David Herro Market Commentary | Third Quarter 2022 and Fiscal Year-End

Theme and Background

This chapter analyzes the macroeconomic reasons behind the global stock market decline in the third quarter of 2022, focusing on Oakmark's assessment of the root causes of current inflation and why the report argues that European stocks are significantly undervalued in the current environment, presenting notable investment opportunities.

Core Thesis

The author's core investment argument is that current European stocks, particularly globally operating European companies, are mispriced due to excessive market focus on negative macro factors (war, inflation, euro depreciation), with valuations having fallen to historically extreme lows, offering a rare long-term buying opportunity. The report explicitly states that when the portfolio's price-to-intrinsic-value ratio falls below 55%, historical data indicates significant excess returns over the subsequent three years.

Counterintuitive Judgments:

• Inflation is not triggered by the current rate hike cycle but stems from the prolonged excessively loose monetary policy by central banks after the 2008 financial crisis, coupled with a failure to tighten promptly after bank reserves became sufficient.
• A strong dollar is not entirely negative for European companies; instead, it creates upward profit pressure for many globally operating European firms (e.g., BMW, Mercedes-Benz).
• Although the current rise in interest rates is sharp, it remains within a normal range when viewed over the 40-year historical perspective (declining from a peak of 13.8% in 1984).

Key Arguments and Data

1. Root Cause of Inflation: After the 2008 financial crisis, central banks implemented massive easing through bond purchases and rate cuts, while regulations forced banks to nearly triple their reserves (within 10 years). These reserves sat idle at central banks earning zero or negative yields, preventing monetary expansion from triggering inflation. Now that bank reserves are sufficient, profits can be used for business expansion or shareholder returns (e.g., holdings in European banks), but central banks failed to exit easing in time. Combined with supply chain disruptions, expansionary fiscal policies, and surging energy prices, this ultimately ignited inflation.

2. Historical Perspective on Interest Rates: The yield on the U.S. 10-year Treasury note has declined from a peak of 13.8% in 1984, falling to as low as 0.5% during the pandemic, and currently sits around 4%. The recent magnitude of rate hikes is abnormal relative to the past decade but not extreme relative to the past 40 years.

3. EUR/USD Exchange Rate: Over the past 14 years, the euro has fallen from 1.50 to 0.96, negatively impacting the dollar-denominated prices of European stocks.

4. Valuation and Financial Data:

• BMW and Mercedes-Benz: P/E ratios of only 4-5x, dividend yields exceeding 7%, substantial net cash positions, and the majority of revenue and profits generated outside Europe (China and the U.S.), benefiting from a strong dollar.
• Other European global operators (luxury goods, industrials, consumer goods) are mispriced by the market due to their headquarters location (Europe), with valuations at extremely depressed levels.

5. Historical Price/Value Ratio and Subsequent Returns:

Oakmark International Fund

Price/Value Ratio Range	3-Year Average Subsequent Total Return	3-Year Average Subsequent Excess Return	Number of Occurrences
Below 0.55	13.6%	6.0%	14
0.55 – 0.63	6.0%	1.7%	18
0.64 – 0.71	5.1%	0.4%	17
Above 0.71	-2.0%	-2.4%	13

Oakmark International Small Cap Fund

Price/Value Ratio Range	3-Year Average Subsequent Total Return	3-Year Average Subsequent Excess Return	Number of Occurrences
Below 0.55	11.2%	1.4%	19
0.55 – 0.63	5.0%	-1.0%	10
0.64 – 0.71	4.1%	-0.9%	15
Above 0.71	0.9%	-1.5%	18

As of September 30, 2022, the price/value ratios for both portfolios stood at 0.46, at historically extreme lows (similar to levels below 40% in March 2009 and March 2020). Historically, when this ratio falls below 55%, the average total return over the subsequent three years is 13.6% (International Fund) and 11.2% (International Small Cap Fund), with excess returns of 6.0% and 1.4%, respectively.

Companies/Assets Involved

• BMW: Represents 2.6% of the Oakmark International Fund. Bullish. Globally operated, with most revenue and profits from China and the U.S., benefiting from a strong dollar. Cheap valuation (P/E 4-5x), dividend yield over 7%, healthy net cash position.
• Mercedes-Benz Group: Represents 2.9% of the Oakmark International Fund. Bullish. Similar to BMW, globally operated, benefiting from a strong dollar, cheap valuation, and solid financials.
• European Banks (not specifically named): Bullish. The report notes that current bank reserves are sufficient, and profits can be used for business expansion or shareholder returns, which is the current situation.
• Other European Global Operators (luxury goods, industrials, consumer goods): Bullish. Mispriced by the market due to their European headquarters, with valuations at extremely depressed levels.

Investment Implications

• Actively go long on European stocks, especially those European companies with global operations where revenue and profits are primarily generated outside Europe (particularly China and the U.S.). The current market has mispriced the intrinsic value of these companies due to macro pessimism and euro depreciation.
• Capitalize on the current extreme undervaluation (price/value ratio of 0.46) to position, as historical data shows that when this ratio falls below 0.55, average total returns and excess returns over the next three years are significantly positive.
• Focus on companies with high dividend yields (>7%) and healthy net cash positions, such as BMW and Mercedes-Benz. These companies offer a higher margin of safety and cash flow returns amid macro uncertainty.
• Ignore short-term macro noise and concentrate on company-level cash flow generation and valuation levels. This mispricing by the current market presents an opportunity that can be exploited by long-term investors.