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Making the Best of "The Least Worst

Choice"
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 three-
quarters 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.

McLennan's Picks

Recent
Company Ticker Price
HeidelbergCement HEI.Germany €45.35
Cintas CTAS $28.38
Pargesa Holding PARG.Switz 81.20 CHF
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 long-
duration 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 cash-
flow 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
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.