Value of tuning out the macro white noise

April, 2012 Print

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LONG-TERM EQUITY INVESTORS SHOULD NOT BE PARALYSED BY THE EXCESSIVE DISTRACTIONS EMANATING FROM EUROPE AND ASIA. IN FACT, ROBERT TAYLOR OF HARRIS ASSOCIATES ARGUES THAT VOLATILITY CREATES OPPORTUNITY FOR INVESTORS FOCUSED ON THE INTRINSIC VALUE OF QUALITY BUSINESSES WORLDWIDE

White noise of macroeconomic worry has been hampering the market’s ability to objectively analyse companies on their individual merits. We certainly witnessed this in the second half of 2011, as quality global companies saw their stock prices tumble on news of sovereign debt issues, or slower growth in China. For example, Daimler lost nearly half of its market value between July and late November, and this was during a time that Mercedes-Benz had some of its best sales ever.

In this prolonged period of uncertainty and volatility, following a disciplined investment process focused on pure business value – and certainly not daily economic news reports – can offer a more sensible route to capital preservation and appreciation. Investing based on macro themes may work for those with short-term horizons. But for investors looking to build durable portfolios to pursue long-term goals, being able to tune out all of today’s market noise has its advantages.

At Harris Associates we aim to avoid the price movements that result from daily headlines. Instead, we look to value businesses through the economic cycle and beyond. So when investors flee good businesses because of shortterm macroeconomic conditions, we view it as an opportunity. Of course, investing in this way takes patience and discipline, but we believe that it has been one of the keys to our long-term investment success.

For more than 30 years we have maintained a steadfast belief that investing in undervalued companies offers attractive profit potential while providing meaningful risk reduction. We construct portfolios on a stock-bystock basis and follow an investment process based on three key tenets:

•Buy stocks selling at a significant discount to the intrinsic business value

•Focus on firms increasing per share value

•Invest in companies with owneroriented management

Owner-oriented management is one of the biggest differentiators we look for in value stocks. We want to invest in companies where we feel the management team really acts and thinks like an owner would. That means that when there is free cash available they do a good job allocating it to its highest and best use for shareholders, and that they own stock in the company themselves.

Volatility creates opportunity

While many define risk as volatility, we view volatility as an opportunity. We define risk as permanent capital loss for shareholders. So if you think about it, as a quality stock gets cheaper, or further and further away away from its true value, the chance of us losing money in that investment then goes down. Therefore, the risk declines.

When estimating the fundamental value of a business, we look at growth potential, balance sheet strength, the quality of management and other factors. If the share price of that business falls below that estimate of fundamental value because of a shortterm, macro-induced panic, we react opportunistically. This in part explains why we continue to favour select European financials with minimal exposure to Greek or Portuguese sovereign debt.

Julius Baer, for example, is a private wealth management company with zero sovereign debt exposure. Yet because it is headquartered in Europe, its stock price fell along with every other European financial. It has close to a 25% tier one ratio, it normally trades at about 12 or 13 times earnings, and it continues to attract net new money. This is the exact type of value opportunity we are looking to identify.

Our main objective is to focus on exploiting value where we can find it. That means we often appear to be contrarians. When markets rebounded in 2009, some dismissed the move as a “dead-cat bounce” and warned investors against a “dash to trash”. We saw it as a significant opportunity. In 2010 through 2011, the same pundits who missed that rally warned to watch for a double dip recession and cautioned that the PIIGS would sink Europe. Then they missed a rally during the first quarter of 2012. Once again we find ourselves going against the grain by investing in European financials, despite the headline risk.

Research leads to high conviction

In today’s uncertain world, there is no lack of value ideas being generated by our seasoned team of research analysts at Harris Associates. By operating as generalists, they get to focus on uncovering value wherever they can find it without regard to country, sector, or industry. It is through their in-depth work that we get to the point where we can put a value on a company.

When an analyst believes a stock should be owned by Harris clients, it is brought before the full international team, which is led by David Herro, Chief Investment Officer of International Equities. It’s the group’s job to try to find holes in the analyst’s contentions of why the stock is a good idea. At the end of the debate, senior members of the team vote on whether the stock should be added to the approved list of about 150 names. In the end, we believe this research and vetting process enables us to have a high conviction on every name we select for a portfolio.

Global equities remain attractive in 2012

We expect the global economy to grow around 3% this year. The US is seeing accelerating growth, and Asia, including Japan, is growing at a meaningful rate. We believe such economic growth bodes well for increases in corporate profitability. When you combine low valuations with economic growth, it is generally positive for stock prices.

European debt crisis flare-ups have helped make valuations attractive for many global blue chip stocks in 2012. We are finding solid blue chip companies selling for under ten times cash flow and with dividend yields of 3-5% in many areas, including the financial sector and consumer durables. These characteristics represent a nice entry point to gain greater exposure to quality global companies.

We continue to see Japan leading the world in terms of discounted valuations. At the same time, we have seen a rising profitability of Japanese companies even as the yen has hit its highest value against the US dollar since the end of World War II. The 2011 tsunami and flooding in Thailand (where many Japanese exporters have manufacturing operations) slowed corporate activity, but all of our Japanese holdings have restored 100% of their production capacity.

Harris Associates remains quite positive on potential US stock market returns, as well. Key reasons for this viewpoint are: P/E ratios of most stocks are still below historical averages; the dividend yields of many stocks are significantly higher than bond yields; balance sheets of many companies are low in debt and high in cash; and low dividend payout ratios for many companies give them good prospects for dividend increases while still providing them excess capital for incremental growth through share repurchases or acquisitions.

Emotion in the market makes it difficult for businesses, but in general, they are still growing and earning acceptable returns. As such, we remain confident that by staying disciplined and focused for the long term, equity investors can take advantage of what we believe is a sizeable opportunity for profit.

Robert Taylor
Director of International Research,
Portfolio Manager
Harris Associates 

FOCUS Global Equities

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