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Online Extra: "Risk to Us Is Not Volatility"


When it comes to investing overseas, Oakmark Fund's David Herro has been a hero. Herro's $3.7 billion Oakmark International fund (OAKIX) managed to stay afloat during the dicey period of 2000 to 2002. In 2000, for example, the fund gained 12.5%, 27 percentage points ahead of its benchmark, the Morgan Stanley EAFE index. And over the past five years, Oakmark notched an annualized return of nearly 14%. As a result, its strong performance in down markets and well as up markets helped it earn an A-rating in BusinessWeek's 19th Annual Scoreboard.

The globe-trotting Herro, who also manages the A-rated $600 million Oakmark Small Cap International Fund (OAKEX), is a kick-the-tires kind of investor who goes wherever he can find the best bargains. That value-minded bent recently has led him to fallen growth stocks such as Japan's Takeda Chemical Industries, Britain's GlaxoSmithKline (GSK) and France's Aventis (AVE). BusinessWeek Personal Finance Editor Lauren Young recently spoke to Herro by phone while he was traveling in Australia. Edited excerpts of their conversation follow:

Q: How do you manage risk in the funds?

A: We manage risk by making sure that we invest in quality businesses that sell at low prices. Risk to us is not volatility. Rather, it's represented by such factors as debt load, lack of sales diversification, too high of a fixed-cost structure, low returns, poor capital allocation, and other company-specific factors.

Basically, true risk to us is the probability that our investment does not generate a sufficient return. The way to mitigate it is by disciplined stock selection that includes some of the factors listed above.

Q: How do you navigate tricky international markets, which can be especially tough given all the volatility?

A: The best way to navigate is to know your course ahead of time. This means knowing the specifics and the risk factors of the markets you're investing in, and most important, being a disciplined stock picker: making sure that investments are bought on the cheap and avoiding fads or trends.

The fundamentals of international investment are basically the same as investing in the U.S.owever, you also need to know the environment, and never invest if there's a lack of proper investment or regulatory infrastructure.

Q: What's the argument for investors to put money overseas?

A: The best reason to invest overseas is to have greater access to undervalued companies.Why limit yourself to just one stock market?When you buy anything from a car to a washing machine, rarely is just one retailer visited.The same theory should be true for your investments.

Q: In the most recent letter to shareholders, you talk about pharmaceutical companies and why some of the fears are overblown.

Could you elaborate a bit, and tell me why you like Takeda, GlaxoSmithKline, and Aventis?

A: Pharmaceutical stocks are now trading at close to 10-year valuation lows.These companies used to trade at over 20 times cash flow and over 30 times earnings. Today, they trade at around 10 times cash flow and 15 times earnings. Many of these companies even have good dividend yields. GlaxoSmithKline yields 3.5% as an example.

We think the fears of shallow drug pipelines, regulation, generics, etc., are more than represented in current share prices of many of these companies. On the positive side, pipelines are improving, the population keeps growing older (and less healthy), and share prices are very, very low. Specifically, all three of the stocks listed above fit our value criteria: They sell at low price and have a good quality cash-flow stream.

Q: What else is important for international stock pickers?

A: Diversification. Many ignored this in the late '90s and lost big. The importance of this must be stressed.Also, another lesson that needs to be heeded is "stay away from manias."In the late '90s, it was tech-media-telecom; today it seems to be China stocks.Caution!


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