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By Bridget B. Hughes, CFA | 06-02-2010 03:04 PM

Being Deliberate in a Downdraft

First Eagle U.S. Value's Kimball Brooker on the fund's recent deployment of cash, avoidance of banks, and a mid-cap insurance pick.

Bridget Hughes: Hi, I am Bridget Hughes. I am one of the fund analysts at Morningstar, and I am here with Kimball Brooker, who is an associate portfolio manager on First Eagle U.S. Value. Thanks for joining us, Kimball.

Kimball Brooker: Thanks for having me.

Hughes: I wanted to ask you about the fund's cash stake and what you've been doing in the past couple of weeks. It had been at a pretty high level earlier on this year, but now that things have corrected, have you been busier and what's happened to that cash stake?

Brooker: We have been busier. We've been judiciously employing our cash, although in a deliberate way. So our cash has come down roughly 150 basis points from where it was before, before this recent downdraft, as we have found the companies that we're interested in drifting into our buy range, which is – we typically think of as a 30% to 40% discount from our estimates of their intrinsic value. So, as some companies have drifted into that range, we've been using some of that cash. But we've been deliberate about it.

Hughes: Just to illustrate what it means for First Eagle to kind of sift through the rubble of a downdraft, I want to talk about 2008 specifically. In addition to your portfolio management duties, you also cover the financials area, and that was an area that was obviously creamed, but not an area where First Eagle went in whole hog?

Brooker: Right. We didn't. The financials are obviously not a homogenous group of companies, and we do own and bought some insurance companies, but we avoided the banks, the U.S. banks in particular. And we did so for a couple of reasons, the first of which was really for many of them, especially the money center banks, the opacity surrounding the balance sheets as well as just the inherent leverage in a typical bank.

Even now, post the crisis, most banks are levered 12:1 on their equity, meaning that they have $8 roughly set aside for $100 of assets. So, if small changes occur on the assets, it can have a meaningful impact on the equity. And we don't really like levered businesses as a general matter, and the banks are very, very levered structurally.

I'd say the third issue that we've struggled with is just the role of the government and the impact that it's likely to have on the banks and their profitability on a go-forward basis.

And finally, valuation. These companies kind of had a very deep trough, as you referenced, but had a very swift return of 2008, 2007 valuations.

So, we've sort of stayed on the sidelines. We're not morally opposed to owning banks. And to be fair, we have a wish list of banks that we feel are relatively transparent, have reasonably good asset quality, and we're waiting and hoping that they come into our purchase zone.

Hughes: Okay. So let's talk of a financial that is sort of a more typical First Eagle type of name, Cincinnati Financial.

Brooker: Sure. Cincinnati Financial is a – it's a regional insurance company with a mid-cap market value. And Cincinnati, since its founding in the '50s, has employed a very straightforward, plain-vanilla underwriting approach that's been – over time, they've had some years where there have been storms and so forth, but that's what they are there for. But over time, the underwriting record has been very profitable. They've been very careful and conservative about reserving and have released reserves every year that – as far as I think we've looked at, 15 or 20 years of data.

What ultimately caused Cincinnati some problems was their investment portfolio and not the insurance portfolio. And it was one specific name in their investment portfolio, which was a bank. It was a bank called Fifth Third, which they had invested in, I think, close to the founding of the company and which had a tremendous run up and then a tremendous fall from grace in 2008.

When we looked at the company, what we saw was a great insurance franchise, which was still intact, an investment portfolio that had been retooled to a more balanced approach with respect to equities that was trading at 70% to its net tangible book value that paid 7% dividend that we felt comfortable was sustainable. In fact, they increased it after we bought it. And we thought it was a good combination of a very attractive valuation, a very stable business with a good management team who we feel is not going to do anything crazy with shareholders' money.

So we're happy owners of Cincinnati. Still looking for banks.

Hughes: Okay. Well, thank you for your time.

Brooker: Thank you.

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