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By Russel Kinnel | 06-21-2012 01:30 PM

Investing in Places the Market Hates

First Eagle's Matt McLennan finds high-margin-of-safety opportunities in areas that have experienced 'seasoned disappointment,' but he warns about today's sovereign markets.

Russel Kinnel: Hi, I'm Russ Kinnel, director of mutual fund research for Morningstar. I'm joined today by Matt McLennan of First Eagle Funds.

Thanks for joining us.

Matt McLennan: It's a pleasure. Thanks for having us.

Kinnel: You have a very wide purview, so why don't you start telling us what are you finding out there. What's attractive?

McLennan: Well I think if you look around the world today, there are a lot of fault lines that are present, which means that there's lots of market volatility. And when there's market volatility there's margin of safety opportunities. So, we're finding value in some places where we wouldn't expect it. For example, we have allocated some capital to technology companies like Microsoft and Oracle. You wouldn't have seen us do that a decade ago. The margin of safety was not present at that point in time.

In Europe, we found some opportunity, perhaps not where you'd expect, not in the banks per se nor in the stable businesses that are trading at high valuations, but in investment holding companies. In the world of investment holding companies, you have the ability to identify double discounts. The companies own stocks that have sold off, and the holding-company discount widens.

And in Japan, there's plenty of opportunity. A lot of the Japanese domestic names are trading at very depressed valuations. In fact, with Nissin Food's, for example, which is over 50% share of the instant-noodle market, we were able to acquire a stake there at a mid-single-digit multiple of earnings before interest and taxes.

Kinnel: So you're essentially going everywhere that the rest of the world hates, right? American investors, if you follow flows, they're taking money out of U.S. equities. They're obviously taking money out of European equities, but you're going the opposite way. Why is that?

McLennan: Well, I think if you look at the history of investing over generations, the greatest amount of money has been lost chasing thematic growth, and the money goes either reflexively to defensive assets or reflexively to find the new economy. And we often find that the most impressive investment opportunities are in more boring pockets of the world, to use a word that doesn't often get used in the investment lexicon. And that's because you can buy good businesses at good prices.

The problem with thematic investing, for example, all the money that chased Japan in the late 80s, tech in the late 90s, or the BRIC countries more recently is that people are not discriminating among individual securities. They are not looking for a margin of safety. Whereas markets that have been abandoned, like Japan after a two-decade bear market, provide the discriminating investor with great margin of safety opportunities to find good businesses at good prices. So, I think it makes a lot of sense as a value investor to be providing liquidity where liquidity is not.

Kinnel: So essentially, where the negative headlines are, oddly enough there's often the lower-risk, better-returning opportunities?

McLennan: Yes, and we're not blindly contrarian in a sense of just following the negative headlines…

Kinnel: You're not buying Italian banks…

McLennan: Exactly. What appeals to us is seasoned disappointment, where a country or an industry has gone through a seasoned period of adjustment, valuation derating, where management practices have become more prudent and disciplined and where balance sheets have become more conservative with the passage of time. That's where you get the beautiful confluence of low price, conservative management, and rock-solid balance sheets, and where you can make high-margin-of-safety investments. And surprisingly, the margin of safety is symmetrical to the return opportunity. If you can buy a value-creating business at a value price, you win twice.

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