David Herro Market Commentary | 2Q17

Theme and Background

This chapter discusses the investment opportunities arising from the sharp global market volatility following the UK Brexit referendum, as well as the importance of the principle of maximizing shareholder value in corporate governance. The author argues that stock price deviations from intrinsic value caused by short-term market panic create significant returns for patient investors.

Core Views

• Market Volatility as Opportunity: The author emphasizes that stock price movements often far exceed changes in a company's intrinsic value. The panic selling triggered by Brexit provides a window for value investors to increase holdings in high-quality companies.
• Shareholder Primacy Principle: Citing Milton Friedman's "shareholder primacy" theory, the author criticizes Akzo's board for rejecting PPG's acquisition offer at a premium of over 50%, arguing that management should focus on maximizing shareholder value rather than yielding to external pressures.
• Contrarian Judgment: Despite widespread pessimistic expectations following Brexit, the UK economy has performed reasonably well (GDP growth of 2% year-on-year). The depreciation of the pound has actually benefited exports and tourism, and the anticipated recession has not materialized.

Key Arguments and Data

• Market Reaction After Brexit: Following the UK Brexit referendum, European stock indices fell nearly 15% within two days, with European financial stocks experiencing even larger declines. The pound plummeted, while the yen strengthened as a safe-haven currency; Japanese exporters' stock prices came under pressure due to yen appreciation.
• Fund Performance: The Oakmark International and International Small Cap funds posted one-year returns of 40.05% and 31.61% (including dividend reinvestment) respectively for the period ending June 30, 2017, significantly benefiting from the post-Brexit rebound.
• UK Economic Resilience: Despite ongoing political uncertainty (the Conservative Party losing its majority), the UK economy maintained a 2% year-on-year growth rate, with a strong labor market and the expected recession failing to materialize.
• Akzo Acquisition Case: PPG proposed to acquire Akzo at a premium of over 50%, but the offer was rejected by the board. The author believes that Dutch corporate governance rules (which do not allow shareholders to directly elect directors) shield management from accountability, resulting in value destruction.

Fund Performance Comparison (as of June 30, 2017):

Fund	Quarterly Return	1-Year Return	3-Year Return	5-Year Return	10-Year Return	Return Since Inception	Inception Date
Oakmark International (OAKIX)	6.16%	40.05%	3.72%	12.68%	4.89%	10.13%	1992/09/30
Oakmark International Small Cap (OAKEX)	9.06%	31.61%	4.14%	11.18%	3.37%	9.87%	1995/11/01

Companies/Assets Involved

• Akzo Nobel N.V.: A Dutch chemical company criticized by the author for rejecting PPG's acquisition offer at a premium of over 50%. The Oakmark International Fund held a 0.4% position in it (as of June 30, 2017).
• PPG Industries, Inc.: A US paint company that proposed to acquire Akzo but was rejected. The Oakmark Fund held no position in it.
• Japanese Companies (General): The author notes that Japanese companies use cross-shareholdings and other methods to hinder hostile takeovers, leading to value destruction, but no specific companies are named.

Investment Insights

• Leverage Panic Selling: Investors should focus on companies whose stock prices have fallen sharply due to geopolitical events (such as Brexit) but whose intrinsic value has not been materially impaired, actively increasing holdings to capture excess returns.
• Beware of Governance Risks: In markets with limited shareholder rights, such as the Netherlands and Japan, management may ignore shareholder interests (e.g., rejecting reasonable premium acquisition offers). Investors should avoid such companies or seek those with management committed to maximizing shareholder value.
• Focus on Currency-Sensitive Sectors: The depreciation of the pound benefits UK exporters and tourism, while yen appreciation pressures Japanese exporters. Investors can adjust regional allocations accordingly.

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Theme and Background

This chapter continues Oakmark Fund’s discussion on value investing opportunities, focusing on how market volatility—such as the sharp decline in the British pound triggered by Brexit, the appreciation of the Japanese yen, and the global stock market downturn—creates buying opportunities for patient investors. The author emphasizes that stock price movements often far exceed changes in a company’s intrinsic value, and Oakmark used this period to increase holdings in companies that were hardest hit but whose intrinsic value remained largely intact.

Core Thesis

The author’s core investment argument is that panic-driven sell-offs in the market (e.g., the post-Brexit plunge in the British pound and global stock market declines) represent a golden window for value investors, as short-term emotional fluctuations distort asset pricing, while long-term value reversion is certain. The counterintuitive judgment lies in the fact that when the market is broadly bearish (e.g., selling off UK assets due to the pound’s depreciation), Oakmark instead takes a contrarian stance by increasing positions, believing that the intrinsic value of these companies has not been materially impaired by exchange rate movements.

Key Arguments and Data

• Performance: The annualized returns (including dividend reinvestment) of the Oakmark International and Oakmark International Small Cap funds reached 40.0% and 31.6%, respectively, maintaining strong performance since the rebound following the Brexit referendum in the third quarter of 2016.
• Market Volatility Cases: The sharp decline in the British pound, the appreciation of the Japanese yen, and the global stock market downturn are the core events that triggered buying opportunities. The author argues that stock price movements far exceed changes in a company’s intrinsic value.
• Company Case: Criticizes Akzo Nobel’s board for rejecting PPG’s acquisition offer at a premium of over 50%, citing Milton Friedman’s shareholder primacy theory and arguing that management should focus on maximizing shareholder value.

Companies/Assets Involved

Company/Asset	Role	Key Data	Bullish/Bearish
Oakmark International Fund	Investment vehicle	Annualized return of 40.0%	Bullish (strong performance)
Oakmark International Small Cap Fund	Investment vehicle	Annualized return of 31.6%	Bullish (strong performance)
Akzo Nobel	Criticized entity	Rejected PPG’s acquisition at a premium of over 50%	Bearish (management decisions harm shareholder value)
PPG	Acquirer	Proposed acquisition at a premium of over 50%	Neutral (mentioned as a case)

Investment Implications

For investors, the implication is: Contrarian buying of undervalued assets during market panic, particularly companies sold off due to macro events (e.g., exchange rate fluctuations, political risks) but with unchanged fundamentals. Specific directions include: focusing on discount opportunities in UK assets following the pound’s depreciation after Brexit, and arbitrage opportunities in cases like Akzo where conflicts between management and shareholder interests arise.