David Herro Market Commentary | 1Q11

Theme and Background

This chapter discusses the impact of global macro events in the first quarter of 2011 (political turmoil in the Middle East, the earthquake and tsunami in Japan) on stock markets and how investors should respond. The author argues that despite frequent macro volatility, the key to long-term investing lies in focusing on micro-level corporate valuations rather than overreacting to short-term events.

Core Thesis

The author's core investment thesis is: Macro turmoil is the norm, but long-term returns depend on micro-level corporate value. Counterintuitive judgments include:

• Despite multiple macro crises in the 1990s (the Gulf War, the Asian crisis, the tech bubble, etc.), the MSCI World Index still delivered an average annual return of 12%, demonstrating that macro noise does not determine long-term returns.
• After the disaster, Japanese stocks traded at even lower valuations (a price-to-book ratio of approximately 1x, far below the global average of over 2x). The author instead increased positions against the trend, believing that the short-term shock did not cause long-term value destruction.

Key Arguments and Data

• Frequency of Macro Events: The author lists major crises since entering the industry in 1986 (the 1987 crash, the 1990 Gulf War, the 1994 "Tequila Crisis," the 1997 Asian crisis, the 2000 tech bubble, and the 9/11 attacks in 2001), proving that prolonged periods of macro calm are rare.
• Historical Returns: In the 1990s, the MSCI World Index delivered an average annual return of 12%, despite multiple crises during that period.
• Japan Valuation Comparison: Before the disaster, the average price-to-book ratio of Japanese companies was approximately 1x, compared to over 2x for the rest of the world. After the disaster, Japanese stock prices fell further, but the author believes no long-term structural value destruction occurred.
• Oil Production: The world consumes approximately 85 million barrels of oil per day, of which Saudi Arabia produces 8 million to 10 million barrels, highlighting the importance of geopolitical risks in the Middle East.

Companies/Assets Involved

• Oakmark International Fund & International Small Cap Fund: The funds managed by the author posted positive returns for the quarter but slightly underperformed their benchmark.
• Japanese Companies: The author had already increased holdings in Japanese stocks before the disaster and further added to positions afterward, believing that short-term earnings impacts do not alter long-term value.
• Saudi Arabia: As one of the world's largest oil producers (8-10 million barrels per day), its political stability is critical to oil prices and global supply chains.

Investment Implications

• Contrarian Buying in Undervalued Markets: When markets panic-sell due to short-term disasters, if fundamentals have not been permanently damaged, investors should take advantage of low valuations to increase holdings (e.g., Japan).
• Ignore Macro Noise: History shows that even with frequent crises, long-term holding of global equities (MSCI World) can still generate substantial returns. Investors should assess the impact of events on the long-term cash flows of specific companies, rather than following market sentiment.
• Focus on Micro Valuations: The author emphasizes that a company's value depends on the present value of all its future cash flows. Pricing errors caused by short-term information flows are a source of excess returns.