David Herro: 'We Are Not at All Afraid to Vary From an Index'

Episode Summary

Executive Summary: Morningstar’s Christine Benz and Jeff Batak interview David Herro of Harris/Oakmark on international value investing. Herro argues the pandemic reinforced the value of flexibility, strong balance sheets, and disciplined valuation. He sees inflation rising, remains constructive on financials and selected cyclicals, and stresses that risk is about permanent capital loss—not volatility.

Main Topics: Pandemic lessons for global investing and team collaboration: Herro says remote work proved the team could adapt quickly, but emphasized the lost value of face-to-face meetings with management and stronger in-person team cohesion. Fiscal and monetary policy as a valuation backstop: He argues the swift global policy response in 2020 shortened the downturn, improving confidence in discounted cash flow assumptions and reducing the apparent severity of valuation hits. Balance sheets, debt, and capital allocation: Herro explains that he prefers strong balance sheets and careful capital allocation, though low rates can justify debt if it is used to create shareholder value; he cites AB InBev as a company deleveraging appropriately. Inflation outlook and portfolio positioning: He is concerned inflation will rise as money velocity normalizes and fiscal/monetary stimulus works through the economy, which is why the portfolio is overweight financials, industrials, and materials. Value investing lessons, volatility, and behavior: Herro says the hardest discipline is buying low and selling high based on intrinsic value, not reacting to short-term price swings or the media cycle. Financials as a long-term opportunity: He believes European financials have been misunderstood for years and now offer attractive valuations, better capital positions, and potential tailwinds from higher rates, growth, and capital returns. Management quality, ESG, and special situations: He discusses evaluating management changes at Credit Suisse and Daimler, argues ESG and shareholder value are complementary, and explains how to price opaque holdings like Naspers or Naver with holding-company discounts.

Key Arguments: The pandemic showed that modern technology can keep investment teams functional, but it cannot replace in-person due diligence with management teams or the cohesion of a live office environment. Aggressive fiscal and monetary intervention in 2020 reduced the severity and duration of the downturn, supporting higher confidence in intrinsic value estimates. Strong balance sheets matter more than textbook capital structure theory because debt can destroy flexibility in a downturn through covenants, bankers, and forced defensiveness. Inflation risk is rising because bank reserves are no longer expanding as much, velocity may rebound, and stimulus is hitting while economies reopen. Financials remain attractive because many European banks are better capitalized, still reasonably valued, and may benefit from higher rates, stronger growth, lower credit losses, and capital return. Risk should be defined as the probability of permanent capital loss, not day-to-day volatility; volatility matters more to short-term traders than to long-term investors with patience and liquidity. Market structure has shifted from pensions and long-only holders to hedge funds, leverage, and passive/index flows, increasing volatility and creating more mispricings for value investors. Good corporate citizenship and shareholder value are not in conflict; ESG is valuable when it improves governance, diversity, and stewardship without becoming an excuse for poor capital allocation. Opaque or complicated businesses can still be attractive if the investor applies a holding-company discount and sees management actions that can unlock value. Investor behavior often destroys returns because people chase recent performance and sell after declines, regardless of whether the underlying value has changed.

Data Points: Harris Associates employees on premise during reopening: close to a third of its 200-ish employees - Herro described the partial office reopening in June 2020 as a first step toward rebuilding team cohesion. Investment horizon for many holdings: more than five or ten years - He used long holding periods to explain why direct access to management is especially important. AB InBev leverage: recently had a bit too much leverage - Herro said the company is paying down debt through asset sales and free cash flow. Financial sector weight in international fund: around 29% over the past decade on average - Benz noted financials’ long-running importance in the portfolio and value indexes. European financials 1-year rally: more than 40% - Benz referenced the recent sharp rebound before asking whether sentiment had structurally changed. Financials yield: four, five, six, seven percent - Herro said low-rate environments made bank dividends attractive relative to other income options. Position size cap: 7% - Herro said the portfolio typically does not let a single stock exceed this level. Top 10 holdings weight: more than 30% - He said the portfolio is concentrated but still diversified. Daimler/BMW drawdown at 2020 lows: lost 70, 80% of value - Herro cited them as examples of strong businesses punished despite net cash balance sheets. Tier one reserves before financial crisis: five or six percent - He contrasted pre-crisis reserve levels with today’s higher bank reserve positions. Tier one reserves today: 12%, 13%, 14%, 15% - He used this to argue that banking-system reserves and money velocity dynamics may change inflation behavior. Inflation comfort threshold mentioned: one or two percent - Herro said a small rise would be tolerable, but two to four percent would be painful. Naspers concentration: almost 80% of its value tied to Tencent - He used Naspers as an example of holding-company opacity requiring a discount.

Pivotal Quotes: "risk really isn't volatility" — David Herro: Herro distinguishes long-term investing risk from short-term market fluctuations. "the last thing you want to worry about in a downturn is dealing with bankers and covenants" — David Herro: He explains why he prefers balance-sheet flexibility over aggressive leverage. "I don't think that trade-off exists at all. I think the two go hand in hand." — David Herro: He argues that ESG and shareholder value creation are compatible rather than conflicting goals.

Implications: Listeners get a clear framework for long-term value investing: prioritize intrinsic value, strong balance sheets, and management quality. The episode also suggests financials and cyclical/value sectors may benefit if inflation and rates rise.