David Herro’s Oakmark International Fund Third Quarter 2014 Letter and David Herro’s Oakmark International Small Cap Fund Third Quarter 2014 Letter
The Oakmark International Fund declined 1% for the fiscal year ended September 30, 2014, underperforming the MSCI World ex U.S. Index, which gained 5%. For the most recent quarter the Fund also underperformed the MSCI World ex U.S. Index, declining 7% versus a decline of 6%. However, the Fund has performed well versus the MSCI World ex U.S. Index since its September 1992 inception, returning an average of 11% versus 6% over the same period.
Intesa Sanpaolo (MIL:ISP), an Italian retail and commercial bank, was the top contributor to performance over the past 12 months, returning 50%. Intesa’s share price has rebounded as fears over Italy’s banking system and government have subsided. We have always believed these fears were overblown and that Italy was in much better long-term fiscal health than many of its periphery countries. The new CEO has committed to return EUR 10 billion to shareholders via dividends over the next four years. This constitutes a cumulative payout ratio in excess of 70%. Even with this return of capital to shareholders, Intesa should be over-capitalized compared with Basel III requirements, leaving the door open for additional capital returns. Additionally, management plans to increase investments in fee-based businesses, including asset management and insurance, and to exit non-core businesses and investments. We believe management has a solid plan for the future and believe the investment will continue to provide value for our shareholders.
Another top contributor was Olympus (TSE:7733), the world leader in endoscopes and other medical equipment, which returned 18% over the past twelve months. Management continues to invest in the medical business with a focus on growth in surgery. Olympus is the dominant player in the gastrointestinal space, but the company is a relative newcomer to surgery. Olympus plans to enlarge its sales staff and enhance its research and development capabilities in the surgical business. Management believes the medical segment will grow 10% this year, driven by higher sales in surgery in addition to endoscope growth in the emerging world. Although the camera business remains weak in our view, Olympus also plans to invest in this division, and management’s goal is to boost revenues enough to cover costs this year.
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There was abundant portfolio activity during the past quarter. We sold our positions in Geberit (XSWX:GEBN) and OMRON (TSE:6645) and added four new names to the Fund: Exor (MIL:EXO), an Italian-based investment company which owns stakes in CNH Industrial and Fiat; G4S (LSE:GFS), a U.K.-based security services company; Melco Crown Entertainment (HKSE:06883), a Hong Kong-based casino, gaming, and entertainment resort operator; and Swedish Match (OSTO:SWMA), a Swedish-based company whose primary source of revenue is derived from smokeless tobacco.
The largest detractor from performance for the quarter and the past twelve months was CNH Industrial (MIL:CNHI), a manufacturer of agricultural and construction equipment. As expected, the company’s agricultural equipment business is experiencing reduced sales due to lower crop prices and farm profitability. However, we believe the agricultural segment to be a structurally appealing industry. Higher adoption of double cropping, increases in farm sizes in emerging and frontier markets, and the global need to increase yield will increase the demand for larger equipment. We believe CNH will continue to benefit from these trends as the second largest leader in this industry. In addition, the company’s commercial vehicles (Iveco) and construction equipment businesses have performed more poorly than expected. Weakness in Europe and Latin America, combined with adverse currency movements, have negatively impacted these businesses and led to very low levels of profitability. As these conditions return back to a more normal level, we believe these two segments will significantly improve. We believe management is taking important steps to enhance shareholder value with its continued focus on operational improvement and restructuring of the company’s balance sheet.
Geographically, we ended the quarter with 79% of our holdings in Europe, 13% in Japan and 4% in Australia. The remaining positions are in North America (Canada), South Korea, Hong Kong and the Middle East (Israel).
The U.S. dollar has strengthened significantly versus most global currencies. This is because of the U.S.’s strong relative economic growth outlook, directions in quantitative easing and geopolitical tensions in other parts of the world. As a result, the Australian dollar, Swiss franc and Swedish krona depreciated during the quarter. Our defensive hedge positions of these overvalued currencies boosted performance for the quarter. We continue to hedge these overvalued currencies and ended the quarter with 42% of our Australian dollar, 33% of our Swiss franc and 30% of our Swedish krona exposure hedged.
We continue to adhere to a long-term value philosophy that has enabled us to build a portfolio of high quality names trading at discounts to our estimate of intrinsic value. We thank you, our shareholders, for your continued support.
David G. Herro, CFA
Robert A. Taylor, CFA
As of 09/30/14, Intesa Sanpaolo SpA represented 2.9%, Olympus Corp. 1.0%, CNH Industrial N.V. 2.5%, Geberit AG 0%, OMRON Corp. 0%, Exor SPA 0.4%, Fiat SpA 0%, G4S PLC 0.02%, Melco Crown Entertainment, Ltd. 0.6% and Swedish Match AB 0.2% of the Oakmark International Fund’s total net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Click here to access the full list of holdings for The Oakmark International Fund as of the most recent quarter-end.
The Oakmark International Small Cap Fund declined 9% for the quarter ended September 30, 2014, underperforming the MSCI World ex U.S. Small Cap Index, which declined 8% for the same period. For the fiscal year ended September 30, the Fund declined 2%, and the MSCI World ex U.S. Small Cap Index returned 3%. Since the Fund’s inception in November 1995, it has returned an average of 10% per year.
The Fund’s regional South Korean banks, DGB Financial Group and BS Financial, were two of the top-performing stocks for the recent quarter. We believe that strong economic growth in DGB (XKRX:139130)’s primary business region and a current undervaluation of the stock adds to DGB’s attractiveness. BS Financial (XKRX:138930)’s proposed acquisition of another small regional bank, Kyongnam Bank, would be a strategic use of capital that could further enhance the company’s competitive position, should the deal close. We also think BS’s strong deposit franchise gives it a significant funding advantage over its peers and should generate substantial profitability once interest rates normalize. (DGB, like BS, should also benefit from interest rate normalization.) We continue to believe the valuation of this high quality regional bank with dominant market share remains attractive, offering a compelling reason to own.
Altran Technologies (XPAR:ALT), an engineering and technology consulting company that offers services throughout Europe, was the largest contributor to performance for the fiscal year ended September 30. Altran’s restructuring efforts demonstrate how our emphasis on quality management teams can pay off. First, the management team reduced overhead costs, and second, Altran has more recently shown material improvements in the utilization of its engineers, causing invoicing rates to rise quarter over quarter. Higher invoicing rates are necessary for Altran to narrow the margin gap compared with its best-in-class peers. We are optimistic that these positive trends will continue into the second half of 2014 and that Altran will report another year of margin improvement.
Fugro (XAMS:FUO) was the largest detractor from performance for the fiscal year and recent quarter end. This Netherlands-domiciled geological engineering company released a profit warning in July, indicating that first-half margins would be in the low single-digits (lower than both market and our expectations) and that it would be booking EUR 300-350 million of impairments in its subsea joint venture and multi-client library. These disappointments caused the share price to decline over 40% during July. The very weak first-half results were a culmination of both a soft end market (a majority of Fugro’s profits are derived from the offshore oil and gas market) and a number of company-specific operational issues. The slowdown in offshore exploration and production (E&P) spending looks like it will likely continue into 2015 and possibly beyond. We have adjusted our forecasts and estimates of intrinsic value to reflect this lower growth environment. However, longer term, we believe that off-shore capital expenditure trends will eventually improve as oil demand continues to increase moderately, while production from existing fields continues to decline. We continue to remain shareholders of Fugro because of its dominant positions in a number of niche businesses that should benefit from an eventual recovery in offshore E&P spending.
Five new securities were added to the Fund this quarter, two of which – Brunel and Countrywide – are previous Fund holdings. Brunel (XAMS:BRNL) is a professional staffing company with major operations in the Netherlands, Germany and within the global energy market. Countrywide (LSE:CWD) is the U.K.’s largest real estate agency and also operates a large surveying business as well as letting business. Melco International Development (HKSE:00200) is a Hong Kong-based holding company that derives nearly all of its value from a 33.6% stake in Melco Crown, an operator of casinos globally, predominantly in Macau. Transpacific Industries (ASX:TPI) is Australia’s leading recycling, waste management and industrial services company; and U.K. based Electrocomponents (LSE:ECM) is the world’s leading high service distributor of electronics and maintenance products for engineers. There were no names fully divested from the Fund during this past quarter.
Geographically we ended the quarter with 22% of our holdings in Asia, 62% in Europe and 13% in Australasia. The remaining positions are in North America, Latin America and the Middle East.
While the U.S. dollar has strengthened, our view is that certain global currencies are still overvalued. We maintained hedge positions on three of the Fund’s currency exposures. As of the recent quarter end, we slightly increased the Fund’s Australian dollar hedge to 39% and continue to have 45% of the Norwegian krone and 34% of the Swiss franc exposures hedged.
Thank you for your continued confidence.
David G. Herro, CFA
Michael L. Manelli, CFA