Tag: transcript-1125


December 12, 2014

A next generation “Great Investor,” First Eagle Global Fund’s Matthew McLennan. First Eagle is known for its value-oriented, margin of safety approach and making preservation of capital its first investment goal. McLennan assumed the role of Portfolio Manager of the First Eagle Global Fund in late 2008 from investment legend, Jean-Marie Eveillard. The now $50 billion plus fund is rated four- star by Morningstar. Over the last five years, with McLennan on board, it is ranked in the top ten percent of its world allocation category. McLennan explains why he is currently finding markets around the world expensive, and why “patience” is his best investment idea.

This week on WEALTHTRACK, why First Eagle Global fund’s Matthew McLennan is counseling patience as his favorite investment theme in this expensive and rapidly changing world. Next generation Great Investor Matthew Mclennan is next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. A viewer recently wrote us and asked how many of our last four WEALTHTRACK guests were bullish, the inference being they all were.

Until now we really haven’t been counting, but we looked back and found that the last outright bull on WEALTHTRACK was back in October when Francois Trahan, Chief Investment Strategist at Cornerstone Macro was on. He and his firm are bullish on the U.S. economy and U.S. stock markets because of many factors, including the steady nature of our economic recovery, the revolution in oil and gas production and our manufacturing renaissance.
For the record this week’s guest is not in the bullish camp.

Matthew McLennan is head of First Eagle Investment Management’s Global Value Team, and Co-Portfolio Manager of its flagship First Eagle Global fund, a position he assumed in late 2008 from investment legend, Jean-Marie Eveillard.
The now $50 billion plus fund is rated 4-star by Morningstar and over the last five years, with McLennan on board is ranked in the top ten percent of its world allocation category.
First Eagle is known for its value-oriented, margin of safety approach and making preservation of capital its first investment goal. As McLennan’s team put it in a recent letter to clients, “we always keep a watchful eye on what can go wrong, not what is going right.”

What can go wrong?

McLennan is monitoring a long list of potential problems including the unprecedented easing policies by central banks around the world, which are keeping interest rates at historic lows, known as financial repression…
The simultaneous record breaking rise in government debt in the U.S. and much of the developed world. The convergence of rising incomes and demand from emerging markets with slowing income gains and increasing income disparity in developed ones. And then there are the geopolitical flare-ups: tensions in Ukraine, the rise of ISIS, China’s economic and military aggression.

What’s at the top of McLennan’s “what could go wrong list” and how is it affecting his investment outlook and strategy? We asked him.

MATTHEW MCLENNAN: well, you know, at First Eagle, we’re always worried about what can go wrong. We see our primary goal being to preserve capital in real terms, and when we look out at the world today, we worry about the scope for both repression and aggression. And when I talk about repression, I’m talking about financial repression. And the root cause of that is too much debt. You know, if we look at the household sector, the corporate sector, and the government sector, and we add that together, we actually have higher debt levels relative to GDP today than we did before the crisis in 2007, so we haven’t deleveraged. The reason interest rates are low is that policymakers need to keep them low to help solve the excess debt.

CONSUELO MACK: To pay for that debt, right? Without basically having governments go under.

MATTHEW MCLENNAN: Without question. And one of the root causes of that excessive debt has been the process of convergence that’s going on in the world economies.

CONSUELO MACK: And explain that convergence concept, because a lot of us don’t really understand it.

MATTHEW MCLENNAN: Well, at the end of the day, there are billions of people on the planet — the traditional definition of the BRICs is over 3 billion people — who want our standard of living. But it’s complicated to get there. And let me give you a bit of a metaphor through the prism of the oil market, for example. The typical U.S. consumer goes through about 22 to 23 barrels of oil per year. If you look at the BRICs region, they’re actually consuming more oil than the U.S. today already, but on a per capita basis, it’s only two to three barrels per year, so about a 10th of U.S. consumption levels. They want what we have, but oil production just can’t grow that quickly for them to have what we have. And so there is inevitably going to be — and it’s hard to believe today, in a world of weak oil prices, tensions as — there’s a process of convergence and competition for resources in the world.

What’s also happened, as these economies in the world are trying to catch up to our standards of living and productivity, is they’ve tried to accelerate it through having cheap currencies. So they’ve into up acquiring vast amounts of reserves, which they’ve held in treasuries and other financial assets of developed economies. And these excesses of reserves and savings have produced huge amounts of investment that perhaps otherwise would not have happened. So you have this phenomenon of mal-investment in places like China, and you had the symmetry of that surplus savings being a savings deficit in the United States and the developed world, and that’s led to surplus debt in the developed world.

So this process of globalization that we all sort of thought is this sort of benevolent influence has its complications as well.

CONSUELO MACK: But we’re not seeing that really reflected in the stock market, certainly. So where are you seeing it where it’s really become a problem for us as investors.

MATTHEW MCLENNAN: Well, it’s interesting. You don’t see the kinds of concerns were talking about on the stock market right now, because the excess debt exists in the sovereign sector. Policymakers are resorting to “financial repression”, i.e., low real interest rates, or negative real interest rates, to help solve the problem.

CONSUELO MACK: On government debt, right.

MATTHEW MCLENNAN: So people feel that equity valuations are well supported relative to low interest rates, but perhaps they’re not asking the right question. Why is it that we have low interest rates in the first place? If it’s because there’s an excess of debt, and if equities are really just a residual claim on the economy, should the equities be cheap, or should they be expensive? I think they probably should be on the cheaper side. And yet equities are expensive relative to history, because people have gotten this spurious comparison between earnings yields and low real bond yields.

So where is it showing up? It’s really starting to show up in the fragmentation of political behavior. The behavior of the key actors in other regions around the world is not necessarily aligned to the American interests.

CONSUELO MACK: And for instance, I mean Putin is a prime example of he’s not behaving the way we wish him to behave. I mean, is that what you’re talking about, and so there are these problem spots and crises that are developing that could really wreak havoc on economies, politics, our geopolitical security?

MATTHEW MCLENNAN: That’s exactly what I’m referring to, because you’ve seen big shifts in the relativities between the capabilities of countries. And so Russia’s had a downshift in gear over the last 15 years or so, relative to the rest of the world, and they’re struggling with that reality. And in some ways, we provoked them, in the Ukraine, by fostering a closer relationship between the Ukraine and Europe. And Crimea has always been strategic for them. I think the lower oil price, as well, it could provoke behavior of a cornered individual. And so we have to be careful what we wish for sometimes.

On the other hand, if you look at China, China as it’s grown over the last 15 years, it’s investment in U.S. dollar terms went from being half that of the U.S. to roughly double that of the U.S., in investment spending annually. As that’s happened, you’ve also seen growth in money supply, you’ve seen growth in military expenditure. So China’s military expenditure has gone from being roughly half that of Japan to roughly twice that of Japan over the same period. And so the Japanese are obviously starting to feel insecure of the margin. We’re already seeing territorial disputes between China and Japan. These changes in relativities, when they play out, have historically not always played out smoothly.

And so we’re not calling for war at First Eagle, but because our focus is on preserving capital, we’re acknowledging the vulnerability that’s there, both in the financial architecture, given the high levels of debt that we see in the world, and geopolitically, given the changing relativities between regions. We don’t think it’s time for complacency.

CONSUELO MACK: How defensive are you at First Eagle, at the Global fund, for instance? What, 20 percent plus cash? About 10 percent in gold and gold mining stocks, which is not unusual for you.

MATTHEW MCLENNAN: Well, you know it’s interesting…

CONSUELO MACK: How do you apply this to…

MATTHEW MCLENNAN: When people speak to us, they always say, well, it sounds like a dire and a bleak outlook. Why is it that you have nearly 70 percent in equities? The reality is that if governments the problem around the world, be it government debt or government geopolitical pressures, businesses are usually the solution. The source of productivity. And so we do like to be an owner of businesses, long-term, but we’re very disciplined about buying businesses when we can see a margin of safety in price. As markets have gone up pretty dramatically over the last couple of years, it’s become increasingly difficult to find the kind of businesses we like that embody a margin of safety in price.

So at the margin, as a residual of a disciplined approach, we’re trimming ideas as they approach the intrinsic value, and it’s harder to recycle that cash into new ideas. And so the cash level has, as you suggested, drifted up into the low 20 percent range in the funds. And so that’s on the higher end of where it’s been over the last five or six years. It’s not a market timing call, it’s a reflection of a disciplined process. But we’re happy to be patient right now. This is not an environment to be impatient. You should act with fortitude when the markets are rewarding risk-taking. Today, when there’s a complacency in markets, I think it pays to be a little bit patient.

CONSUELO MACK: Matt, in previous conversations, we’ve talked about stocks being the least worst alternative, as an investment. What’s your view of stocks now?

MATTHEW MCLENNAN: Well, it’s become much more security by security right now. I think as an asset class, it’s a much more difficult thing to get enthusiastic about, because multiples are high, and margins are high. And so what we’ve essentially seen happen, through this rally, is a bringing forward of returns. And so I think expected returns going forward are going to be much more modest then we’ve experienced over the last five or six years, and so we have modest expectations for returns in bonds, in equities, pretty much across any manmade security, because the price of money has been fake.

And so what we’re trying to do at the margin, within the equity universe, if the problem’s monetary abundance, we’re trying to identify scarcity one security at a time, and buy it with a margin of safety, and were emphasizing businesses today that I would say are either resilient staples in nature, or that have already gone through their own adverse business cycle. So we’ve got a margin of safety going in, in a market that doesn’t offer much of a margin of safety.

CONSUELO MACK: Scarcity. How do you define a company that represents scarcity?

MATTHEW MCLENNAN: Well, scarcity, to us, can have two forms. It can either be tangible or intangible. Tangible scarcity is, in some ways, easier to understand. It may be the ownership of a hard-to-replace precious metal mine. It could be the ownership of …

CONSUELO MACK: Gold, for instance?

MATTHEW MCLENNAN: Exactly. Or very well-located real estate, or timberlands that are shrinking in acreage. So that’s tangible scarcity. But perhaps more of our portfolio is actually represented by what I refer to as intangible scarcity, and that is a business model that’s very difficult to replicate, a business model where a company has a strategic lock on a market, 40, 50, 60 percent market share, so that it can grind out cash flow generation through thick and thin, and has the ability to essentially repurchase stock over time, pay a dividend, and grow in line with nominal activity without a lot of incremental capital. If you can identify a business that’s hard to replicate, or a physical asset that’s hard to replicate, in a world of monetary abundance, we think that’s a decent place to start, provided you’ve paid the right price.

CONSUELO MACK: Gold prices, along with other commodity prices, have been falling. Is gold a better buy now?

MATTHEW MCLENNAN: Well, we think of gold as money, and not as a commodity, but it’s fair to say that the commodity complex as a whole has been very weak. Agricultural commodities, base metals, energy. All those prices have come under dramatic pressure, which to me signifies the slowing of the Chinese economy. We’ve been talking for some time about our concerns about the super-investment cycle in China. I think the week commodity complex is highlighting a slowdown in China. And in a sense, the baby has been thrown out with the bathwater.

Gold has traded down, with other commodities, but we see gold as really having more of a reserve monetary status. It is the one element, if you will, on the periodic table, that we think is best suited to be a monetary reserve. Its inertness means that it’s naturally resilient in the face of business cycle fluctuations, because it’s not as useful as other commodities. It also lasts forever, which means that its supply is much more stable. Because what matters is all the gold that’s ever been mined, rather than the mining in any given year. So scarcity, predictable supply growth, and resilience to economic distress are the elements of gold that make it unique as a monetary reserve.

And if you get back to my observation before, that we have more debt in the system today than we had in 2007, and I’ve posed the rhetorical question, should equities be expensive or cheap. I’d also pose the same rhetorical question about gold. If there’s too much debt, should gold be cheap, or should it be expensive?

CONSUELO MACK: It should be expensive, right?

MATTHEW MCLENNAN: I think that there’s an argument to be made that gold has a place in a long-term portfolio as a potential hedge.

CONSUELO MACK: Talk about the resilience in companies that you’re looking for. And you have a very broadly diversified portfolio. You’re running over $50 billion in assets under management in the Global fund. That’s a lot of assets. So when you’re looking at companies in a diversified portfolio, how difficult is it to find those kind of resilient names that you’re talking about when you’ve got to have this much money invested?

MATTHEW MCLENNAN: Well, we have the benefit of having invested in this style for decades, at First Eagle, and we have a large list of companies that are on our wish list for investing. And essentially, we are patient investors, and we spend our time waiting. And many of the investments or the businesses we’d love to own, we don’t own today because there at the wrong price. And so we have a long list of companies that we’d want to put capital into, and just think of us patiently waiting, watching the grass grow, if you will, and putting that capital to work episodically in windows of distress. Typically, when those distress windows occur, it’s quite easy to get invested. And as you’ve identified, we are quite diversified. We look nothing like an index fund. We have very eclectic holdings, but we do value diversification. We’re prudent long-term investors, and just like we don’t try and predict where the S&P’s going to be, or where interest rates are going to be, we don’t know which one of our investments is going to work out best in any given year, and so we like the notion of having a range of different seeds planted in interesting industries and interesting businesses around the world.

CONSUELO MACK: Looking at some of the top holdings, and I guess your top five holdings are around 11 percent of the portfolio, and your top holding is actually gold bullion, at I guess a little under five percent the last time I looked.

MATTHEW MCLENNAN: That’s correct.

CONSUELO MACK: But you’ve got companies like Microsoft and Intel and Oracle and Comcast, and I’m just interested, because Microsoft, Intel, Oracle, and Comcast are all U.S. companies.

MATTHEW MCLENNAN: Well, it’s interesting. If you looked at our portfolio back in the late 1990s, we had virtually nothing in the technology arena. We started investing heavily in the technology arena during the last financial crisis. We finally saw companies that were generating cash flow, starting to pay dividends, buying back stock rather than issuing stock, looking to do accretive M&A, not on price-to-concept. And so we started to see a lot more rational behavior and lower prices, and so these have been interesting investment opportunities for us.
And if you think of companies like Microsoft or Oracle, which are two big software investments for us, these businesses have each gone through their equivalent of the Pepsi challenge over the last couple of years. Microsoft, because it wasn’t in mobile. People failed to realize, though, that Microsoft’s core profit engine is in the corporate space. They have a cash flow generating machine in corporate software, from server software through to windows and your email. And the same case for oracle. People have been worried about the Cloud, but Oracle’s business model is transitioning to the Cloud. And Oracle gets almost all of its profits from recurring revenue from maintenance, with inflation escalates built in.

CONSUELO MACK: How interesting.

MATTHEW MCLENNAN: And so when you look at the operating profit stream of these companies, it looks a lot more like a Colgate/Palmolive. These are corporate staples, is the best way to think about them. And we were able to buy them at very high single-digit free cash flow yields at a time when they were doing rational things with the capital, and so that’s the reason they’re in our portfolio, not because we love the U.S., and not because we love tech, but because we found businesses with business models difficult to replicate at the right price.

CONSUELO MACK: Japan. First Eagle was very heavily invested in Japan. Are there any markets that are cheap right now? And are there opportunities that you’re seeing in the emerging markets, for instance, that have been sold off, or in Europe, or..?

MATTHEW MCLENNAN: It’s getting increasingly difficult to find regions that are cheap as a whole, because the overall level of asset prices around the world has gone up quite a bit.

CONSUELO MACK: It’s rising, right.

MATTHEW MCLENNAN: And Japan, as you correctly identified, was an area where we put quite a bit of capital to work in what was quite a contrarian call at the time, but now we’ve become a net seller of Japan. Not because we don’t like the potential for Japan to recover, but simply because the margin of safety and price has dramatically reduced. Many of the businesses that we know and love there now trade at close to intrinsic value, and so we’ve looked to recycle that capital.

It has become difficult, and I would say, as we look around the world, the opportunity set has become less regional, and it’s become more idiosyncratic, company by company, trying to identify, as I mentioned before, resilient staples that are out of favor for one reason or another, or businesses that may have a little more cyclicality that are already in a more challenging cyclical environment.

CONSUELO MACK: Well, talk about a challenging cyclical environment, energy is an industry that is very challenged right now. Is that an area that you’re looking at? Are there attractive energy companies that have been on your list that you’re saying, wow, they’re finally down at the prices where we think that they’re well valued?

MATTHEW MCLENNAN: Well, energy’s an area where we’ve had relatively little exposure until recently. We’ve had a handful of names.

CONSUELO MACK: Because it was too expensive?

MATTHEW MCLENNAN: Well, you had prices that were clearing at levels that incentivised new production to come on. Having said that, with the oil price in the mid-60s, it’s now a much more challenging outlook for some of the marginal producers. And we don’t know where the oil price will settle. Like anything else, we can’t predict it in the near term. But if you go back to the discussion we had before, about the typical U.S. consumer consuming 22 to 23 barrels a year, and consumers in the emerging economies consuming a 10th of that, at some point, it’s quite possible that the real price of energy has to be substantially higher.

What we also see is that where energy is becoming more abundant in supply is in more unconventional areas. And so I think one of the areas that we’ve started to make some investments in is companies that benefit from the mix-shift of capital spending to those unconventional areas. And a good example of that would be National Oilwell Varco, which is the world leader in providing the components to rigs that are used for ultra-deep-water energy extraction, or shale. As the mix of energy spending is going there, you don’t have to necessarily bet on the oil price, per se, over the long-term. You’re betting on the mix of capital spending changing. And so we think it is a time to start to do a little bit of work in the space. And we’re patient, and we’ll wait and see where prices settle. But I think it is one area where there could be opportunities in the coming months.

CONSUELO MACK: And as far as declining energy prices, we’ve had some WEALTHTRACK guests on who were looking at a more positive scenario, being that we are 70 percent consumer- driven, that cheaper energy prices are like having a gigantic tax cut for consumers. It’s very stimulative, and also, it’s made the U.S. much more competitive. We have a manufacturing renaissance. What about the positives there? I mean, isn’t it possible that we could be in actually kind of a long-term secular positive trend in the U.S.?

MATTHEW MCLENNAN: Well, there’s no question, in the short term, that lower energy prices are a net positive for the U.S. consumer. I mean, it really helps boost real disposable income, and helps them effectively go out … And you seen companies like Walmart trade up in value as they cater to the consumer that’s going to be the most sensitive to lower energy prices. But the U.S. manufacturing renaissance may not be quite what people expect. It may not produce the jobs that people expect. We see it requiring a lot of robotics and factory automation equipment. And so while you may see the on-shoring of jobs, it’s going to be quite painful for places like China that have built huge manufacturing capacity.

But it may not bring the jobs people expect. Think of agriculture. A century ago, most people were employed in some agricultural enterprise. Now it’s a fraction of the population, a couple percent, and yet we’re all well-fed. I think the same thing can happen in manufacturing.

CONSUELO MACK: If there’s one investment that we should all own for a long-term diversified portfolio, what would it be?

MATTHEW MCLENNAN: Well, I would say at a time like this, the key investment you need is patience, and you can see that in our cash at the moment. But beyond that, I think if you’re thinking creatively about a diversified portfolio, at a time when you probably already own a lot of stocks, you may want to think of the stock that helps provide somewhat of potential hedge to your portfolio, than something that’s just going to exacerbate your returns. And so an idea that would come to mind is a company like Fresnillo, which is the world’s leading silver miner. There also a low-cost miner of gold.

CONSUELO MACK: And they’re based where?

MATTHEW MCLENNAN: They’re based in Mexico. They’ve been a low-cost producer of silver for decades. In fact, they started mining in 1554. So talk about duration. We like businesses that have duration. The Baillѐres family that controls Fresnillo through the holding company Peñoles are very long-term conservative investors, with a similar philosophy to First Eagle. They distribute a dividend across time. And silver prices have gone from $50 to $16. And it’s been a more exacerbated move than gold, and so if you think there’s problems in the world, and at some point precious metals could be more precious than they are today, then Fresnillo is a high-quality business that definitely out-of-favor today, having lost more than half of its value the last couple of years, that could be an interesting contrarian seed for a portfolio that’s long equities are ready.

CONSUELO MACK: Patience is a virtue few investors have. Clearly, you have it, at First Eagle. So Matthew McLennan, thanks very much for joining us.

MATTHEW MCLENNAN: Thank you very much, Consuelo.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long-term. This week’s action point is follow Matt McLennan’s advice and be a patient investor. The most successful investors we have interviewed over the years all share that virtue. They are not afraid to wait for that proverbial fat-pitch, the baseball analogy where as a hitter you let numerous balls pass you by and wait for Mr. Market to throw you a perfect pitch right down the middle of the strike zone before you swing, increasing your chances of getting a hit.

Unlike in baseball, time is on your side. Don’t be afraid to wait for better opportunities and prices down the road.

Next week we will explore some emerging markets that are too big to ignore, Brazil, China and India. But is now the time to get involved? Portfolio managers, Kenneth Lowe from Matthews Asia and David Nadel from The Royce Funds will weigh in.

In the meantime to see today’s interview again and our exclusive extra interview with Matthew McLennan go to our website wealthtrack.com.

Have a great weekend and make the week ahead a profitable and a productive one.

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