Japan is looking expensive, says Oakmark's David Herro on international investing opportunities

International Equity Investing: A Value Perspective

Key Concepts:

• DXY (Dollar Index): Measures the value of the U.S. dollar relative to a basket of six major currencies.
• Return on Equity (ROE): A measure of a company’s profitability relative to shareholders’ equity.
• Price-to-Earnings (P/E) Ratio: A valuation ratio of a company’s stock price to its earnings per share.
• Free Cash Flow Yield: A financial ratio that shows how much cash a company is generating relative to its market capitalization.
• Multiple Expansion/Contraction: Changes in the valuation multiples (like P/E) of stocks or markets.
• Devaluation: A deliberate lowering of the value of a currency.
• Value Investing: An investment strategy that involves selecting stocks that trade for less than their intrinsic values.

Dollar Weakness and International Equity Performance

The discussion centers around the current environment of dollar weakness and its impact on international equity investing. The speaker, David Herro of Oakmark, notes that the dollar has retreated from a high of 105-110 on the DXY to around 95-96, reversing approximately 10% of its previous gains since bottoming around 2011-2012 (when the DXY was around 75). This dollar weakness is a tailwind for international investments, as a weaker dollar boosts returns for U.S. investors when converting foreign earnings back into dollars. However, Herro emphasizes that dollar strength over the past decade has been one factor contributing to the underperformance of international equities compared to the S&P 500.

Double Impact of Dollar Strength & Multiple Contraction

He explains a “double impact” has caused this underperformance: the strong dollar and significant multiple expansion in U.S. stocks coupled with a simultaneous devaluation of foreign stocks. This means U.S. stocks have become more expensive relative to their earnings, while foreign stocks have become cheaper. He believes this situation is now beginning to reverse, with earnings growth in foreign companies starting to materialize, albeit not at the same pace as in the U.S.

Valuation Discounts & Revaluation Potential

Historically, foreign stocks have traded at a 15% discount to U.S. stocks. Currently, that discount stands at 25-30% based on a one-year forward P/S (Price-to-Sales) ratio. Herro believes this discount is excessive and that there is significant room for both the dollar to weaken further and for foreign stock valuations to revalue upwards. He states, “You still have undervalued stocks with undervalued currencies.”

Geographic & Sectoral Opportunities

Herro identifies specific areas offering attractive valuations:

• Pharmaceuticals: Companies like AstraZeneca, Roche, and Novartis (based in Switzerland and the UK) are considered good values due to their strong positions and reasonable pricing.
• Consumer Staples & Discretionary: Companies like Danone and Unilever are attractively priced, particularly in the consumer staples sector.
• Luxury Goods: Despite recent weakness due to the Chinese consumer slowdown (linked to the real estate bubble), companies like Louis Vuitton, Caring, and Richemont (Cartier) are trading at valuations not seen in a long time.
• Industrials & Financials: These sectors are well-represented in overseas indices and offer attractive valuations compared to the U.S.

He acknowledges concerns about slow growth and bureaucracy in Europe but points out that many European companies are global businesses, with significant revenue streams from Asia and North America. He uses BMW as an example, noting that roughly one-third of its business comes from each of Asia, Europe, and North America. He highlights BMW’s free cash flow yield (over 10%) and projected growth (4-5%) as indicators of its value.

Japan: An Expensive Market

Japan is identified as an exception, considered expensive by Herro and Oakmark. The core issue isn’t necessarily the price paid (P/E ratio around 18-19 times, not at the extreme levels of the 1989 bubble), but the quality of what you get for that price.

Quality vs. Price: The ROE Metric

Herro emphasizes the importance of Return on Equity (ROE) as a measure of business quality. Japanese companies have an average ROE of 8-9%, significantly lower than U.S. companies (20s) and European companies (high teens). He argues that despite a market de-rating, the low ROE of Japanese companies doesn’t justify the price paid. He uses Kao (Japan’s equivalent of Procter & Gamble) as an example, comparing its margins (9-10%) to those of Procter & Gamble and Reckitt Benckiser (mid-20s). He concludes that the disconnect between how Japanese companies are run and their valuations makes it difficult to find compelling investment opportunities, despite acknowledging they do hold some Japanese stocks.

Notable Quote:

“Value to us is not just the price you pay, but it’s a fraction. It’s what you get for the price you pay.” – David Herro

Logical Connections:

The conversation flows logically from the macro environment (dollar weakness) to the implications for international equity investing. It then delves into the reasons for past underperformance, identifies current opportunities based on valuation discrepancies, and highlights a specific market (Japan) where caution is warranted. The emphasis on ROE consistently reinforces the value investing philosophy underpinning the analysis.

Conclusion:

David Herro presents a bullish case for international equities, driven by a weakening dollar, improving earnings growth, and significant valuation discounts compared to U.S. stocks. He advocates a value-oriented approach, focusing on companies with strong fundamentals and attractive valuations, particularly in sectors like pharmaceuticals, consumer staples, and luxury goods. While acknowledging the challenges in certain markets like Japan, he believes the overall environment presents a compelling opportunity for investors seeking diversification and potential outperformance. The key takeaway is that international markets offer a compelling value proposition that is currently being overlooked by many investors.