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Richard Bernstein once was a top Wall Street strategist. Now, he's managing investors' money by focusing on markets, weightings and investments styles. An Interview with Matthew McLennan, who is Chief, Global Value Team, First Eagle Investment Management.
"The least worst choice," which is how Matthew McLennan of First Eagle Investment Management describes equities, is hardly a ringing endorsement. But McLennan, who heads the firm's global value team, nonetheless maintains that for stockpickers willing to do the work, there are good opportunities. First Eagle is a value shop, overseen for many years by well-regarded investor Jean-Marie Eveillard, who retired last year. It stresses the importance of finding a margin of safety by investing in companies with strong balance sheets and management teams aligned with their shareholders' interests. McLennan, who joined the firm a little over two years ago after a long stint at Goldman Sachs Asset Management, is carrying on that tradition. The 41-year-old money manager, who grew up in Australia and worked in London, brings a global perspective to his work. His duties include co-managing several portfolios, including the First Eagle Global Fund (SGENX). One area where he and his team believe that they have found opportunities is Japan. The global fund has a three-year annualized return of 3.03%, putting it in the top 5% of its Morningstar category. Barron's spoke with McLennan last week in his midtown Manhattan office. Barron's: You've spent a lot of time reading financial history and biographies. What have you learned? McLennan: If you look at history, there are recurring patterns of behavioral shortcomings, particularly when people act with hubris or haste or some form of dogma. We have certainly seen a huge change in technology over the past couple of thousand years–but not a lot of change in basic judgment. One of the most commonly recurring mistakes that people make is that they think they have a crystal ball and they can predict the future with precision. We've always erred on the side of trying to have the right temperament here, rather than acting as clairvoyants. So our goal is about capital preservation and seeking a margin of safety. What are a few of the key lessons you took away from the recent financial crash? It really reinforced basic principles of prudence, of underwriting and the idea that a margin of safety is not just about price. A margin of safety also has to include other variables, such as the integrity of a company's balance sheet and its capital structure. We also consider how
prudently management acts and the extent to which it is aligned with shareholders. What we saw in 2008, in particular, was the elimination of a lot of businesses that depended upon the confidence of the capital markets to roll over their capital structures. Fortunately, we were not exposed to a lot of those permanent pockets of capital impairment. We were not big holders of the traditional financials, in large part because the way we define margin of safety included capital structure. For example, if you are looking at a wholesale-financed bank and the bank only has 10% equity to assets, almost no matter what you pay for the equity, you are paying at least 90 cents for the assets. That is not a big margin of safety. Besides companies that don't have a lot of debt, what else do you seek in trying to find that margin of safety? We think about it across different time horizons, because we are very long-term investors. And so, from a longer-term perspective, we tend to focus a lot on a company's culture. We also focus on substitute products that could hurt a company's business model. And so, before we even talk about price or capital structure, we are thinking about the long-term drivers of the business. And then, as the time horizon becomes more anchored to our investment horizon, which is the next three to five years, clearly questions of capital structure and integrity matter a lot. It's not just the level of debt, but the term structure of the debt—and how management is evolving the balance sheet over time, whether they are generating free cash flow, living within their means or borrowing to expand aggressively. We obviously prefer prudent evolution and a conservative balance sheet. From a price standpoint, we are very focused on trying to buy businesses at single-digit multiples of EBIT [earnings before interest and taxes] and cash flow. What else do you assess before buying a stock? We think we can buy businesses that are priced for a fade. Yet our analysis suggests that if the culture is strong, the market position is resilient and the capital structure has integrity, it's likely we are getting something for free. Some of the stocks you hold have price/earnings ratios of 14, 15 or higher. That's not dirt cheap. How does a value investor justify that kind of a multiple? In valuing businesses, we look at the overall enterprise. So we view equity as a residual claim on a business, once you have paid off the debt holders, contingent claimants, minority interest and the like. In some cases, P/Es can be distorted in the near term. That can happen if a company's earnings are cyclically depressed or if there is a holding company structure or if there are surplus cash and investments that may not be contributing a lot to earnings. But when you think about the overall enterprise value, those assets can be quite worthwhile. So many of the stocks that we own today hold large amounts of cash, but that cash is yielding nearly nothing. And particularly if you are coming off the bottom of an earnings cycle, the earnings may be depressed. So conventional P/E analysis may suggest that the stock looks a little expensive. But when you think of what you really own as a shareholder– that is, a business that is unlevered and has net cash and you owned it at the bottom of the cycle–there are a lot of ways that can work out well. What did you mean when you described equities as "the least worst choice?"
Our goal at First Eagle has always been about the preservation of capital in real terms. What is tricky is that, incredibly, the real return available in government securities is low or negative in many jurisdictions around the world. And clearly gold, which in some ways serves as nature's currency, has been bid up symmetrically as the real return on creditworthy government paper has come down. As it is being bid up, prospectively you would imagine that the real returns for gold will have to be more modest than they have been historically. So when we look at the goal of preserving capital in real terms, we have to acknowledge that it is difficult to do so in creditworthy government paper, which has low or even negative real returns. We therefore have to look elsewhere to identify attractive real returns. For the equity markets as a whole, the valuations are not extreme. We are certainly not at the bubble levels we saw in the late 1990s. We are certainly cheaper than we were in 2007, but we are not at the bargain level that we saw early in 2009. So what does that mean for investing in stocks? If equities as a whole have broadly rational valuations, a discriminating stockpicker can go beneath the surface. And you don't have to own everything. But you can identify real businesses at real prices. And so we are gravitating toward stocks, which are roughly threequarters of our global portfolio. What is your gold weighting? We have approximately 10% of the portfolio in gold bullion and gold equities. Gold for us has been a source of ballast, if you will. We view it as nature's currency that can't be printed and, thus, its value tends to go up at times when faith in the current monetary architecture is lowest. And its value tends to go down, as it did in the late 1990s, when faith in that architecture was higher. Why do you have a big weighting in Japan? About 20% of our global portfolio is in Japan, which clearly has gone through a difficult couple of decades. In Japan, we look for individual securities, rather than the stock market as a whole. This year, some of our best investments have been in Japan, despite the fact that the Japanese market has been somewhat sluggish. Can you name some companies you like? Industrials have done well for us in Japan over the past 12 months. If you think about China over the past decade, it has largely been a story of urbanization and the Chinese buying iron ore and copper and looking to build out cities. But what we are seeing more of is the need for the Chinese, the Indians and the industrializing countries of the world to invest in their intangible capital stock. And the Japanese industrial companies, whether it is in fields like robotics, pneumatics or electrical sensors, own a lot of the intellectual property that those emerging economies will need. Some of these Japanese companies performed very well coming out of the crisis. If you looked at the companies that we own like SMC [6273.Japan], a big player in pneumatic systems, its shares were quite depressed at the market trough. But it had a huge net cash position as a percentage of its market cap. And so, as the economic backdrop has normalized,
those businesses have performed quite well over the past 18 months. SMC is up 40% over the past year, in local currency.
Company HeidelbergCement Cintas Pargesa Holding Source: Bloomberg Let's talk about another stock you hold. HeidelbergCement [HEI.Germany] is listed in Germany, but the majority of its profits come from outside Germany. The majority of their business is in the production of cement and the mining of quarry aggregates. They have a dominant position in the Eastern European cement markets and in rapidly growing emerging markets like Indonesia. They have a strong market position in Africa. They are the No. 1 cement producer in western Canada, around the oil sands, and they are a dominant player in Scandinavia. Here is a company with a very strong position in markets that have structural growth, long-term, so it should be able to grow with attractive returns on incremental capital. Its quarry and aggregate reserves are very longduration assets with 50 or 60 years of reserve life. Obviously, in the current environment when people don't like European cyclicals, the stock is out of favor. And the construction industry has been quite depressed. That presents an opportunity. The stock's P/E is in the midteens, so what makes its valuation attractive? Its earnings are very depressed. And if you look at its current Ebitda [earnings before interest, taxes, depreciation and amortization], it is probably one-third below its sustainable level, looking out a few years. But our average holding period is five years. We also like Cintas [CTAS], the uniform-rental company based in Cincinnati. For us, a mundane business can be beautiful, and Cintas is an example of that. In their core Midwestern markets, they have nearly 40% share. It is a business where there are local economies of scale. What's to like about this business? Shares of uniform-rental company Cintas are underpriced. Barron's Clare McKeen reports. They typically rent uniforms for not much more than a dollar a day. As the economy transitions from traditional manufacturing to services, there are a lot of situations where uniform rentals will be required. Whether it is a fast-food outlet or a hotel, many businesses find it more cost-effective to outsource their uniform needs. With employment markets depressed now, the end markets for Cintas are fairly depressed, as well. So the current cashflow stream is below its potential. But Cintas has a long-term, sustainable competitive advantage. It has a very seasoned management team. Scott Farmer, the CEO, is the son of the founder, and Robert Kohlhepp, the chairman, has been with the company since the 1960s. We Ticker HEI.Germany CTAS PARG.Switz Recent Price €45.35 $28.38 81.20 CHF
own stock along with key family members, so we think there is an alignment of long-term interests. Despite the tough environment, the company has close to $3 a share of free cash flow, and the stock is around 28, as we speak. The stock was north of 40 a few years ago in a better business environment, and here is a company that has earned a lot more than it has recently. The valuation for Cintas is quite conservative. You are paying probably seven or eight times normal EBIT for a business probably worth a low double-digit EBIT multiple over time. How about one more stock? Pargesa Holding [PARG.Switzerland] is a Swiss-based holding company, and it is a good example of the way we look to create value at First Eagle. Pargesa is a leading shareholder in Total [TOT]; Lafarge [LFRGY], a competitor of Heidelberg's; GDF Suez [GDFZY] and others. It's one of the leading investors in each of those companies, and has board representation. Pargesa's larger investments, like Total, Lafarge and GDF Suez, trade around five times next year's cash flow—so they're arguably cheap themselves. And Pargesa trades at more than a 20% discount to the sum of its listed investments. And its management team is a thoughtful capital allocator. Thanks, Matthew.
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