David Herro of Oakmark International Fund

S&P Rank: 3 StarsBargain Hunting Abroad

Quick Take: Just as American tourists shop for clothing, leather goods and other products when they are cheaper overseas, David Herro looks for bargain-priced stocks around the world.

Herro, who has managed the Oakmark International Fund/I (OAKIX) since its inception in 1992, keeps an eye out for stocks priced well below what he thinks a company is actually worth. To make it into the portfolio, a company also has to increase its free cash flow over time.

The International fund, which buys large and mid-sized companies, was down 16% this year through September, while the average international stock fund lost 20.7%. Over the long-term, the fund has a more impressive record, however. Oakmark International returned 8.9% on average for the ten years ended last month, compared to its peers, which gained 4.2%.

Herro also pilots the Oakmark International Small Cap Fund/I (OAKEX), which invests is smaller companies than the International fund. However, that fund is currently closed to new investors.

The Full Interview:

David Herro concedes that stock exchanges in Europe and Japan have tended to move in the same direction as those in the United States over the last few years.

So why should American investors look beyond their own borders? Herro says the question should be: Why limit yourself to just one country?

"There's a huge market out there," the fund manager says. "Over half the world's equities are located outside the U.S. We think it's very important to expose yourself to these potentially very good investments."

Herro, who prizes inexpensive shares, adds that foreign stocks currently look better than domestic ones in terms of valuations and dividend yields.

In picking stocks, Herro focuses on those trading at a discount to a company's estimated intrinsic value. Next, he wants enterprises that generate loads of free cash and that use it in ways to benefit the business and shareholders, such as reducing debt. Herro also prefers companies that dominate their markets, or are the lowest-cost producer in their industry, since this can enable them to raise prices.

As an example of the kind of stock he likes, Herro cites Chargeurs SA, a French textile company that is a long-time holding in the Oakmark International fund. Although Chargeurs' top and bottom lines don't grow very much, the company continually increases its margins and cash flow, he says.

A new addition to the portfolio is Credit Suisse Group ADS (CSR), a global financial services company Herro began buying this month because it seemed attractively priced. The stock had been trading for about 60% of its book value, according to Herro. He also likes its banking business, which he describes as "basically a money machine."

Massachusetts regulators have charged that the company's Credit Suisse First Boston unit issued overly optimistic research reports to garner investment banking business. Herro, however, says the subsidiary's problems are already factored into the stock price of its parent, which he reasons is unlikely to be hurt by any settlements stemming from the allegations.

"Every investment out there has a few blemishes," Herro says. "If you want to buy good companies at low prices, those blemishes have to be visible."

The $1.4 billion fund typically owns 45-60 stocks, with the top ten accounting for up to 40% of its assets. The No. 1 stock in the portfolio is drug maker GlaxoSmithKline plc ADR (GSK). Herro was drawn to the stock because he thought it was "extremely undervalued." In addition, he says, the U.K.-based company "throws off a lot of cash and is using it wisely" to bolster product research, development and distribution, and to buy back stock.

A Swedish telecommunications company, Ericsson(LM)Tel`B`ADS (ERICY), ranks second in the fund. Like many of its rivals, Ericsson, which supplies hardware and software for conventional and mobile phones, has fallen victim to overcapacity in the industry.

"The good news is that a lot of their competitors are extremely weak and are almost unable to compete," but Ericsson has been "able to maintain their market leadership," Herro says.

Eventually, capital spending for telecommunications, including wireless systems, will increase, and when it does Ericsson will be poised to benefit, Herro maintains.

The world's second-largest media company, Vivendi Univl SA ADS (V), holds third place in the portfolio. Herro began buying the Paris-based company in July, when chief executive officer Jean-Marie Messier resigned under pressure. His successor, Jean-Rene Fourtou, should be "much more conducive to building shareholder value," Herro says. Although Vivendi's stock is trading for about 13 euros, Herro says, he believes it is worth 30 euros.

Lately, Herro has been finding value in advertising and media concerns like Vivendi, which he says made up about 18% of the fund's holdings at the end of September. Health care stocks accounted for about 12%, and financial services companies comprised 14%.

Herro's investments are based primarily on his assessment of individual companies, so the fund's country weights are a product of his stock picking, he says. The bulk of the International fund's holdings -- about 70% -- are in Europe, while 15% are based in Japan and elsewhere in Asia, he says. The fund has also has small stakes in Australian and Mexican companies, and a cash position of about 5%, he says.

As for the correlation among U.S. and foreign stock markets, Herro thinks it is "somewhat of a temporary phenomena" resulting from volatile price swings here and overseas.

"When there's a lot of euphoria, when there's a lot of fright, markets act the same way," Herro says. "I think when these markets start to recover, you'll see different recovery paths."

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