David Herro, Chief Investment Officer for international equities at Harris Associates, is bullish on the big Suisse bank and expects more discipline from cement giant LafargeHolcim.

For many investors European financial stocks are a no-go zone. Not so for David Herro. He thinks the recent setback in the sector offers attractive value and he doesn’t shy away from names like Credit Suisse (CSGN 13.42 1.05%), Julius Bär (BAER 39.17 -0.13%) or EFG (EFGN 6.23 -0.64%) International. The fundsmanager from Chicago who manages for Harris Associates two international stock funds with total assets of around $30bn spots growth opportunities for Swiss financial institutions in areas like wealth management. The successful value investor is also optimistic for the new cement giant LafargeHolcim (LHN 45.52 -0.5%) which, in his view, should profit from the consolidation of the global cement industry.

Mr. Herro, there was quite some turmoil in the global financial markets recently. How did you experience these turbulences?

The mood of the market was very panicky. At one point, our key fund was down over 17%. Yet, we ended up closing the quarter down like 2%. That just shows what can happen within a three month time period and how irrational markets can behave in the short term. This is why it’s so important to stay focused on fundamentals. About David HerroDavid Herro has been a manager of the Oakmark International Fund since 1992, the Oakmark International Small Cap Fund since 1995 and the Oakmark Global Select Fund since 2006. He is also the Chief Investment Officer for International Equities at Harris Associates, which he joined in 1992. His career honors include being named Morningstar's International Stock Fund Manager of the Year in 2006 and International Stock Fund Manager of the Decade for 2000-09. Mr. Herro has an M.A. in Economics from the University of Wisconsin-Milwaukee (1985) and a B.S. in Business/Economics from the University of Wisconsin-Platteville (1983). He is an active supporter of the Republican party and a passionate fan of the Green Bay Packers.

What do you think are the reasons for these hefty mood swings?

Part of the instability in today’s financial markets is certainly caused by political uncertainty: In the United States, in China and in Europe with the risk of a Brexit. So what we have is political uncertainty all over the world and people manifest this fear by actions with share prices. I think incorrectly so because stock valuation is a function of a company’s ability to generate free cash for its owners over the short medium and long term. That’s what determines the worth of a business not whether Mr. Trump is running for President, chairman Xi Jinping has a mess on his hands or whether there is going to be a Brexit. These things are like storms: they come, it rains, it causes a lot of wind, there is a little bit of damage but then they move on. Nevertheless, investors continue to hyper react in such situations and really long term value investors should use this as opportunities.

So where do you spot opportunities?

We are value investors. That means we determine the intrinsic value of a company and if the share price falls significantly below that value we add to our position. On the other hand, if price and value converge we begin to trim gradually. Take Glencore (GLEN 148.95 4.93%) as an example, one of our more controversial positions. When the stock price dropped to 70 people were saying that the company was going under. Well, today the price is over 140. It has doubled and Glencore is not going under, especially when you look at the steps the company has taken to shore up the balance sheet. Glencore is going to be one of the few mining companies generating free cash flow this year at even lower spot prices than what we have today. So they’re recovering nicely. But again: People panic and every one sells.

But it’s not always that simple to keep a cool mind in such kind of situations.

If you have been in this business like me since 1986 you realize that much of this market disruption is transitory. For instance, the crisis of 2008/09 was about the worst we have seen since the thirties. And yet, we’ve recovered. So in the long term, you can’t base your base case on death and destruction. Many of our clients have been around for some time now. They have seen the cycles and they have seen how we behaved through them. But newer clients sometimes get worried and ask: “Why are you not in utilities and other safe things?” Because you have to look at price! Let’s say you own a Volkswagen (VOW 132.5 0.76%) Golf that’s worth $30’000. Why should you ensure it for a million? But that’s what people do when they overpay for safety. I’m not saying: “be reckless”. I’m saying be diversified, invest in businesses with good balance sheets and with good management teams that are selling at prices well below intrinsic value.

So what shares look attractive in terms of value?

We are overweight Europe and especially the financials. Financials have gotten killed and this is one of the puzzling things about the first quarter of 2016. Okay, it’s not a perfect robust environment for European banks. Negative interest rates certainly don’t help lending spreads. However, you see credit expansion going on for the first time in a long time, you see lower loan losses, you see banks that are better capitalized than ever, you see higher fee income. But the markets have just taken one factor – and that’s a negative interest rates – and use it to completely drown out anything that’s positive. To me, that’s irrational.

Particularly hard hit was Credit Suisse, one of your largest positions.

The setback in the shares of Credit Suisse is not justified. Six or seven months ago the share price was at SFr 26. Today it’s about half that. But it isn’t worth half of what it was six months ago. This price destruction does not at all mirror what is happening with the intrinsic value of the company. We have been invested in Credit Suisse for more than ten years. We almost sold out completely around 2006. Then the financial crisis came and Credit Suisse did better than most other financials. The company seems to have learned from its debacle in 2001/02 with the tech bubble. But recently, it faced some headwinds. Headwind number one was a change in the regulatory environment. The regulator in Switzerland just kept wanting more and more capital. Headwind number two was the big fine they had to pay because of the privacy rules, the bank secrecy.

And most recently, the company had to issue a profit warning. Is the new CEO Tidjane Thiam on top of the situation?

The prior CEO meant to de-emphasize the investment bank, but quite clearly didn’t do it fast enough. As a result, he left his successor with a bigger problem than he should have. Mr. Thiam is completely and adequately focused on doing what is the right thing. That is transitioning the bank at a quicker pace from risk taking in the investment bank to using that capital to build out the wealth management business. That means to deploy capital where it has the highest chance of making a trough cycle return. This is what was supposed to have happened two or three years ago.

How much longer can you be patient?

Mr. Thiam is going to get behind all this. But this isn’t easy. Now, he has to downsize the investment bank even faster and of course everyone there is going to complain about it. You know the nature of traders. As he is cleaning the place up there is going to be noise in the short term as many of the parties who caused this mess are being wound down and unhappy about it. Well, too bad. They had a skewed probability distribution as to their rewards. If their trades made tons of money they made tons of money and the shareholders hardly made any. And if their trades lost money they lost nothing and we lost. So they should be ignored. They should keep their mouth shut and they should feel guilty for causing this value destruction to the shareholders.

And what about improvements in the board of directors? At the end of the day, the board is co-responsible for the strategic missteps in the past.

There is a word in Japan called Kaizen. It means continuous improvement. I think every board in the world can continuously improve, including the one at Credit Suisse. A board should always look for ways to improve itself, ways to make sure that the company has astute, active board members who are helping the management to achieve the goals and objectives of the company. You need people who understand the language of value creation: running assets as efficiently as possible for medium and long term profitability, not for a quick profit. I guess, if you look at what’s happened, certainly people made mistakes. Some of these assets shouldn’t have been on the balance sheet. Obviously, there was some issue somewhere. That might indicate that we need some strengthening on the board. You need to have members who understand the business, who can help make sure we have compliance and systems in place so we don’t have these booboos.

Additionally, there is also the question whether Credit Suisse is going to need more capital.

If we look at the end of this year or at the beginning of next year I think the clean up will be largely over if not completely over. And we will be able to see the results of putting capital where it belongs and that’s where it earns a through cycle return. Also (ALSN 64.2 -0.31%), if they float the universal bank that frees up more capital. So Credit Suisse should be on a good basis.

You are also invested in Swiss financial companies like Julius Bär and EFG International. What do you like about Swiss banks in general?

So far Julius Bär has done a pretty good job. We started investing in the company when Mr. Raymond Bär started to get rid of everything. He consolidated the share classes and brought in outside of the family management. Remember: They had an investment bank and they had a brokerage firm. So we’ve been invested in Julius Bär for a long time. They have been fairly acquisitive but so far it looks like their acquisitions made sense and and have been done at the right price. The world needs good wealth management. Wealth is growing, this is a growth industry.  It should be a good mid to high single digit growth business over time. If you do it right you should be able to make money on it. And that’s what the Swiss banks were always good at.

However, when it comes to reputation, the Swiss financial industry has seen better days.

The Swiss banks relied on a crutch called secrecy and that has ended. The big ones knew it was ending pretty soon and they started to go onshore. Julius Bär, UBS (UBSG 14.68 0.76%) and Credit Suisse have all gone onshore. But the smaller ones, the ones who relied on offshore money are in trouble. They don’t have the systems and they will need to be consolidated. So you see EFG buying assets and you are going to see more of that because these little guys who haven’t done the compliance right and who have relied too much on undeclared money are going to be in trouble. You have a dichotomy in the Swiss financial industry: The strong ones will get stronger over time and the weaks ones will either go away or they will have to merge.

Speaking of consolidation: That’s also an important trend in the global cement industry. Is that why you hold a relatively large stake of LafargeHolcim?

The stock has bounced a little but there is still a lot of value  on the table. In the past, you had an industry that used to just add capital and fight each other like crazy. Now, the sector has become a lot more consolidated. There is a whole new discipline, especially since you have players that are far more attuned towards earning a trough cycle return on that capital. It can’t be 5, 6 or 7%. It should be 10 to 14%. That’s why I think this is a very low price to pay today for these assets given the levers and flexibility that LafargeHolcim has to create value.

Then again, the global economy has cooled down significantly. So the business environment is not very friendly to the company.

Of course, in regions like Brazil or Russia there are headwinds. But in general, the company is on the right track. They have a good India exposure that should eventually be a very nice thing. Also, the US market is doing ok. Additionally, the mindset has really changed. In the past, Lafarge in particularly but Holcim as well were terrible capital allocators. Now, instead of just mindlessly putting capital in the ground where it doesn’t earn any return, the company can take that capital and do something smart with it, whether it’s going to be giving it back to the shareholders or paying down debt. Also, there is an extremely strong ownership alignment on the board. This will make sure that the management does the right thing. So I think it’s going to be a good situation despite the fact that there are some macroeconomic headwinds. Those should soon turn into tailwinds.

«This is a reasonable price for Gategroup»China’s HNA Group has launched a SFr 1.4bn takeover bid for Switzerland’s Gategroup air services company. David Herro will take a close look at the offer since his Oakmark International Small Cap fund has been an owner of the Zurich based company for quite some time.

Mr. Herro, what’s your take on the offer for Gategroup?
This is a price that is reasonable. I mean HNA is not way overpaying for Gategroup but they’re not picking up the company on the cheap, either. That’s why I would say it’s a reasonable price.

So are you going to tender your shares to HNA?
We haven’t made any final decisions yet. I would just comment that I think it is a reasonable price.

What would the take-over mean for the future of Gategroup?
It looks like that HNA is going to keep the same management team. That means they want to pursue the existing strategy. Usually, one of the reasons why you take a company private is that you want to more aggressively restructure it. As a public company Gategroup is harder to restructure. So I’m only guessing that it’s ok to assume that HNA plans to restructure the business more aggressively.

The hedge fund RBR Capital Advisors doesn’t seem to welcome the takeover offer for Gategroup and thinks the price should be around SFr. 100 per share. What are your thoughts on that?
I think they would have to demonstrate why they assume the shares are worth SFr. 100 a piece. This is a business that is not growing at 20% per year. So you are not going to get sky high multiples. I really would be curious how they justify that price. What we can see, we don’t think the shares are worth SFr. 100.

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