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Investing in Places the Market Hates

Russel Kinnel

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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Kinnel: Since you are risk-averse, obviously, you think a lot about where not to invest. What are the areas that seem least attractive or highest-risk to you?

McLennan: Well, at First Eagle we always have an eye to what can go wrong, and typically the areas where greatest investment risk exists is where greatest investment enthusiasm exists. So where you see high levels of fixed capital investment in a world where there are investment booms is often where risk perception is lowest and vulnerabilities are highest. And so, it's been difficult for us, for example, for us to find opportunities in Chinese construction in the last couple of years now; those stocks have corrected quite a bit. But that's an area where there was a great deal of thematic enthusiasm behind the urbanization trade in China. We steered clear of that because we couldn't find a high-margin-of-safety opportunities.

Around the world one other area that I'd point out where there is an absence of real return is the sovereign markets of the world. There is no risk-free investment today. It's an unusual state of the world when a 10-year Treasury has a negative real yield, where you're guaranteeing the real erosion of your principal over a decade. That's a new state of the world and presents a lot of problems for long-term investors.

Kinnel: That's a great point. That's something we're really hearing from a number of managers from a lot of different backgrounds and angles that Treasuries are maybe their least favorite investment.

McLennan: Well I think that the price of the Treasury market is fake. I mean when the Federal Reserve is explicitly repricing interest rates all the way up the curve, call it Operation Twist, call it QE whatever you may like, the whole curve has moved to a level that it wouldn't have cleared were it not for that intervention. And when you toy with prices, there are second-order consequences that come from that. But for us when we look at a Treasury or we look at the sovereign markets in general, it's fair to say that the level of debt relative to gross national savings is at a generational high, and the real return is at a generational low. So, it's not a particularly attractive mix of risk and reward at this point in time.