Oakmark International Small Cap Fund

David Herro, the fund manager of the Oakmark International and the Oakmark International Small Cap Fund, recently hosted a conference call to discuss both funds. Below we summarize what we think were some of his key points, specifically as they relate to the Small Cap fund.

The International Small Cap Fund has assets under management (AUM) of about $1.6 billion. It is a relatively low cost fund with an annual management fee of 1.15%. Morningstar calculates that the average fund in the category has an expense ratio of 1.38%. The fund currently holds 60 equities.

Herro invests in companies that he believes trade at a substantial discount to what he considers to be their true business value (which is the approach employed by all the investment professionals at Harris Associates, the fund’s investment manager).  Every stock purchase is viewed as if they were buying a piece of a business, not just a stock certificate. Having a smaller portfolio (15-60 stocks, for example, rather than 100-150) is important to Oakmark’s investment philosophy. By building focused portfolios, their managers' best ideas can have a meaningful impact on investment performance.

Stocks in the International fund are selling at 50% of Herro’s valuation and stocks in the International Small Cap fund are selling at 53% of Herro’s valuation. Oakmark’s preferred method of valuation is a discounted cash flow model. (They will use also use other methods such as sum of the parts, but they prefer discounted cash flow.)

With these valuations, Herro finds the current environment a unique opportunity to buy stocks at extremely low prices. After the market crashed during 2008-2009 investors moved toward bonds because they feared that events would continue to spiral downwards, but conditions have improved. Macro issues have continued to cause share prices declines but have not impacted companies’ overall business performance.

Herro says it is somewhat more difficult to find good, undervalued situations currently. He views emerging markets as fairly valued, with developed markets selling at low prices, so he is focusing on developed markets.  Herro believes the best scenario is to find well-priced developed market stocks that are growing their business in emerging markets. This also provides additional corporate governance protection. To Herro, what’s important is how the company makes its money and how it’s priced, not where it’s located.

Herro believes that a meltdown of sovereign debts is highly unlikely in France, Spain, and/or Italy, and also doesn’t see it as a major long term issue. Banks are selling at half of book value in Europe, which represents good value in his opinion. In Japan, they are selling for just under book value, so Herro believes it’s less attractively priced than Europe.  Even at that valuation, financials are an underweight in the International Small Cap fund. 25% of the International Small Cap Fund’s holdings are based in Japan with a total of 43% throughout Asia.

We continue to like the Oakmark International Small Cap Fund.  The fund’s research-driven, consistent pursuit of the best values overseas coupled with its compact portfolio shows us some of the attributes that we look for in our active fund managers. While volatile, we think the fund is an excellent option to obtain exposure to smaller capitalization international stocks.

Returns through 3/31/2012

	YTD	1 Year	3 Years	5 Years	Since Inception*
International Small Cap	17.77%	-1.97%	32.46%	-0.85%	10.51%
MSCI World ex-US Small Cap	10.37%	-7.38%	25.41%	-2.11%

Source: Oakmark

* Inception is 11/1/1995

Assistance on this post was provided by Grace Guo

(Harvest Financial Partners owns the Oakmark International Small Cap fund in client portfolios and uses it as an investment option in a number of retirement plans where Harvest is the investment advisor.  The authors own it and other Oakmark Fund in their personal portfolios.  Positions may change at any time)