David Herro Market Commentary | 2Q16

Theme and Background

This chapter discusses the impact of the 2016 UK Brexit referendum on the short-term performance of Oakmark's international funds (Oakmark International Fund and Oakmark International Small Cap Fund). The author argues that market panic selling triggered by political events led to sharp declines in stock prices, but the intrinsic value of companies did not change proportionally, creating buying opportunities for long-term investors.

Core Views

• Market panic is an opportunity, not a risk: The author asserts that "volatility is opportunity," arguing that stock price declines driven by short-term fear are disconnected from intrinsic value, and investors should exploit this divergence.
• European financial sector is overly pessimistic: The market worries about the impact of low and negative interest rates on bank profitability and balance sheets, but the author believes these concerns overlook improvements in industry fundamentals (e.g., capital adequacy ratios doubling) and valuation attractiveness.
• Contrarian judgment: The author believes a weak pound may stimulate the UK economy, the UK government may introduce pro-growth policies, and the EU could push for reforms due to Brexit—these potential positives are overlooked by the market.

Key Arguments and Data

1. Market overreaction:

• Within two days after the referendum, European stock indices fell nearly 15%, with European financial stocks declining even more.
• The author emphasizes that the intrinsic value of companies did not change proportionally, and the panic selling was a "knee-jerk reaction."

2. Fundamental improvement in the European financial sector (compared to the post-2008-2009 crisis period):

• Capital adequacy ratio: European banks now require nearly twice the capital compared to 2008.
• Loan-to-deposit ratio: Declined from 125% to 104%, indicating enhanced funding stability.
• Leverage ratio: Rose from 1.8% to 5.1%, significantly improving bank safety.

3. Valuation attractiveness (MSCI Europe Financials Index vs. MSCI World Index):

Metric	MSCI Europe Financials	MSCI World Index
P/E Ratio	13	20
P/B Ratio	1	2
Dividend Yield	6%	3%

4. Macro environment support:

• Global consumers are in an extremely strong economic position: low interest rates, low energy costs, and low unemployment in the developed world.
• Low and negative interest rates are not permanent; future interest rate normalization will improve bank profitability.

Companies/Assets Involved

• Oakmark International Fund: Underperformed due to heavy exposure to the European financial sector (banks, insurance, asset management companies), but the author believes this sector will deliver positive returns over the long term.
• Oakmark International Small Cap Fund: Suffered from holdings in UK real estate-related stocks, though the author does not name specific companies.
• Japanese export sector: The yen appreciated due to safe-haven demand, impacting the fund's holdings in Japanese export companies, but the author does not elaborate.

Investment Insights

• Increase exposure to the European financial sector: The author is clearly bullish, arguing that current valuations (P/E 13, P/B 1, dividend yield 6%) offer a significant margin of safety, and industry fundamentals (capital adequacy ratio, leverage ratio) are far superior to 2008.
• Build positions using volatility: Investors should ignore short-term political noise and buy undervalued assets during panic selling, especially bank and insurance stocks.
• Focus on beneficiaries of pound depreciation: A weak pound may stimulate the UK economy, and related UK domestic companies (e.g., real estate, consumer) may rebound, but this requires waiting for policy implementation.