Monday, February 9, 2009 8 comments ++[ CLICK TO COMMENT ]++

First Eagle conference call... possibly Jean-Marie's last one

First Eagle Funds recently had a conference call discussing their semi-annual update and market commentary. You can access the MP3 audio here and the transcript here. This might be Jean-Marie Eveillard's last conference call. He will still be around but he is essentially retiring so we may not see much of him anymore. Matt McLennan and Abhay Deshpande will take over as co-managers of the portfolios. It's a tall order and it remains to be seen how they perform. So far, I have to say I'm impressed with Matt McLennan, who seems to really know his stuff (here is a CNBC interview from December and Bloomberg interview from January.) But knowing your stuff is not good enough to be successful in investing so we'll see how good his, and his partner's, stockpicking will be.

Here are some of my thoughts on some points discussed in the conference call:

On Japan

John Arnhold: Jean-Marie, world equity markets seem to have become quite correlated. You have increased your exposure to Japan. Why?

Jean-Marie Eveillard: Well, we're not saying anything particularly positive or negative, for that matter, à propos Japan. The Japanese economy is not in good shape, but neither is the American economy or the European economy, for that matter. The Japanese market has been disappointing over the past 20 years since the Tokyo stock market bubble collapsed at the end of 1989. I think out of the past 20 years, maybe three or four were good or half-decent years in the Tokyo stock market. The locals are discouraged; the foreigners are discouraged as well.

We like to sniff amid the rubble. And frankly, the fact that we have increased our positions in Japanese stocks has a lot to do with us coming up with unusual investment opportunities from the bottom up, identifying businesses which we think are worth a lot more than the current stock prices.

John Arnhold: Matt, would you like to add a couple of words?

Matt McLennan: I would concur with what Jean-Marie said. I think, after two decades of poor economic performance and largely deflationary conditions, many of the Japanese companies have engaged in what many outsiders viewed as very serially conservative behavior. They have been hoarding cash, much to the chagrin of investors, and not distributing it. But that has left us in a situation today, two decades later, where the cumulative effect of poor price behavior in the securities has meant valuations that are generationally low. We see the market as a whole trading at a discount to book value. And as Jean-Marie said, many of the individual companies that we would look at as world-class leaders are trading at less than $0.50 on the dollar of our sense of intrinsic value.

The second thing, as I mentioned in my earlier comments, is that as we accept that the future is uncertain, we not only look for a valuation margin of safety, we look for capital structures that are prudent and management behavior that is prudent. We see that in spades in Japan. If you look at the major investments that we hold in Japan, the thread of continuity that would link them, other than cheap prices, is that they all sit on large net cash positions.

So as deep as this economic trough is going to be, we feel confident that there is no financial viability issue for these businesses. They have the staying power to persist.

And finally, the management culture here has been much more about building franchises that will endure for the next generation as opposed to milking them in the last economic cycle. That gives us the conviction to invest in many names on a bottom-up basis.

The problem that I struggle with when it comes to Japan is the fact that ROE is very low. This is partly for the strengths that were cited in the quotes. Namely, Japanese companies have high cash on their balance sheets. My question is, even if these companies survive and earn a profit, how will shareholders extract that from these companies. Barring some serious shareholder activism, all that is going to happen is that the profits are going to accrue as cash, earning very close to 0% interest, or end up being possibly re-invested in questionable projects and possibly lost.

The amazing thing is that Japan has always been like this. I am reading--actually had to return it to the library and need to sign it out again :(--Jim Grant's Trouble with Prosperity and it seems Japan was an export-oriented, protectionist, state back in the 1920's as well (incidentally Japan had a depression around that time period, the early 1920's--not related to the Great Depression.)

Japan is one of the most contrarian, major, investment destinations. You know investing in stocks is contrarian when the general population likens it to gambling. Some Japanese resident who sent me an e-mail before indicated a similar thing. Supposedly the public isn't into stock investing and considers it almost as a "low form" of activity, equivalent to gambling.

Jean-Marie Eveillard has been bullish on Japan; so has Martin Whitman, GaveKal, and it even seems Marc Faber. Others such as Jim Grant have promoted bullish views in the past. Most of them have been hurt badly, if we go with market prices, and some have even underperformed the US markets (this is harder than it seems given how the Yen strengthened so much lately.) Do note that Warren Buffett has not invested in Japan even though many Japanese stocks hit all Graham-type requirements and are world leaders in their markets (one can argue that Buffett doesn't like foreign markets but the fact that he invested in PetroChina, which has high political risk, while not investing in any Japanese stocks says something.)

It's not clear to me if Japan will recover... or if it will go into a long-term decline. Just because something is down doesn't necessarily mean it will rally. I'm guessing but I would imagine that the Netherlands stock market, which used to be one of the top markets 300 years ago, probably underperformed Britain/America/etc (I need to double-check this--anyone have a chart going back that far?) But Jean-Marie Eveillard and this team are value investors who approach from a bottoms-up perspective whereas my thoughts are shaped by macro speculations.

On Junk Bonds

John Arnhold: Do high-yield bond opportunities fit into your future considerations? Can you please comment on the perceived risk levels, value and spread ratios you see?


Matt McLennan: I think there has been a fair amount of commentary in the press about bonds, investment-grade bonds or high-yield bonds, as an asset class being more attractive than equities. We don't necessarily agree with that observation. I think that when you are looking at fixed-income markets, you really have to pay attention to the details of the individual securities. When you compare fixedincome securities to equities as a whole, in some cases, it is an apples-to-oranges comparison.

When we are looking at the world of subordinated or high-yield debt--or even some of the senior debt that has become available in the bank debt market more recently - it is important to note that many of the issues that we would look at here originated in LBO transactions. Given the depth of the economic crisis that we are going through and the higher leverage levels that were attendant to some of these leveraged transactions in this cycle versus prior cycles, one has to factor in the possibility that there is not only a higher probability of default on some of the issues that we see today, but the severity of defaults and therefore the recovery rates that we may be likely to get could be lower than historical recovery rates.

We have seen the ability to attach, from a valuation standpoint, a lower cash flow multiple through the purchase of equities particularly in markets like Japan with net cash on the balance sheets. So in cases where we can own the equity at a lower multiple of cash flow than buying the debt and where we do not have any financial viability issues and we do not have to go through the courts in a workout process that could be complicated in a deep economic trough, then we are happy to buy equities in certain circumstances as opposed to bonds.

Anyone thinking of investing in junk bonds needs to keep the quoted point in mind. Namely, a lot of the junk bonds are from LBOs which have a higher probability of default and lower recovery than the historical norms. Although yields have declined in the last two months, this is one of the reasons high yield bonds were pricing in better yields than even during the Great Depression. Apart from the fact that the junk bond market wasn't developed during the Great Depression--junk bonds were popularized in the 80's; during the 30's, the junk bond equivalents were defaulted railroad bonds or second-tier bonds--the bond covenents have been weaker in the last decade.

Also, First Eagle managers don't mention this but many of the high yielding bonds are in industries that may be overbuilt. One has to make a macro call here and I would guess that retail and auto industry, for example, are overbuilt and many will not just default but dissapear all together.

For these reasons, I would avoid investing in junk bond passive mutual funds or ETFs. Unless the index screens out these questionable bonds, you will likely have a big chunk of the undesirable covenent-lite LBO bonds and almost-bankrupt auto/retail/media/etc companies. One needs to take the risk and pick a few specific bonds, or forget about junk bonds and stick with equities.

On Government Intervention
John Arnhold: You have mentioned many times that the government has taken unusual steps and that there may be unintended consequences of these actions. What do you think some of the unintended consequences may be?

Jean-Marie Eveillard: ...If anything, I suspect that the unusual fiscal and monetary steps that have already been taken, as I said before, will continue and, if anything, the government and the Fed will probably do too much as opposed to doing too little. And if indeed they do too much, then the unintended consequences could be that the policies would be seen as potentially inflationary, and accordingly, either long-term Treasury bond yields would increase or the Dollar would decline, or speaking generally, there would be, some suspicion towards all currencies. So that would be some of the unintended consequences.

At the same time, I think that by doing possibly too much, probably that makes it more likely that the economy will find a bottom at some point this year and start recovering a bit. But the question aside from what I just mentioned is there is also the matter of, will the recovery be sustainable to the extent that what the government is talking about is adding debt on debt.

I disagree with Jean-Marie Eveillard. I am skeptical that the economy will start recovering later this year (although it depends on what one means by "recover") and I am definitely not in the inflation camp. This is not to say that high inflation is impossible; high inflation can materialize but I view it as a low probability and I'm not making investment decisions as if that will happen.

Investment Suggestions
John Arnhold: The cash percentage in the portfolios has declined over the past few months. Can you provide a few examples of where you're putting cash to work?

Matt McLennan: ...We have used the lower prices to selectively invest in businesses that we perceive to have a royalty-like participation, if you will, in the future nominal income stream over the world economy. Businesses like Fanuc in Japan, which is the world leader in robotics, and machine tool controllers. Businesses like Wharf in Hong Kong, which have a dominant port position, a pre-eminent real estate and a land bank in China at a meaningful discount to its book value. And, business like Kuehne & Nagel in Switzerland, in Europe, which is a world leader in sea freight forwarding, with net cash on the balance sheet.

We mentioned that a decade ago we had been largely out of the tech sector in the United States, given the excessive valuations in that business and the poor corporate allocation of capital. We have actually made some small investments in the technology sector recently as prices have become very low in response to macroeconomic concerns. These businesses, like the Japanese industrials or the Kuehne & Nagel that I mentioned earlier, have very large net cash positions, dominant global market positions and will participate in the longer term growth of the nominal economy of the world and we feel the current valuations afford us a margin of safety as long-term investors.

Some of the mentions, like Fanuc, is something we have encountered before. I looked at Fanuc, as well as another similar company, Yaskawa Electric last year. First Eagle is a value investor whereas I am more macro-oriented and was cautious last year. One of the my concerns back then was my belief that there is overcapacity in manufacturing in China. If so, then demand for robotics, motors, etc, will decline. These shares have collapsed but it's not clear to me if it was due to my macro thesis coming true or if it was simply due to the credit crench and irrational selling. In any case, the prices are so low now--back to 2002 prices--that I would start looking at them again. If you do research them, keep in mind, like most industrials, these companies are cyclical so either buy them when P/E is really high, or use, say, a 5 year earnings average. When I looked at these Japanese companies, they seemed to have better balance sheet but seemed worse than American industrial companies like Black & Decker, Emerson, and so on. If you are macro-oriented, do keep in mind that a stronger Yen hurts these companies (but calling a currency correctly is really tough.)

I do not have much interest in real estate so I'll ignore Wharf, the Hong Kong conglomerate. Essentially, I consider commercial real estate, except in some specific cases, outside my circle of competence due to my lack of interest. I am also bearish on China so I would be careful with these Hong Kong companies. However, they are very cheap so if don't share my concern over China then do check them out. Martin Whitman also has a bunch of Hong Kong companies that operate in China. Whitman says that if they lose money, it will be political or legal reasons, and not due to investment reasons. To that, I say, it makes no difference how you lose and political risk is something that one should be careful about when they leave the confines of the developed world.

I never heard of Kuehne & Nagel before so I'll take a look. Sea freight forwarding doesn't look that appealing to me, given the potential for world trade to slow down for the next few years. Nevertheless, the fact that it is a Swiss company with net cash makes it attractive (I am more interested in a Swiss company with net cash than the countless Japanese companies with net cash.)

On Gold
John Arnhold: Thank you. What are your thoughts on gold and its current role in the portfolio?

Abhay Deshpande: Well, as Jean-Marie has mentioned before, we view gold as insurance against the unknown, and the future is unknown, so inherently it's a policy against unknown future events. The problem is that these days the policy premium has gone up quite dramatically with gold at near $900 an ounce. It is high versus historic benchmarks, whether gold stocks themselves, the equities of gold companies, or broader indices like the S&P 500. I guess we have to ask ourselves the question “Is this old history, or history in the making that we are going through right now?” And right now or at least very recently say in the last three or four months, gold in just about every other currency, apart from the U.S. dollar and Japanese yen, is at a new high in those local currency terms. It has performed its job for everyone in these countries. It has held its value. It has acted as a store of value. As J.P. Morgan said, “Gold is money.” And so we have to understand that there is a chance that this insurance policy premium may still be worth holding. But at the same time, we do recognize that the price is much higher than it has been.

Jean-Marie Eveillard is one of the rare value investors who owns gold bullion. A lot of it too. In fact, First Eagle has owned almost $1 billion worth of bullion for many years now. However, unlike goldbugs who bet on gold in anticipation of higher prices, Jean-Marie Eveillard uses it as insurance.

It will be interesting to see if the new managers of First Eagle share the same enthusiasm for gold. They seem to think that prices are high but who knows what they will do. If First Eagle sells their bullion, it will be a big sell signal for gold.

Unless you have a large portfolio, I do not recommend owning gold bullion. The only exception is if you are gold macro speculator or gold trader, in which case it's your lifeblood. For an average person, gold will be a drag, just like how, if you insure portfolio by continuously buying put options, it will cost you a few percent in the long run. In the super long-run, the return on gold is around 1% to 2%, similar to cash; stocks, bonds, and real estate have all beat gold in the long run. However, if you time it as a gold trader or macro investor would, you will do well. Gold is one of the best performing assets in the last 10 years, but I doubt it will be one of the best assets in 10 years from now.

Although I only started following Jean-Marie Eveillard in the last couple of years, I'm going to miss him. He is one of the few value investors that is global and easy to follow... if anyone knows of any other superinvestor that tends to invest globally, let me know...

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8 Response to First Eagle conference call... possibly Jean-Marie's last one

February 10, 2009 at 2:37 PM

graph of the Dutch stock market 1602-present here:

February 10, 2009 at 7:18 PM

Thanks for the chart ContrarianDutch... I think that's the oldest continuous chart I have ever seen.

It's more complicated than I thought though... Netherlands does seem to peak in the 1710's--my condolence to you on missing out on being an aristocrat in the 1700's when Netherlands was at the top of the world ;)--but the numbers aren't comparable to the 1900's given how countries went off the gold standard. It looks as if the ascent in the 1900's is far greater than in the 1700's but I wonder if that would be the case if we adjust for inflation.

Anyway, interesting nevertheless... thanks for hte chart...

February 10, 2009 at 9:50 PM

Two managers, though you know them both and have probably already considered them.

(1) Marty Whitman -- his flagship Third Avenue Value Fund as increasingly been willing to invest outside the US since the 1990s. Last I checked his two largest holdings were in Hong Kong.

(2) Peter Cundill -- his flagship Cundill Value Fund has a truly global focus. The only problem is that since selling his company to Mackenzie Financial, their marketing the Cundill name like mad and the funds are growing in number. I wonder if Peter Cundill is in the process of pulling back, but if he's involved at all it's keeping an eye on his baby (the Value Fund).

Just a couple of suggestions.

February 11, 2009 at 10:06 AM

Thanks for the suggestions John...

February 11, 2009 at 2:28 PM

You're welcome.

The spike in the Dutch stock market in the early 1700's was a last hurrah before the empire went into terminal decline. If I were to pick a period in Dutch history to get rich in it would be from 1590 onward.

I mean, just imagine buying VOC stock at NLG 3000,-/share on the IPO and then seeing it rise and rise while you cash huge dividends (NLG 500,-/share or more per year, sometimes as much as NLG 1200,-/share) every year... Of course, I would have to be very rich to afford even one full share to begin with...

For the less rich, there were of course the "Ducatons", the oldest derivatives I am aware of and essentially "fractional shares" that allowed ordinary people to buy into the stock market.

Also notice how stock market capitalization did not return to it's 1720 high until 1960.Talk about stagnation....

February 11, 2009 at 3:15 PM

On top of adjusting for inflation, it would be great if we had a total return index, which includes dividends. I wonder how the 1700's peak really compares to the present. It's really hard to say right now. Of course, we have more listed companies now and it's not a clean comparison so it's never perfect.

I notice a trend here that is similar to other mega-booms. Most of the money was made in a short period very early on (I guess this is what growth investors and macro investors try to capitalize on.) You probably made more money from 1602 to 1640 than in the next 300 years (you would have made comparable returns if you bought after a crash as in 1676 too.) This only refers to price returns and if you included dividends, holding for a 300 hundread years would yield more than the first 40 years did. But, just from a price point of view, it's interesting how nearly all the price gain occurred in the first 40 years.

The railroad boom in America in the 1800's was similar. The majority of the price gains were in the first few decades, well before the peak. (I'll try to post a chart from a book I'm reading soon.)

February 12, 2009 at 5:40 PM

The Netherlands was on a silver standard until 1872 and a gold standard from 1873 to 1936. So until 1936 there should be little inflation to distort the real return.

As for VOC dividends, these declined through the 1700's as profit margins declined, so the 1600's were definitily the good times for investors.

August 26, 2010 at 7:13 PM

related link about currency and precious metal :

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