First rule of investing: Don’t lose money. Second rule of investing: Don’t forget the first rule of investing.
That sums up a part of the philosophy of the risk adverse First Eagle Funds. Its value-oriented managers often quote legendary value investor Benjamin Graham and Warren Buffett, his most famous student.
“We see our goal as to avoid the permanent impairment of capital and try to provide a real rate of return after taking into account inflation and other factors,” says John Arnhold, chairman and chief investment officer of First Eagle Investment Management. “We’re always looking for what can go wrong,” he adds of the seven funds that have some $79 billion in assets, with about half in the flagship global fund. The company has some 200 years of investment history, going back to 19th century Europe.
First Eagle's value philosophy is that bad times are the best of times for us. It calls for its funds to buy in such a way that there is no question that they have achieved a margin of safety that will minimize losses even in the worst of environments.
They seek companies that are dominant in a sector, have pricing power and that have suddenly have been marked down. Until then, fund managers, who do little trading, will wait, sometimes holding large amounts of cash. “You have to wait for the fat pitch,” Arnhold says.
So Arnhold agrees that most money is not made in stocks when they’re sold. The biggest part of profits comes from buying a company so cheaply that fat profits are almost guaranteed, according to the Graham philosophy followed by First Eagle funds. (See Sidebar I “Benjamin Graham on the Margin of Safety”).
“We choose stocks on the basis on a bottom-up process,” adds Colin Morris, lead portfolio manager of First Eagle Investment Management U.S. Equity strategy. That means the best time to load up is generally when markets are in turmoil.
But until another bear market, the funds can turn in mediocre performances. They can have significant holdings in defensive assets that generate little income in the short term. But they are designed to protect against huge losses in bad markets as well as prepare for buying opportunities.
“At the height of bull markets it can become more and more difficult to find good companies, whose shares are priced with an adequate margin of safety,” says Matthew McLennan, portfolio manager for the First Eagle Global Fund.
And when First Eagle managers believe markets have become too frothy or that they can’t find good buys, they usually load up on cash and gold. First Eagle managers, who shy away from macro calls, seem to be preparing for the next market blowup. For instance, the global fund recently has owned between 5 percent and 10 percent in gold bullion.
Even in buying gold, First Eagle is looking to save pennies. It likes gold mining stocks because “gold in the ground is cheaper than gold out of the ground,” according to Arnhold. Ultimately, gold is a hedge against bad markets, Arnhold notes.
Still, First Eagle officials, in a series of interviews with Financial Advisor magazine, would make no macro predictions. Nevertheless, they intimated that the market could be close to a downturn. And First Eagle officials believe that, whenever it happens, they will be ready for it. Their investors, which include many of the managers who have significant stakes in the funds, will come through with much fewer scars than other fund investors.
Arnhold, whose business has Germanic roots dating back two centuries (See Sidebar II, “Helping Germany and Others Become Industrial Powers”), says First Eagle’s predecessors were able to survive the hyper-inflationary disturbances of Weimar, Germany. Arnold directs his funds using a philosophy that even pre-dates the classic value investing philosophy of Graham’s classic tome, The Intelligent Investor.
“I’ve taken this philosophy a step even farther back with my family in Germany,” Arnhold explains. “We apply common sense. If you owned a good business that had free cash flow and had a dominant market position, then they were able to withstand the high inflation and the depression.”
Arnhold notes that First Eagle’s predecessors bought lots of beverage companies in Weimar, Germany. They were good companies in any environment, he argues. “These companies withstood the hyperinflation and depression because people still wanted drinks.”
The First Global portfolio today includes communications, industrial and technology staples that most people will continue to use even when times are bad. These include television giant Comcast, which recently was the lead portfolio position in First Eagle Global Fund’s portfolio. Other leading positions were technology giants Cisco Systems, Intel and Microsoft, and industrial giants Cintas and SECOM Ltd.
Another example of a value stock is financial institutions that proved they were ready to weather the 2008 meltdown. Arnhold recently liked Bank of New York Mellon Corp.
Added Morris: Opportunistically, we’ve taken positions in large U.S. regional banks that have low-cost deposit franchises and a great distribution. These banks weathered the storm better than most of their peers,” he says, “which is a reflection of their underwriting discipline. They generate capital at attractive rates. And they were able to strengthen their franchise through the acquisition of distressed competitors at very distressed prices.”
And the best time for this approach is in the middle of a market meltdown, First Eagle officials say. So they pay attention to macro events riling markets. Still, Arnhold emphasizes, his funds are looking for new positions one by one. Another value theme of First Eagle funds is holding companies.
At times, holding companies can provide a double discount, according to Kimball Brooker, portfolio manager for First Eagle Global and Overseas Value Strategies.
“The term double discount applies when two layers of valuation discounts exists,” Brooker says. “The first discount may arise when the holding companies trade at a discount to the sum of the parts. In the case of Groupe Bruxelles Lambert, for example, whose assets are almost entirely shares of public companies, the holding company trades at approximately a 30 percent discount to the sum of the investments.".
The second discount, he adds, can arise owing to the value of the intrinsic value versus the market value of the companies within the holding company. Then, he believes, a double discount happens “when the holding company is trading at a discount to the market value of its assets and the market value of its assets are trading at a discount to our estimates of their intrinsic value.”
But First Eagle’s bargain buying strategies are not all beer and skittles.
This relentless emphasis on buying cheap also means, First Eagle officials concede, that their funds and managers sometimes are going to find slim pickings as bull markets go on and one. And, by implication, they will perform poorly compared with indexes and peer funds during long-term bull markets. That’s because they will go through times when it will be nigh impossible to find properly priced stocks and they will end up with a big cash component.
That’s why its funds can, when managers think bull markets are becoming frothy, sometimes hold huge amounts in cash. But cash, when the central bank has made a commitment to almost zero interest rate until unemployment comes down to 6.5 percent, is an albatross in this environment. It represents a negative real rate of return, yet it is a big part of First Eagle funds.
Indeed, recently the First Eagle Global Fund had 20.7 percent of the portfolio in cash. And that was significantly above its three-year cash weighting of some 15 percent. By contrast, early in 2009, when the market was coming out of a horrific year of losing some 40 percent, the global fund cash component was only some 4 percent, according to Arnhold.
But today because it is carrying an asset that weighs down the portfolio, the funds will sometimes look like also-rans. But, if they continue to follow a strict only-buy-on-the-cheap philosophy, seemingly sluggish performance is inevitable.
First Eagle Global, through the middle of May, was recently up some 7.9 percent. That means, in following its strict value discipline, it was trailing its index by some four percent.
“They just don’t want to buy things without a margin of value and safety,” according to Bridget Hughes, associate director of Fund Analysis for Morningstar. But that buying discipline, she adds, also has a downside.
“They have a conundrum of sorts," she says. "The cash is acting as a drag on performance at a time that cash means a negative real rate of return,” Hughes adds. Meanwhile, she adds, another potential problem with the fund is that investors will be fed up with so-so returns and leave." However, Morningstar backward looking evaluation gives the Global Fund four stars and its forward looking rating is silver.
But First Eagle officials say that’s OK with them if short-term investors cash out. That’s because they only want long-term investors. They emphasize that they “are not asset gatherers.” They will continue to wait for the better times for their style of investing. And that means if markets go deep into a bullish phase, First Eagle Funds buy less and less.
They’re waiting for a market shake out, such as possibly a repeat of the bear market of 1973-74, that will lead to bargain-basement bonanzas. That’s when the market went down some 40 percent over an 18-month period. Buffett, sitting on the sidelines with tons of cash and waiting for the equity fire sales, swept in to buy huge amounts of suddenly cheap, franchise stocks -- stocks with huge market shares -- such as Coca-Cola and Gillette.
Arnhold says First Eagle wants volatile markets so it can do the same: “We’re looking for good companies that are temporarily mispriced,” he says.
The downside of this careful view is that First Eagle funds can look bad into the middle or at the end of bull markets. That’s when First Eagle funds often aren’t shooting out the lights while the top-performing funds are streaking at the height of bull markets. In fact, they can, at times, be trailing their peers by large amounts.
Still, First Eagle officials say that’s not a problem. Indeed, their value-oriented managers say they are content to get somewhat smaller returns in a bull market in exchange for their funds not blowing up in a bear market.
For instance, in 2008, the year of the market meltdown, when the S&P lost some 40 percent, the First Eagle Global lost 21 percent, considerably less bad than the market and better than 80 percent of the funds in its category, according to Morningstar.
But, by contrast, the next year, as markets snapped back, First Eagle Global returned 22.91 percent, which lagged its MSCI index some seven percent. That meant that some 55 percent of funds in its category performed better than First Eagle Global, which suddenly looked like an also ran. But Arnhold insists that short-term performance won’t have any effect on the company’s Graham-Buffett approach.
Indeed, the family’s small gold fund was recently down some 30 percent through the first quarter of the year. But Rachel Benepe, manager of the First Eagle Gold Fund, says she is not going to change the fund’s strategy.
“Gold was up when the market was down 40 percent in 2008,” according to Benepe.
History would seem to support First Eagle’s stand fast and “damn the pricey stocks” pledge.
“In the late 1990s when the stock market was booming for five straight years,” Morningstar’s Hughes notes, “their strategy was questioned when they weren’t getting the returns of other funds in their category. Yet they never changed.”
Sidebar: First Eagle’s Margin Of Safety Explained
Benjamin Graham, the man many First Eagle officials consider their mentor, explains the philosophy that guides investors and fund companies that buy on the cheap.
“The margin of safety is always dependent on the price paid. The margin of safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable balance between price on the one hand and indicated or appraised value on the other. That difference is the safety margin.”
If this strategy is effectively executed, Graham explains, “It is available for absorbing the effect of miscalculations or worse-than-average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results.”
Source: “The Intelligent Investor,” pages 281-82
Sidebar: Helping Germany And Others Become Industrial Powers
First Eagle Funds began life as S. Bleichroder in 1803. In the 19th century, First Eagle’s predecessors were money managers who helped Prussia develop into a major industrial state that prospered and expanded. There was no modern, united German state until 1871. That came after the victory of Prussia over France in a lightning war in which Prince Bismarck’s North German Confederation, whose general staff led by generals Moltke and Roon, used railroads as no nation had ever before, easily defeating Louis Napoleon’s France in the Franco-Prussian War of 1870. First Eagle’s antecedents helped Germany, and the rest of Europe, industrialize. Here is a timeline of the firm’s history:
1803: S. Bleichroder founded in Berlin.
1864: Gebr. Arnhold (Arnhold Brothers) founded in Dresden
1931: Gebr. Arnhold combined with S. Bleichroder
1937: All business moved to New York City under the name S. Bleichroder
1939: Firm named changed to Arnhold and S. Bleichroder
1967: Established firm’s first offshore fund, First Eagle Fund, N.V.
1987: Established firm’s first U.S. registered mutual fund, First Eagle Fund of America
1995: Firm became S.E.C.-registered investment advisor
1999: Acquired a majority share of Societe Generale Asset Management Corp, formed what is now Global Value Team
2002: Sold investment banking and global securities business to focus exclusively on investment management
2009: Renamed firm First Eagle Investment Management
2011: Established high-yield fund
2012: Established Global Income Builder fund
Show Me The Bargains!
May 22, 2013
First rule of investing: Don’t lose money. Second rule of investing: Don’t forget the first rule of investing.