David Herro Market Commentary | 4Q14

Theme and Background

This chapter reviews the core reasons behind the losses of Oakmark International and Oakmark International Small Cap Funds in 2014, with a particular focus on the author’s observations following a visit to China/Hong Kong in December 2014. The market backdrop includes a significant appreciation of the US dollar, a sharp drop in oil prices, weak economic conditions in Europe, and ongoing anti-corruption efforts and reforms in China.

Core Thesis

The author argues that China’s ongoing anti-corruption campaign and market-oriented reforms (such as deregulation in energy and financial services, and state-owned enterprise reforms) are positive and deep-seated, unlike the superficial changes seen over the past decade. Although these measures have led to short-term economic slowdown, they will, in the long run, shift China’s economy from an investment-driven model to a consumption-driven one, providing a more sustainable engine for global economic growth. The author believes that current market pessimism has led to an undervaluation of China’s consumption-related assets, creating significant investment opportunities for long-term investors.

Counterintuitive Judgment: The author views China’s economic slowdown (from high growth to medium pace) as a positive signal, indicating a more sustainable growth model rather than a crisis.

Key Arguments and Data

• Unprecedented Anti-Corruption Efforts: The Zhou Yongkang case reportedly involves an amount close to $15 billion. The author believes this marks the tail end of the anti-corruption campaign, after which the reform agenda will take center stage.
• Clear Reform Direction: Citing The Wall Street Journal, the author suggests that Wang Qishan has been authorized to pursue “creative destructionism,” with the goal of shifting the economy from policy/investment-driven to consumption/demand-driven.
• Market Mis-pricing: Current market participants are linearly extrapolating short-term weakness into permanence, leading to “quite weak” stock prices for China’s consumption-related companies. The author sees this as a buying opportunity.
• China’s Savings Rate: Approximately 30%, but the scale of savings exposed to the shadow banking system is unknown, posing a potential risk.

Companies/Assets Involved

Investment Implications

• Increase exposure to China consumption-related assets: The author believes that current pessimistic pricing of Chinese consumer stocks offers a long-term buying window, particularly for companies benefiting from the consumption-driven transition.
• Focus on reform implementation: Once the anti-corruption campaign concludes and the reform agenda becomes clear, investor confidence, consumption, and growth are expected to rebound. The current downturn presents an opportunity to position for this recovery.
• Watch for two major risks: Potential wealth losses hidden in the shadow banking system, and the possibility that the government may “micro-manage” consumption (e.g., promoting domestic goods, restricting luxury items). The latter, though less likely, warrants attention.