Holding cash and making no excuses

First Eagle fund manager says stock market is fairly to fully priced with pockets of opportunity

Feb 25, 2014 @ 12:01 am

By Trevor Hunnicutt

It doesn't get much more conservative than holding more than a fifth of investors' money in cash and another nearly 10% in gold-related investments. But that's exactly what one First Eagle fund has been doing. Managers of the value-oriented First Eagle Overseas Fund say bargains are hard to come by in a market awash in cash cheapened by the Federal Reserve's loose monetary policy. The fund's one-year performance through Feb. 21, 12.82%, trails by more than 7 percentage points a benchmark MSCI index against which it's tracked, according to Morningstar Inc. But its 15-year return of 13.17% far exceeds the benchmark's 4.60%. InvestmentNews asked one of the funds' portfolio managers, Kimball Brooker Jr., how long they plan to sit on the sidelines.

InvestmentNews: You conceded in your last commentary to investors that your gold and cash exposures hurt you “in relative terms,” yet you continue to hold a lot of both. How long do you intend to do that?

Mr. Brooker: Our default position is cash. And if we can't find something that meets our criteria both for valuation and quality, we won't risk our investors' capital. We think of ourselves as absolute-return-driven investors and think it's risky to chase relative returns, because if you do that you risk incurring permanent impairments down the road.

Temporary impairment is where the stock price moves around, but the value of the business doesn't. You can incur permanent impairment by overpaying for businesses. Even if it's a decent business, you might have overpaid for it. The intrinsic value of a company is different from its stock price.

Purchasing power is eroding through inflation, but at the same time cash has got a lot of option value. It's an option to deploy cash into sensibly priced investments at the right time. Most asset management firms are fully invested and that can come with costs in markets that aren't so pleasant as these.

InvestmentNews: Your team has argued that we are living in a Keynesian mirage. What does that mean and how does it impact your approach to the markets?

Mr. Brooker:The central banks around the world doing what they've been doing, which is to try to create an environment of easy credit, is sort of at the heart of the Keynesian approach to economic policy.

There's an open question as to whether the growth we've been experiencing, whether that's really real, or whether we're just benefiting from the increase in asset prices because of monetary stimulus.

We are very much a bottoms-up investment shop, with a focus on owning the highest-quality businesses we can, with a decent margin of safety between what we pay for the businesses and what we think they're worth.

You've had a decent run here with respect to corporate profitability and you have corporate margins in the U.S. that are very high by historical standards. There's an ongoing debate about whether those margins are sustainably high or whether they will revert to a historic mean.

That's the big macro question. The way that gets translated into what we do on an individual security basis is we'll look at a company time series, let's say profit margins, and we'll try to come up with a normalized number. In the interest of conservatism, we'll use a lower margin to reflect the possibility that the margin mean reverts.

InvestmentNews: You're also finding it “more difficult to find bottom-up opportunities.” Is that still the case?

Mr. Brooker: It's changing a little bit. I still think it's difficult, but one area that's been interesting to watch is, as a number of emerging markets have come under pressure, there have been some companies with exposure to those markets whose stock prices have suffered as investor sentiment has gone from one that was very bullish on the growth of emerging markets to being much less bullish.

It's still not easy to find cheap stocks right now.

But with all that said, I would call the market — we're talking very broadly — I wouldn't call the markets a bubble. They're fairly to fully priced.

But there are pockets of the market … social media looks off to me as a fundamental investor. I'm not sure how you can justify some of those valuations. Someone once said that bubbles are made of dreams, and I think at the heart of a bubble is some game-changing new thing, new way of making money that sort of captures people's imagination. I think that might be what's underlying some of the valuations of those stocks.

It's hard to say that sort of mindset — whether it's a high level of confidence or euphoria — I don't feel that way about the rest of the market, which is one of the reasons why it's hard to say the market is in any sort of bubble territory. There's not the same level of confidence in the psychology of the market at the moment.

InvestmentNews: Are you praying for a bear market so you can start buying again?

Mr. Brooker: This is a be-careful-what-you-wish-for with stocks. Typically, when you have a market correction where sellers are selling indiscriminantly, that's usually not a bad time for us to deploy the cash that we've got. Over the last five years, that happened a few times, but I don't think we need a repeat of 2008-09 to deploy the cash, but a little bit of a break would certainly help us chip away at it.

InvestmentNews: Given your reticence to compete in relative terms, how should investors assess how you're doing? Should investors expect relative underperformance from your fund in bull markets?

Mr. Brooker: We're not going to sacrifice our discipline on price and risk to chase rising stock prices. When you do that you risk losing money later.

Over the long term, because what has tended to happen in strong equity markets, we tend to lag, or historically that's been the case, so I would suggest that if someone were evaluating us that they do it over the long term.

I also think that this approach doesn't necessarily resonate with every investor and so I think the other thing is the mindset that we encourage our investors to take is one of a partnership with us over a long period of time.

We have a conservative and very traditional approach to managing our clients' money and there will be times when it's out of favor. We try to tune out that noise and focus primarily on avoiding permanent impairments and being careful about company valuations, and over time it should do OK.


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