Why I'm betting big on EuropeJune 14, 2012: 5:00 AM ET
The vaunted international stock picker David Herro is betting big on banks in France, Spain, and Italy. But he doesn't call himself a risk-taker.
By Mina Kimes, writer
FORTUNE -- David Herro seems awfully relaxed for a man who has more than $1 billion invested in European banks. It's a sunny morning in late May, and I'm sitting across from the boyish 51-year-old fund manager in his downtown Chicago office. He's giving me his full attention, but I can't stop glancing at the headlines blinking on the Bloomberg terminal behind him. The euro is about to hit a two-year low. Greece is on the brink of disaster. Spain's real estate market is in shambles, and Italian sovereign debt is as fragile as stained glass. The global economy is roiling, and Herro is positively beatific.
"Eventually they're going to get these problems solved," he says. "If you look at the economic history of the world, problems come and problems go. There are problems, and they do have to be dealt with. And our view is that all these problems are manageable."
Herro's cheery tone, coupled with his Wisconsin accent, makes him sound more like a folksy radio host than a financier. But his easygoing demeanor belies the intensity of his conviction -- and the amount of money he's putting behind it. Over the past two years Herro has amassed huge stakes in banks like France's BNP Paribas, the Bank of Ireland (IRE), and Spain's Banco Santander (SAN). He is the biggest U.S. shareholder of Italy's Intesa Sanpaolo. Collectively, it's a big, bold bet -- and a terrifying one when you consider that most investors are avoiding these stocks as if they were the return of the bubonic plague.
But Herro, the man whom Morningstar crowned international stock fund manager of the decade in 2010, doesn't see himself as a risk-taker. To hear him tell it, he's simply doing what he's always done -- hunting for good companies that are trading at a steep discount. Today those companies just happen to be European banks. Herro is a bottom-up value investor, which means he focuses on individual companies' prospects and prices rather than on broader economic trends.
"Trying to predict the macroeconomy is extremely similar to trying to predict the weather," he says. "You can't let the last storm impact the way you see the future. This is exactly what the investment community does, and it shouldn't do -- it gets obsessed with macroeconomics, and it ignores microeconomics."
Herro isn't the only investor to embrace that idea: Scores of money managers claim to worship at the altar of Peter Lynch and Warren Buffett, the best-known bottom-up investors. But it isn't always easy to take a chance on -- or stick with -- a company whose stock is plummeting. In that respect, few investors are as doggedly steadfast as Herro. "When an investment doesn't look like it's working in the short term, he's willing to hold on and ride through negative volatility," says Jeremy DeGroot, chief investment officer of Litman Gregory, an asset-management firm that hired Herro to advise one of its funds. "He has the conviction to place his money where he thinks the returns are."
The strategy has prevailed over the long term -- Herro's $7.7 billion fund, Oakmark International (OAKIX), has returned 9.2% a year since 1992, while the MSCI EAFE index, which tracks developed markets outside North America, has returned just 4.9%. But it has been painful at times. "If you're a shareholder in his fund, you have to be comfortable with having periods of significant underperformance over short- or medium-term periods," says DeGroot.
This is one of those periods. Oakmark International is down 10% over the past three months. The threat of Greek contagion is driving up bond yields in Spain and Italy. European banks are trading at a fraction of their book value. Investor confidence is plunging over fears that the eurozone faces an imminent demise.
Herro doesn't stick his head in the sand when macroeconomic currents like these roll in; he tries to figure out whether companies have the wherewithal to withstand bubbles, busts, and other market-shaking events. He doesn't think Europe is going to come apart. "I think that's two, or one, or a half percent chance," he says.
If Greece leaves the eurozone, he continues, the rest of the continent will act fast to protect Spain and Italy. "Most of the countries aren't as bad off, and they realize the harm that would come to them by having forced adjustment vs. voluntary adjustment," he says. "Germany is going to have to give a little more to save this thing." While the German population may despise the idea of bolstering their southern neighbors, it's in their self-interest, he says. If Germany loses the euro, its currency will skyrocket, squeezing the export-heavy economy.
In the meantime, the market is still treacherous -- and Herro, with his outsize bank holdings, seems a little like a lone sailor rowing his dinghy into a whirling storm. For every David Tepper, the Appaloosa hedge fund manager who made a killing off Bank of America (BAC) during the financial meltdown, there is someone like Bill Miller, the vaunted mutual fund manager who lost big on Bear Stearns and Freddie Mac -- proof that some value stocks never bounce back.
The next couple of years will pose a crucial test for Herro. But he refuses to play up the drama of the situation. "We're invested in European financials because -- buy low, sell high," he says simply. "And now they're low."
Around midmorning we leave Herro's office and head outside. The fund manager, a competitive cyclist, leads with his shoulders -- he doesn't really walk, he marches. Our destination is Millennium Park, which is next to Lake Michigan. Wending between tourists, we pass the Jay Pritzker Pavilion, a massive outdoor band shell. Every summer the Pavilion hosts the final night of the Chicago Dancing Festival, an event that draws dance companies from around the country. Herro helped launch the festival in 2007. His partner of 13 years, Jay Franke, is its artistic director.
Herro's advocacy of dance has bolstered his friendship with Chicago's mayor, Rahm Emanuel, himself a classically trained dancer. The relationship was unexpected: Herro, a staunch conservative, has funneled hundreds of thousands of dollars in recent years to Republican causes and candidates. He has a paper cutout of Ronald Reagan hanging in his office, as well as a framed picture of himself, Franke, and GOP presidential candidate Mitt Romney. "There was a Reagan phrase -- government that governs the least governs the best," he tells me after we find a place to sit in the park. "For the most part, libertarian policies make sense."
The fourth of six children, Herro grew up in tiny Fond du Lac, Wis. His father, who is Lebanese American, worked for a mechanical contractor, and his mother was a nurse. Herro had a typical small-town upbringing. He owned a shotgun and hunted ducks. He played offensive guard for his Catholic high school's football team. He was a terrible student -- he got C's and D's, he says -- but he was always interested in investing, in part because he caddied for a local stockbroker as a teenager.
After getting his bachelor's degree at the University of Wisconsin at Platteville, Herro worked for Hormel (HRL), hawking bacon and hot dogs. A year later he decided to go back to school to become an economics professor. His focus was, ironically, macroeconomic theory. He didn't become interested in microeconomics until he was enlisted to teach a course on the subject. "I was up there teaching the Theory of the Firm, and it made so much sense," he says. "I had an epiphany."
A year and a half into his Ph.D. program, Herro quit and took a job managing international stocks in Des Moines for what is now the Principal Financial Group. He was 25 years old and had never been overseas (he took his first trip abroad the next year, to Europe). He also had no financial experience. So he turned to his academic studies to develop an investing model. "With my training as an economist, I thought, We could use microeconomic theory here," he says. Herro's bottom-up, value-oriented strategy proved effective, and in 1989 the State of Wisconsin Investment Board recruited him. A few years later he was poached by Chicago's Harris Associates, which oversees the Oakmark funds.
Oakmark International roared straight out of the gate, returning 54% in its first year. Then came the Asian financial crisis. As markets across Asia collapsed in 1998, Herro and his team went on a shopping spree for stocks in South Korea, Singapore, and Malaysia. "It seemed like we were the only ones buying," he says. "Every other month we were going over there, looking for companies." Shareholders bailed, and Herro poured his own money into the fund, which fell 7% that year. Then, over the next two years, Asian markets bounced back -- and Oakmark International rose 52%, crushing the index's 13% return.
Herro invests more like a business owner than a speculator, drilling into cash flow statements so that he can figure out how companies really work. Rob Taylor, the co-manager of Oakmark International, recalls that years ago he was struggling to analyze a textile manufacturer in New Zealand. Herro dropped by his office and walked him through the business model. "He really tried to dumb it down to where you could actually mentally see, all right, this is the spool of thread, and this is how it goes from here to here," Taylor says.
Over the past 20 years Herro has never strayed from his core tenets. But he has fine-tuned his approach. He now thinks the price/earnings ratio, perhaps the most widely used metric in investing, is a "useless measure"; he cares about free cash, not earnings. He obsessively monitors the businesses in his portfolio and can recite minuscule details about them with ease.
Although Herro travels frequently to cities like London and Tokyo, his favorite place in the world, he tells me, is the lake house in Wisconsin he shares with Franke. He devotes a lot of time (and money) to local museums and nonprofits, and is a major benefactor of several charter schools. He loves animals -- he owns Persian cats named Scratchy, Junior, Bruiser, and Gigi -- and Packers football.
When I tell him that Green Bay wide receiver Donald Driver just won Dancing With the Stars, he bursts into a grin. "I gotta text him!" he says. Herro, who met Driver a few years ago, pulls out his phone. "You ... are ... a ... stud," he says as he pecks.
The sun's glare is growing slightly unbearable, so we get up to leave -- and Herro stops abruptly, distracted by a photographer taking pictures of a group of children. He runs over and asks him who made his tripod. "Is it a Vitec?" he asks, referring to a small British manufacturer. The photographer, a twentysomething hipster wearing a beaded bracelet, seems taken aback. After giving me a dubious glance -- I shrug -- he says yes.
Herro fires off questions. Does he like the tripod? Why? There's a piece of masking tape on one of the legs -- is it broken? After the photographer answers the questions (he likes Vitecs because they come in several sizes, and the tape is there in case he needs it later), Herro thanks him and walks away. "We own Vitec Group -- that's one of our holdings," he tells me, his cheeks flushed with satisfaction. "And he was using a Canon camera -- we own that too!"
In the mid-1990s Herro became briefly famous in England. He had invested in the struggling London advertising firm Saatchi & Saatchi. When the board awarded its chairman, Maurice Saatchi, a lavish pay package, Herro was appalled -- so he led a shareholders' revolt that resulted in Saatchi's ouster. The British tabloids hounded him for weeks. Herro doesn't think of himself as a Carl Icahn-type activist shareholder, but he is preoccupied with corporate governance. (The idea that a company's CEO can also be its chairman is "an obscene concept," he says.) He places a large emphasis on finding well-managed companies.
To evaluate executive teams, Herro spends a great deal of time abroad. Taylor, his colleague, says the fund manager is a master at getting executives to open up. Herro starts off by cracking jokes and asking disarming questions about executives' personal lives. Then, once his counterparts are comfortable, he swoops in. "He'll keep asking questions and then, in a very nice way, kind of say" -- Taylor lowers his voice to a menacing whisper -- " 'Well, it just doesn't seem like you really understand the value of the business here.' "
When rumors spread last fall that Japanese technology company Olympus was guilty of accounting fraud, Herro, who owned a large stake in the company, blew up at the vice president over the phone. (The executive was recently arrested.) But despite being burned by Olympus, Herro insists that Japanese corporate governance is getting better. Three of his biggest holdings are broker Daiwa Securities, Toyota (TM), and Canon (CAJ). He is less enthusiastic about emerging-markets stocks, which he sees as overpriced.
The day after our first meeting, Herro and I are back in his office, once again talking about Europe. The sovereign debt crisis has taken a toll on his fund, which has 57% of its assets invested in non-U.K. European countries (the average foreign large-cap blend fund has 39%, according to Morningstar). Last year Oakmark International returned -14%, slightly worse than the EAFE index. Even so, the fund has taken in $430 million this year, according to Morningstar. Back in March, Herro told a television interviewer that his bank holdings could rise as much as 75% over the next few years. I ask him whether he still sees that much upside. "Oh, it's more now!" he laughs.
"The key is to focus on those financial institutions that have diverse streams of income, good capital positions, and well-costed operations," he continues. "For instance, we look at a Société Générale and we look at a BNP. We think BNP is in a much better position financially -- but they're probably down about the same." BNP, he adds, is trading at 50% of its book value despite having a large deposit base that will insulate it from funding shocks.
Another one of his biggest holdings is Banco Santander, the giant Spanish bank. Spain, like Ireland, is reeling from a collapse in real estate. Herro admits that Santander's domestic loan portfolio is tenuous but points out that the bank currently derives about 80% of its profits from overseas. Its biggest risk, he says, is that the government will force it to absorb a smaller competitor.
We move on to Intesa Sanpaolo, whose stock is down 42% over the past year. When I ask Herro why he has invested in Italy, one of the most precariously situated countries in Europe, he grabs a scrap of paper off his desk and draws a squiggly outline that looks like a boot. "This third of Italy" -- he points to the top of the drawing -- "is like Switzerland. It's rich." While Italy's public debt load is formidable, he says, its private sector has massive savings that can still be deployed. Intesa's healthy loan book and a strong deposit base will help it survive. "It's being punished because it's an Italian bank," he says. "Unless you believe that Italy is going to default, this is a steal."
There's the rub. As a microeconomist, Herro can tout these banks' fundamentals all he wants, but their continued viability depends on a big macroeconomic contingency -- the continued existence of the eurozone. BNP, Santander, and Intesa all own sizable swaths of sovereign debt. If Spain or Italy defaults, it won't matter that these banks have high capital ratios. There will be a widespread financial crisis in Europe, and they will suffer.
As Herro scribbles more charts, I steal another look at the terminal. Most of the stock prices on the screen are red -- another bad day in the market. I ask him why he continues to believe that bottom-up stock analysis will work in a world that seems to be controlled by macroeconomic forces.
"This market is the most conducive for bottom-up investing!" he tells me. "Everyone is so concerned about the macro overlay that you have panic buying and selling of certain sectors and regions, which means there is so much inefficient pricing that we as bottom-up investors can exploit." Herro puts down his pen and smiles. "This is our time."
This story is from the July 12, 2012 issue of Fortune.
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