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McLennan: Intrinsic Value Still Intact in Japan

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. Although we did see the Japanese markets begin to recover on Wednesday [in Japan], news flow [early Thursday morning in Japan] continued to disrupt the [global] markets as Japan markets were closed.

Talking with us today to give us some perspective and insight on the situation in Japan is Matthew McLennan. He is a portfolio manager with First Eagle, including on the First Eagle Global and the First Eagle Overseas funds.

Thanks, so much for calling in today, Matthew.

Matthew McLennan: It's a pleasure.

Stipp: The first question for you, in both of those funds, you've had an emphasis on Japan, so I'm curious to know as you're assessing your portfolio holdings, what factors are you looking at to determine how they may be impacted by the disaster and the unfolding crisis that's happening in Japan?

McLennan: Well, if you look at our portfolios, the reason why we've had an emphasis on Japan--historically in the Global portfolio, we've had a high-teens percentage of the portfolio in Japan and in the Overseas it's been in the high 20s--is that we've seen a margin of safety in the underlying securities that exist in that market. And when I talk about our margin of safety, I'm referring to the fact that the valuations of the businesses that we've identified in Japan have been attractive, and in many cases the capital structures have also been very resilient with no debt and net cash. So, if we've been able to identify companies that embody low valuations and sustainable global market positions with rock-solid balance sheets, then that's where we've gone as the least-worst place to deploy capital, if you will, from the point of view of our overall portfolio construction.

So, in looking at the current situation in Japan, we start out with a piece of mind that despite the fact that we may see adverse stock price reactions in some of these securities in this window of uncertainty, the underlying businesses that we're part owners of in Japan have a great deal of resilience. The starting valuation that we went into this with was quite low.

So, those two factors as a whole help mitigate, if you will, the probability of a permanent impairment of capital. At First Eagle, we've always been focused first and foremost on avoiding permanent impairment of capital.

Stipp: I think one of the questions that investors have as they're looking at this region and the sell-off that we saw the first couple of days after the disaster struck, and you alluded to this is, how much of that price drop is real fundamental loss of value and how much might be fear selling?

So, as you look across your holdings, you said that you had had a margin of safety already. Do you think that your prospects may have dimmed to any extent for those holdings or do you see that the price movements may just be temporary because of the uncertainty?

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McLennan: Well, there's an objective and a subjective angle to assessing any change in the underlying fundamental intrinsic value. Clearly, in the conversations that we've had with our companies to-date, there has been minimal economic impact, if you will, on most of the companies, in that the affected areas in Japan represented a single-digit percentage point of the overall economy, as measured by GDP or industrial production. And so to the extent that the physical damage done to-date has influenced, tragic as it is, a small proportion of the economy, that's helped mitigate the damage to-date.

I think what the market has been more worried about is the prospective damage that could come out of any nuclear disruption or any follow-on aftershocks that may occur, which is obviously a more difficult thing for us to assess.

When we look at those variables, we obviously listen to what we can hear in publicly available sources that have credibility. So we have seen the Head of the IAEA, Amano, discussing his perspective that the situation, whilst very serious, is more contained at this point than the situation in Chernobyl and on the nuclear side. We have seen the U.S. geological survey indicate that when you have aftershocks to any given earthquake, they tend to be one level lower, if you will, in terms of their intensity, and we have seen a number of aftershocks of lower intensity. And we see respected institutes like the Harvard School of Public Health currently saying that the existing radiation does not pose a serious public health issue.

So on the information that we have available from credible sources, it appears that the damage to existing intrinsic value has not been material.

Clearly there are any number of scenarios that investors can dream up or that could transpire. The future is intrinsically uncertainty, and I think it is that which is weighing on stock prices at this moment, as opposed to readily identifiable losses in existing intrinsic value.

Stipp: Follow-up on that, Matthew, have you folks at First Eagle been considering adding to any positions or taking any new positions, due to the fact that some things could be oversold because of the fear of that uncertainty?

McLennan: If you look at how our portfolio was positioned from an overall perspective in the lead-up to this crisis, you'll see it in the recent half-year, our cash levels had crept up in the portfolio. It's not by virtue of us making a market-timing call, but as market levels around the world got to higher levels, there was a degree of incremental complacency in valuations. Certainly we weren't at bubble levels in equity market valuations around the world, but the markets were clearly factoring in a more rosy reality, which meant that we had a number of investments that were starting to approach intrinsic value, which we were trimming at the margin, and it was at the margin a little bit more difficult to deploy capital with a lower frequency of discounted opportunities. And so the cash levels had built a little in the lead-up to this crisis into the 15% to 20% range depending on the fund, and we have therefore had the deferred purchasing power to take advantage of this market discontinuity.

There have been a number of opportunities for us in the past few days to deploy capital into some of our existing Japanese holdings on what we believe are very wide valuation margin of safety terms, and a good part of this has been helped by the fact that we had the deferred purchasing power there as part of our overall strategy.

Our overall strategy is not to predict what's going to happen in the world, but to be positioned to endure and to be positioned to take advantage of opportunities that the ups and downs of reality provide for us.

Stipp: If I could ask you a quick follow-up on that point, we've also seen global markets selling off also in sympathy with the Japanese market. Have you seen opportunities open up in other parts of the world because selling has seemed to be a common theme globally over the last few days?

McLennan: I think it's fair to say that if the current route that we've seen starts to take root in global markets, as the markets are not just focused on the uncertainty in Japan, but recent uncertainties in the Middle East and there have been the lingering concerns of the financial architectural challenges in Europe and elsewhere around the world. As the market absorbs all these sorts of issues, if it does move into more distressed or lower territory, then you would expect us as structural buyers of business to be more aggressive in identifying opportunities because the margin of safety will be getting larger.

So, we tend to be more fully invested when markets get into distress. We like, as value investors, to be a provider of liquidity, and so the environment as we sort of see it, to-date the correction we've seen around the world has been fairly modest in nature. Were it to become more serious or entrenched, you would expect us to be broadening the scope of opportunities that we're looking at.

Stipp: Matthew McLennan for the First Eagle Funds, thanks so much for calling in today and for your insights.

McLennan: Thank you very much.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.