Jason Stipp: Does your margin of safety requirement, does it vary depending on the kind of company you are looking at, and how do you determine how much margin of safety you are going to require before you purchase?
Matthew McLennan: Well, at First Eagle, when we think about margin of safety, one of the factors that may distinguish us a little bit from many equity investors is we typically look at that margin of safety on the asset level of the companies. So we think about what are the assets worth. We'd look at the underlying EBIT that a business generates, so not adjusted for capital structure or tax distortion, and we capitalize that at a prudent multiple. And we then strip out all of the residual claims on the business, the debt, any contingent legal claims, minority interest, and we come up with a truly residual value for the equity.
So, what we're trying to do is buy the assets typically for $0.70 on the dollar, and so for a highly levered capital structure, we're going to require a bigger margin of safety than for an unlevered capital structure, and so that's a key factor to incorporate into one's thinking.
But getting back to your question, which is how do you incorporate the business quality into the margin of safety? It's a tricky thing because you risk double-counting. If you think of a commodity business, a commodity business might only be worth eight, nine, 10 times EBIT, but a true franchise that has a degree of pricing power and growth could be worth a midteens multiple of EBIT.
Now, with a commodity business worth nine times EBIT, we're going to be willing to go and pay six times EBIT. For a franchise, if you had a smaller margin of safety and a higher multiple, you might end up paying 13 times EBIT and at a certain point, if your analysis is wrong, if your subjective assessment of the quality of the business is wrong, you have a lot of downside if you are going at a 13 times EBIT.
So when we think about margin of safety, we typically like to pay single-digit EBIT multiples to buy businesses, irrespective of the quality. That means that we're not putting too much stock in the subjective sense of the quality of our franchise and double counting a higher multiple and a lower discount going in.
Obviously, that's a broad framework. There are going to be exceptions to every rule, but that's the mind-set that we employ when we think about it.