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Investing on a Fault Line

Jason Stipp recently went on the road to check in with some money managers, including First Eagle's Matthew McLennan. We talked about how the fund's Japanese names are holding up, valuations in overseas versus the domestic market, and also the role of gold in the First Eagle Fund portfolios.

Jason Stipp: When we last spoke in mid-March, after the Japanese disaster had occurred, you talked about the businesses that you own in Japan. You said they had a lot of resiliency. You mentioned that you also had good margin of safety on those businesses.

Given where the Japanese markets have been trading, the trailing 13 months are down about 10%, the indexes. Can you put the performance of your holdings and where you see their valuations in that context, both their operations and their current valuations?

Matthew McLennan: Absolutely, and I think you are right to distinguish the operations from the current valuations when you think about the long-term intrinsic value of the business. But if we take a step back from the tragic events of the recent earthquake in Japan, and we look at the Japanese stocks that we own, last year they were amongst the best securities that we owned in the portfolio.

Some of our best stocks were the Japanese industrials--companies like Fanuc in robotics and servo motors, SMC in pneumatics--these were strong contributors to our performance last year. And in fact they have proven to be quite resilient this year as well. And if we look at the performance of our Japanese stocks, they have pretty much held their ground this year in a market that, in Japan, has been very weak, and so it goes to the heart of this notion that what you're investing in is individual stocks rather than a stock market per se.

But when you look at the companies we own in Japan, and we think about the word "resilient," it's worth thinking about what we mean by that. First and foremost, the companies that we own in Japan, by and large, have very strong market positions. Fanuc, which I mentioned before, is really dominant in the market for servo motors; SMC in pneumatics, truly dominant; Shimano in bicycle components, over 50% market share.

We can go down the portfolio, and one of the common threats that links many of the bigger Japanese positions is the strength of market position, and not only do they have a strong position and a market position that is often global, but they have very strong balance sheets as well. Many of them have no debt at all and are sitting on net cash, and they have been able to deploy that capital to their advantage.

Companies like Fanuc and Shimano were able to buy back stock in distressed environments over the last couple of years, and that has helped keep them in good stead, and when you think about the combination of market position strength and balance sheet strength, and you add on top of that management teams that are focused on the generational integrity of their businesses, you get what we call "resilience" and that has really been the hallmark of the sorts of investments we look for around the world, but we found them in Japan as well.

And what's happened, getting back to your opening comment about valuation, is that a two-decade bear market in Japan has given us the opportunity to own these sorts of businesses at very modest valuations, relative to what you'd typically pay for this kind of quality business.

Stipp: So certainly the fact that management is choosing to deploy capital, allocate capital to buy back stock that's undervalued, also a good sign of their integrity on that front.

McLennan: It is interesting. I mean, often the Japanese have a reputation for not being good distributors of capital, but if you look at the Nikkei today, or the Japanese market more broadly speaking, it typically has a dividend yield actually slightly in excess of the S&P 500, and most of the Japanese companies that we look at have payout ratios now that are in the 30% to 40% ratio of earnings. No less than their other Western counterparts, and companies like Fanuc have bought back nearly other 20% of their stock; Shimano bought back a third of their stock in the last decade.

And so there has been an evolution in the way that the Japanese think about capital distribution, and perhaps it's crept up on people rather than the revolution that some managers were looking for.

Stipp: Just a quick follow-up question on the crisis in Japan. I read your shareholder letter that you put out shortly afterward, and you talked about how you're gathering information to understand the situation and what was happening there.

Did you learn anything about investing during a time when there was so much uncertainty and so much information was coming out, conflicting information, about managing through a time when there was so much volatility?

McLennan: Well, it's a great question. I mean, ultimately, when you think about what happened in Japan, where you have one of the world's most productive economies essentially perched on a geophysical fault line, I think it provides a very interesting metaphor for how you should think about investing more broadly.

When you look at the global markets, they sit upon several fault lines, not just the geophysical type, but you have to go into the realm of the less tangibles, the financial architecture and it's imperfections, and the geopolitical and the complexities that are involved there, and what you note is that if you sit on a fault line, crisis can happen at unpredictable junctures and sometimes be devastating.

And I think the mind-set that we bring to investing at First Eagle is to accept that no matter what the environment feels like, we're existing productively on a fault line of sorts, and we have to structure our affairs to endeavor those kinds of crises, but also we want to still own enterprises that we participate in the march of man, and so the balance we're trying to strike in our approach to portfolio management is to buy good businesses at good prices, so we can endure and have some cash and gold as deferred purchasing power to take advantage of the distressed opportunities that result from crisis.

But on the other hand, you want to have the mind-set that gives you a dose of humility, if you will, to say, I can't predict the future with certainty, and therefore you demand a margin of safety in all the investments that you make.