In a recent interview with Value Investor Insight reviewed by ValueWalk, well-known fund manager David Herro of Harris Associates discusses the evolution of his investing philosophy as well as what value means to him today. He also offers some insights into his current favorite sectors and companies. Of note, Herro was named Morningstar’s Foreign Equity Manager of the Decade in 2010.

David Herro notes the high level of economic turbulence in markets today. “There’s always a lot going on,”  he says, “but we’re probably closer to a peak than a trough on that front right now.”

He has run the Oakmark International Fund since 1992, and has produced a net annualized 10.6% compared to 6.4% for the MSCI World Index (ex U.S.). Sectors Herro is investing in right now include luxury autos, farm machinery, asset management and private banking.Avoiding value traps

Herro says that he started out as a moire pure Graham and Dodd value investor, focusing primarily on low price/earnings ratios, good balance sheets and high dividend yields. He continues to say the problem with that strategy is “you can get caught in too many value traps.” Herro concluded he was better off focusing mainly on two variables in weighing investment attractiveness: company valuation and business quality.

He breaks down what he means he means by business quality. “Quality to me is a company’s ability to intelligently allocate capital and generate good economic returns from its businesses. If they’re proficient in allocating capital and they earn good returns, that means they’re going to grow value per share. That growth of value over time is the best catalyst to get price and value to converge.”

Specifically, David Herro states when asked about his early career and investment philosophy:

Starting out I was a Graham and Dodd investor, focused on low price/ earnings ratios, good balance sheets and
high dividend yields. The problem with that is you can get caught in too many value traps. I concluded I was better off focusing primarily on two key variables in weighing investment attractiveness: company valuation and business quality. Quality to me is a company’s ability to intelligently allocate capital and generate good economic returns from its businesses. If they’re proficient in allocating capital and they earn good returns, that means they’re going to grow value per share. That growth of value over time is the best catalyst to get price and value to converge.

Value is about identifying short-term challenges

Herro emphasized that he remains very focused on paying a cheap price, but of course that opportunity only comes “when there’s some short-term challenge.” He tells an anecdote about a trip to Hong Kong and Japan earlier this month where he bumped into an investor talking about a beaten-up sector he was staying away from. He recalls thinking to himself “Well, that’s exactly where you should be looking!”

As an example, Herro points to CNH Industrial, the maker of farm equipment and heavy-duty trucks. The stock is weak mainly because “we’re going through a tough period in agricultural-commodity prices, which has put pressure on farm incomes and therefore on farm-equipment spending.” He notes that the stock might not move up for some time until the current down cycle ends, but he believes “agriculture is a great long-term growth story given economic and demographic change around the world.”

David Herro further states :

This once was all part of Fiat, but is now an independent company with primary operations in tractors and combines, construction equipment, commercial trucks and powertrains.

The agriculture-related business, which accounts for about 65% of our estimated terminal EBITA, is the second-largest tractor
and combine company in the world behind Deere – bigger than Deere outside the U.S. and smaller than it in the U.S. We consider these two companies the class of the global industry, with the biggest machines, the best technology and the
broadest distribution. So even though the cyclical downturn in farm incomes is hurting CNH’s results now, we believe that’s temporary and that it and Deere are well positioned to steadily take market share as the global agriculture market grows and modernizes.

The second-biggest business is commercial vehicles, consisting primarily of mid-size trucks sold under the Iveco brand. This business is struggling because the two geographic areas in which it’s strongest, Europe and Latin America, are facing macro headwinds. The company is doing the right things in response, such as consolidating plants and cutting expenses, but it’s also continuing to invest in modernizing its product line. As business conditions in key markets bottom out and return to a more normal level, the profitability upside in trucks is substantial.

David Herro

David Herro on Russia

When asked “Any chance you’re tempted by Russia?”, Herro replied, “No chance. I can live with unstable  economies, but not without a rule of law or reliable financial and accounting systems. I met with BP a few years ago when we owned its shares and they’d say, “Russia’s different now, Putin wants a better country.” Not long after, BP’s joint venture in Russia was more or less stolen out from under them. I have yet to invest in a Russian stock and unless things dramatically change there, I don’t expect to.”

Other famous investors, including Jim Rogers, Jim Grant are hunting in the country for bargains.