Bargains Among Battered European Bank Stocks? Oakmark Intl’s David Herro Makes His Case
You could excuse David Herro for being frustrated and blue right about now given that his $8.4 billion Oakmark International fund lost 10.4% in the second quarter. Big investments in troubled European banks including Credit Suisse, BNP Paribas and Banco Santander were a serious drag. But Herro, who has serious cred in international investing circles isn’t blinking.
A telling excerpt from commentary Herro wrote to accompany the just-released second quarter shareholder letter:
“The strong sell-off in stocks seems to be way overdone. Note that the fundamental value of any business is determined by the present value of ALL future cash flow streams. However, “Mr. Market” frequently prices businesses based on short-term macro and political fears. Our task is to incorporate the impact, IF ANY, these fears have on the actual ability of companies to generate current and future cash flow streams, as it is these streams, not political uncertainty that is the key determinant of business value. In most cases, this key number – the present value of all cash flow streams – is at worst mildly impacted by market volatility and thus we are provided with a buying opportunity. Specifically, given that our investment time horizon is one of an investor and NOT a trader, we can take advantage of a weak market environment by investing in what we believe are high-quality businesses at very low prices. Thus, as mentioned before, it becomes a very fertile environment for value investors.”
Why listen to him? Well, Morningstar, the mutual fund research firm, named him the Foreign Equity Manager of the Decade a few years ago. More recently, the fund’s three year annualized gain of 10.3% through mid July is nearly four percentage points ahead of the MSCI EAFE index, the standard benchmark for international investors.
Herro, if you haven’t already figured it out, is a card-carrying value investor. So while many investors shudder over Europe’s woes, he’s willing to invest in—and stay invested in- quality businesses when they are, in his opinion, unjustly battered.
Herro’s bottoms-up strategy has led him to an overweight in the troubled overseas financial sector. According to Morningstar, Oakmark International has 27% of its stock portfolio riding on financial service companies, compared to 17% for similar funds. And Herro is clearly betting that some Euro-based banks getting smacked silly right now are compelling long-term investments. His portfolio has sizable stakes in Credit Suisse Group ( CS), BNP Paribas, Lloyd’s Banking Group ( LYG), Spain’s Banco Santander ( SAN) and Italian bank Intesa Sanpaulo.
So what’s Herro smoking? Well, in part he figures the banks are guilty by association. The standard non-Herro riff is: They are banks. Worse yet, banks based in Europe. So they must be close to implosion. Herro has a more nuanced take.
To understand Herro’s interest in the sector, consider Credit Suisse, one of Switzerland’s largest banks. The Swiss central bank advised Credit Suisse, and UBS ( UBS), on June 14th to increase their capital base to build a bigger buffer if the Euro begins to crumble. (Switzerland is not a part of the Euro, but will be impacted it there are any exits.) Credit Suisse said its capital base is just fine, thank you. Still, there’s been little good news in its numbers lately. Earnings have taken a serious hit.
And Return on Equity has cratered as well.
That’s caused plenty of pain for shareholders for the past year, and makes for an ugly stock chart.
Herro thinks investors have misunderstood Credit Suisse. As he told Bloomberg recently, the company is being beaten up as if it were a standard issue retail bank. But it’s really centered on being an investment bank and a wealth management-driven operation with an emphasis on ultra high net worth clients. That business added more than $8 billion (US) in new assets in the first quarter of the year.
And Herro clearly disagrees with the Swiss National Bank’s capital request, which he deemed as “odd” in his second quarter letter. Herro went on to explain himself:
“We already know that the Basel 3 [capital] requirements for Swiss financial institutions are some of the most stringent in the world, another example of Swiss governmental agencies’ extreme conservatism. We take capital strength and solvency very seriously, as it helps protect downside risk when investing. With little exposure to sovereign debt, excellent liquidity and a strong balance sheet that is growing stronger, Credit Suisse’s financial strength satisfies our investment criteria.”
Nonetheless, in mid-July Credit Suisse announced plans to bolster its capital, in a move no doubt designed to address continued pressure on the stock price since the SNB voiced its concerns.
But Herro is the sort of investor who will calmly wait years, not merely months, for his thesis to play out. With patience, there’s the potential for a nice fat 4.5% dividend yield to collect. The key word here is “potential,” however. If Credit Suisse does appease its central bank with more capital, the money could come from would-be dividend payments. If that happens, Credit Suisse will need all the patience from investors it can get.