation with Christine Benz and Jeff Ptak of Morningstar:
How does flexible fiscal and monetary policy shape portfolio management?
Benz: Fiscal and monetary policy has been extremely flexible during this period. What implications has this had for the way you choose stocks and manage the portfolio?
Herro: Well, to be fair, the swiftness of fiscal and monetary policy actions at the onset of the pandemic actually gave us confidence that we would have a less impactful downturn due to economic lockdowns. Around the world, central banks and governments have responded quickly; I think it must be a record. This efficiency made us confident in the valuations of our businesses, even if we had to adjust downwards for most of them. The slowdown in the early days of the pandemic created a shorter policy; valuations were therefore less impacted. This was one of the lessons learned from attempts to integrate the aggressive fiscal and monetary policies that were used globally. This gave us more confidence in our valuation figures. We knew there would be a safety net. Considering the fact that many people were still working (albeit from home), this meant that the economic impact was low. We were also convinced that once the worst of the pandemic was behind us, we would resume our operations as normal, which essentially happened.
Did the federal response during the pandemic affect portfolio decisions?
Ptak: Warren Buffett has previously indicated that one of the reasons Berkshire did not make big deals was that once the Fed stepped in, the need for companies to seek capital from Berkshire was dramatically reduced. Have you seen a similar effect or limited opportunities among the non-U.S. Companies you follow? It seemed like knowing that that safety net would be there bolstered your confidence in owning some of the more cyclical stocks you had in the portfolio. Is that the case?
Herro: Mr. Buffett looks for companies that really need capital and provides it to them. He is a very active investor. And he does so on very generous terms to Berkshire Hathaway. If you remember, he did it during the great financial crisis. We have a very similar philosophy on finding undervalued companies and investing for the long term. But we kind of limit ourselves to investing in companies that are already in business and are not necessarily looking to inject fresh capital into their balance sheets.
In March, you had an extreme gut reaction. Even companies with healthy balance sheets that did not need capital saw overwhelmingly negative price reactions, especially those linked to the real economy; industrialists, financiers and materials, in particular, have been crushed. They didn’t need capital. But their stock prices behaved almost as if they needed emergency capital. I consider German car manufacturers to be prime examples. Daimler and BMW had net cash on their balance sheets. And yet, both lost 60%, 70%, 80% of their value at some point in the spring of 2020. They didn’t need capital, but their prices were selling and behaving like they needed capital. capital. The stock prices were so weak, which gave us a great opportunity to increase our positions in these world class brands, these companies with strong balance sheets, which we believe will see a strong market reaction in terms of orders. and sales when normalcy returns.
How Does Inflation Determine Security Selection Decisions?
Ptak: We would be remiss if we didn’t ask you about inflation. How concerned are you? And has it influenced the decisions you’ve made recently in how you choose stocks or structure the portfolio?
Herro: Well, I care. My graduate studies focused on monetary theory, and I was taught by a very strong monetarist. I believe in Fisher’s MV = PQ – money times speed equals price level times output. We have not had inflation over the last decade, despite the increase in the money supply, because we have had a massive and massive accumulation of reserves in the global banking system, which has resulted in a decline in the speed. So the money that was increased was not multiplied by the economy because the banks were forced to increase their reserves. Before the financial crisis, Tier 1 reserves were around 5% or 6%. Now they are at 12%, 13%, 14%, 15%. Thus, reserves have more than doubled and tripled. It is a global phenomenon; essentially, banks accumulate capital.
What we see today is that the banks are at their level of capital after this accumulation of 10 or 11 years; they no longer need to accumulate. And I believe that the money that is produced will end up being multiplied by the system and not just accumulated in terms of barren reserves. And that will have an impact on inflation. Additionally, the United States has had a few pandemic stimulus bills that have been passed and a few more have been proposed. (Europe has not been as expansionary as it has used other tools to help its people weather the pandemic.) Well, you can’t continue to do this without impacting inflation, all the more so that it comes at a time when the global economy is reopening. Fortunately, the global economy is not reopening all at once. As we see, supply chains and logistics systems could not handle it. The economy is opening up in stages, even within the United States. All of these things will put pressure on inflation. Whether it’s excess monetary policy or fiscal policy, you’re going to see an impact on inflation. I think the monetary authorities are a little too reserved on this subject. I think they are fooled by the last 10 years of low speed. If this speed of money accelerates, then they will have to act faster than we think.
So our portfolio is somewhat positioned for that because today we find value in financials and some of the industrial companies and some of the materials companies. This is where we are overweighted, and it is companies that will benefit from inflation. Slightly higher inflation isn’t really good for people, but it will be good for our wallet. In fact, a small increase won’t bother anyone, because what is 1% or 2%? But if inflation goes up to 2%, 3% or 4%, it really hurts, especially for people on fixed incomes.
What’s the biggest lesson active portfolio management teaches?
Benz: What’s the biggest lesson you’ve learned as a portfolio manager that only experience can give you?
Herro: One of the lessons – and I think it’s a lesson that differentiates portfolio managers from being fair, bad, good, average, or great – is that you have to be able to use steps and a lot of groundwork to execute your philosophy and process. We are value investors. It is not easy to come 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 it without taking any shortcuts. Once you’ve established that’s the hard part, really sticking to it – really buying bass and selling treble – seems simple. But it is very difficult for human beings not to be excited when prices go up and depressed when prices fall.
You have to differentiate. This is the critical point. You have to differentiate between changes in intrinsic value and changes in stock prices. Because in the short term, Mr. Market bounces in all directions. Just look at the past two or three days: the Japanese market was up 3% or 4% yesterday and down 3% or 4% the day before. It doesn’t make sense, right? It is a short term price movement that simply moves on any short term flavor of the day. The value of these underlying companies has not changed much. The key is not to react as an investor to the movement of prices, but to react to the movement of value; the underlying value of the company should govern your actions, not the movement of the price, because the price is a given. If price and value converge, of course you are selling; if the price drops faster than the value, it may be a worthwhile investment to buy. The point is, as an investor, you cannot pass judgment on the price movement of your business; the emphasis should be on value. For me, this is the biggest lesson a successful investor needs to learn and set in their mind. It is also the most difficult lesson, because of this psychological will to naturally hate something that goes down and to love something that goes up.
This article was adapted from an interview broadcast on Morningstar The long view Podcast. Listen to the full episode.