Matthew McLennan

Uploaded by WealthTrack on 21.09.2012

CONSUELO MACK: This week on WealthTrack- in a world littered with investment choices,
why First Eagle Funds’ Matthew McLennan values scarcity and resiliency in his portfolios.
A next generation Great Investor Matthew McLennan is next on Consuelo Mack WealthTrack.
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Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Have the financial markets
become more stable? Is a sense of equilibrium returning to the global financial system?
Several widely followed measures would seem to indicate yes.
First of all, the stock markets have been on a roll. Year to date, the S&P 500 is up
by double digits. On closer inspection, one stock has had an outsized impact. Apple’s
stock has been a huge contributor to the market’s success. Its stock has more than doubled this
year. It now represents about 5% of the value of the entire S&P 500 index, and it is the
world’s most valuable company. It is also the market’s third largest dividend -payer
after Exxon Mobil and AT&T! So to a certain extent, the market is captive to Apple’s
A bigger influence is the overall outlook for earnings, and they are going in the wrong
direction. According to Standard & Poor’s, analysts are trimming their earnings forecasts
for this year and next, as are companies themselves. The Financial Times recently reported that
companies were three times more likely to say they would miss analysts’ expectations
than beat them during the recent earnings season.
There is one area however where a decline is welcomed by most: in market volatility.
A chart of the Market Volatility Index or VIX tells that story. The VIX, which hit record
highs during the financial crisis and has periodically come back to haunt investors
since, has subsided this year. Do we dare breathe a sigh of relief? Look to Fed chief
Ben Bernanke and European Central Bank President Mario Draghi for that answer. Recently their
words and actions to boost world economies have had a calming effect here in the U.S.
and in Europe, but for how long?
That is one of the questions we will put to this week’s guest. He is Matthew McLennan,
head of First Eagle Funds’ Global Value team and since 2008 portfolio manager of the
flagship First Eagle Global Fund, as well as its Overseas and U.S. Value mutual funds.
First Eagle Global is five star rated by Morningstar because of its outstanding track record and
focus on capital preservation. I began the interview by asking Matt why he is worried
about what is below the seemingly placid financial surface, what he calls a “collision of macroeconomic
tectonic plates.”
MATT MCLENNAN: Well, you're absolutely right to say that there's not enough fear out there
for us to feel emboldened. In fact, there is an emergent sense of complexity, or complacency,
I should say, in markets, and complexity in the macroeconomic fundamentals.
I think it's helpful just to look at some basic statistics. I mean if you go back in
time a dozen years ago to around the Y2K time frame, the U.S. was clearly the largest provider
of global savings and investment. The gross level of savings in the U.S. was about $1.8
trillion then. And China back then was only $440 billion. So the U.S. was the key driver
of marginal savings and investment behavior in the world and people knew what the Washington
consensus stood for. Whether they liked it or not is another thing, but there was a defined
paradigm for the world economy. If you look at those numbers today, according to IMF forecasts,
the U.S. level of gross national savings is roughly the same, $1.9 trillion.
CONSUELO MACK: Than it was over a decade ago.
MATT MCLENNAN: Exactly. Yet the nominal economy has been inflated by virtue of the Feds easing
activity. So as a percentage of our economic output, savings have gone down. On the flipside,
Chinese national savings are around 3.8 trillion. So they're up over eightfold during that period.
So there's a massive change in the structure of the world economy in terms of where the
incremental flows are. And I think people have yet to come to terms with that. We don’t
know what the Beijing consensus is. And we don't exactly know who the leaders will be
in Beijing next year, nor in America, for that matter. And so that's a very important
tectonic collision of macro plates, that shifting imbalance, different regimes, different ways
of thinking, and a market that's not fully developed at this point in time, and that
can play out in very complex ways.
CONSUELO MACK: Right. So what's the greatest danger of this imbalance, as far as we are
concerned as investors?
MATT MCLENNAN: Well, I think there are a couple of dangers. The first thing is that if the
U.S. is running a savings shortfall or a current account deficit, then that savings shortfall
has to shop somewhere in the U.S. economy. Now it was in the private sector in the late
'90s and the mid-2000s , with the capex bubble, and the equity bubble, and then the real estate
bubble, but if there's a shortage of savings in the private sector that means credit growth.
But the private sector of the U.S. economy is now in deleveraging mode.
CONSUELO MACK: Right. At least the consumer is.
MATT MCLENNAN: Exactly. And the corporate sector balance sheet is pretty strong as well,
which means that all of the re-leveraging or all of the savings shortfall has to occur
in the government sector of the economy. So we're locked into these structural fiscal
deficits that are larger than our current account deficit. And so if you think about
that all of a sudden, it presents an ugly potential situation, because in order for
that level of debt to be sustainable, the Federal Reserve really over time has to grow
the nominal economy and money supply faster than the size of the deficit as a percentage
of GDP. So you have an imbalance, you have a fiscal deficit that's greater than that
imbalance, you have money supply growth that's greater than that, and by the way, if we're
ever to rectify that imbalance, the Chinese money supply growth has to be faster. So in
a way, the bad price of money, the bad exchange rate between China and the U.S. has created
a contagious effect. Bad money creates bad money. And here we are at a stage in U.S.
history where the Fed is committed to printing money. It's on its third round of quantitative
easing. And it's very hard to earn a real return now for U.S. citizens.
Ultimately to be resolved, you're going to have deflationary pressures in the U.S., which
are hard to absorb socially, because people have built vulnerable capital structures.
We expect that we can have stable nominal GDP growth. On the flipside, in China, if
they take an inflationary path to solve their problem at a time of slowing growth, that
could cause great social concerns at a time of political change. So these macroeconomic
tectonic plates create social issues. And, in fact, the competitiveness imbalance between
regions has, in large part, fueled the growing wealth gap that we've seen in the United States.
And this is part of the problem, you know, our policy framework is trying to solve a
local problem, but the true problem is global in nature.
CONSUELO MACK: So First Eagle Global, First Eagle funds, your mission is to avoid the
permanent impairment of capital. How are you doing that in this kind of an environment?
MATT MCLENNAN: It's critical that people understand what risk really means, and people think of
risk typically as a statistical construct, as price volatility, but you're absolutely
right in suggesting that true risk is downside volatility, capital impairment that's permanent
in nature, and what's also important is that it has to be thought of in real terms. And
the problem is …
CONSUELO MACK: Taking account of inflation.
MATT MCLENNAN: Absolutely. And if you think about the structure of asset markets today,
buying a ten-year government bond means locking in a negative real return for ten years. That
is a permanent impairment of capital in real terms. So while people might say the treasury
is the risk-free asset, it's actually guaranteed wealth destruction in real terms. It's just
amortized across time. In countries that can't print their own money, there's the very real
prospect of default, like Greece. In countries with challenged sovereign credit metrics,
like the U.S. that can print their own money, you get this phenomena that's essentially
akin to an amortized default. And so for us at First Eagle, the answer isn't simply in
owning long-term government bonds. If you want to preserve your capital in real terms,
you have to be willing to own real things, and for us that's primarily the ownership
of businesses and businesses that are traded with a margin of safety in price.
CONSUELO MACK: So what is it about a company, what's the characteristic that gives you that
margin of safety where it won't go down so much in value that you're going to have a
permanent loss of your value?
MATT MCLENNAN: You're absolutely right to distinguish between permanent and temporary
impairment of value. Whenever you buy into an individual company, you own some of the
stock, you're going to have price risk. But you have to distinguish between price risk
and the risk that the permanent value of that company is impaired. And so we look for a
few things, but one of the most important things that we look for is scarcity. You see,
if a company owns a tangible asset that's supply constrained, like with the ownership
of a precious metals mine or something of that nature, or a timberland, or if a company
owns an intangible scarce asset, which can be a dominant market position, for example,
that enables it to have pricing power over time, there's an asset there that ought to
accrete in value over time as the Fed and the monetary authorities of the world inflate
the level of nominal GDP You can preserve your earnings power against that inflation
strength. You can't do that in a treasury. So scarcity is important.
CONSUELO MACK: So let me stop you there. Scarcity. You mentioned that there are a couple of kinds
of scarcity. So one is the scarcity of a tangible asset. So give us an example of that.
MATT MCLENNAN: Well, the ultimate scarce tangible asset is gold. It's nature's currency. It
can't be printed. There's less than one ounce per capita in the world. And the supply is
stable, because all the gold that's ever been mined is still in existence. So it's not linked
to the annual supply. So we know with virtual certainty what the supply of gold will be
over five, ten years. And it's certainly growing less fast than the supply of money. So gold
is a natural commodity that is scarce. And that's why people hoard it in vaults. But
our belief at First Eagle is if you're willing to hold gold in the vault, you should be willing
to hold it in the dirt via an equity if you can get it even cheaper. And so there could
be companies like a Newcrest, for example, that own vast gold reserves in Australia,
Papua New Guinea, Indonesia, where if you look at the cash costs of them extracting
that gold out of the ground and then you look at their enterprise value per ounce, you're
buying the gold a lot cheaper than you can buy it spot.
CONSUELO MACK: So typically, the First Eagle Global fund, for instance, has about ten percent
in gold or gold stocks, right? And you've always talked about it being nature's currency,
but also, as you were just describing, there's a new attribute, which is as a currency substitute,
right? So gold has an even more allure than it has had in the past.
MATT MCLENNAN: You know, the Fed is, in a sense, playing with fire here with its quantitative
easing. They're trying to turn cash into trash. They want people to go out and buy risk assets,
yet if you think about it, it is a risky situation. Number one, for the reasons I mentioned before,
it exacerbates the savings investment imbalance. It doesn't fix it. Number two, if you're trying
to turn cash into trash, you risk losing control of the whole expectational framework around
what constitutes money. And the risk for the Fed is that the gold genie is out of the bottle.
If you look at how gold is trading now relative to other commodities, relative to where it's
traded over the last decade or two, it's starting to trade at a premium that reflects its monetary
character. Furthermore, central banks have started buying gold for the first time in
a generation. So there is a very delicate cusp point here. If the fiscal authorities
of the world are letting the stock of government debt get high relative to national savings,
and if the monetary authorities are essentially expanding the money supply and keeping the
real interest rate below its natural equilibrium level, then all of a sudden people look for
an alternative form of money that's less ideal and more real, and there's risk in trying
to turn cash into trash.
CONSUELO MACK: And yet you've told me the past that basically 10% is kind of the limit
that you'll go to in First Eagle, but the situation that you're describing to me, which
seems to be a long-term trend of cash being turned into trash, why wouldn't gold have
a larger part of your portfolio?
MATT MCLENNAN: Well, I think one of the things that's worth really reflecting on is that,
and it's sort of second fault line that's out there in terms of the global economic
substructure, is the fiscal situation of the world. Now if you have a continued monetization
of the fiscal deficits, then you're absolutely right, that the equilibrium value for gold
goes up over time. But there are the scenarios. If you think of the ECB's actions in the last
couple of weeks, committing unlimited amounts of money to buy short-term government bonds
in trouble peripheral countries like Spain and Italy…
CONSUELO MACK: European Central Bank. Right.
MATT MCLENNAN: …it wasn't an unconditional commitment. It was a commitment that they
would do it if those countries signed up for macroeconomic adjustment packages, which are
deflationary in nature. Fiscal austerity. Maybe one of the reasons the Fed has embarked
upon this third round of quantitative easing is that it's starting to worry about the probability
of us going across the fiscal cliff, and the Congress, the Senate, the new president, whoever
it might be, not coming together to actually resolve the differences, and us having a very
meaningful fiscal contraction next year. We could enter a window of time where the markets
start to factor on the need for fiscal austerity. That may not necessarily be a great environment
for gold. Now if we knew exactly what was going to happen one way or the other, we'd
either have all gold, or all cash, or all equities. We don't. And so the fact that it's
there almost as a monetary reserve for us is really more of an expression of humility
and the fogginess of our crystal ball.
CONSUELO MACK: So the other part of scarcity, which is you were saying is a brand, or a
product, or whatever, so give us an example of what you mean by that. Frequently, they
call it a moat, right?
MATT MCLENNAN: A moat, in common terms. And it's an intangible asset. It's something that
doesn't show up on the balance sheet, but it's every bit as valuable as a tangible asset.
If you're a company that dominates a narrow slice of the world economy, you have economies
of scale. It makes it very hard for someone to compete with you on equal terms. It means
that the duration of your business is likely to be longer. It means that you have a degree
of pricing power. A combination of pricing power and duration mean that you have an asset
that's more real in nature. And that's what we look for in businesses. We don't always
find it, but when we do, it's very appealing.
And you'd asked earlier what stops permanent impairment of capital. If you have some form
of scarcity and duration, and you combine that with a strong capital structure, limited
amounts of debt, so that the assets don't transfer to the debt holders, and a management
team that operate prudently, you have scarcity and resilience. And that's really what we
look for at First Eagle, and we look for it in equities primarily, because that's where
the biggest volatility is, and, therefore, the biggest price margin of safety.
CONSUELO MACK: So looking at your top holdings, for instance, what are a couple of companies
that would fit that bill, that have that intangible scarcity factor?
MATT MCLENNAN: And it can be in sort of quirky areas. So for example, one of the larger holdings
we've had the last few years has been FANUC, in Japan, which is essentially dominant in
the world of server motors and robotics. Our team members have just returned from the great
industrial show in Chicago, and looking at all the new factory automation equipment that's
out there, and FANUC is absolutely dominant in the areas in which it competes. So in a
sense, you're not betting in buying FANUC on which auto company is going to win the
competitive war; you know that the FANUC equipment is likely to be used in those auto factories.
And if you have a dominant market share, you have good margins. FANUC has had 40% margins
through the cycle. And if you've got a profitable business like FANUC, with those intangibles,
you don't need debt. They have net cash. And adding to the scarcity is not just the market
position, but they've used some of their free cash flow over time to buy back stock. So
you've got declining shares and increasing business quality. We call it the Bordeaux
test. Is the business going to get better with the passage of time, and is the supply
going to shrink with the passage of time? It's like a great vintage Bordeaux.
CONSUELO MACK: Looking at your top ten holdings, for instance, and other characteristics, it's
a very eclectic portfolio. Is that intentional? You know, why is variety important at First
MATT MCLENNAN: We very much value trying to find eclectic royalties. I think if we're
owning slices of the world economy in unrelated areas, what we're doing is essentially creating
an ability to participate in that growing nominal stream with less risk. And often it's
the eclectic markets that end up getting dominated. You know, the big markets have many, many
players in them. And many companies are strategically attracted to them. Think of how many banks
there are, for example, or think of how many pharmaceutical companies there are. It doesn't
mean that there aren't attractive investments. But the companies that really own markets
tend to own eclectic markets. And for us, if we can't find scarcity in the price, in
a tangible asset, for example, like gold, or precious metal reserves, or in an intangible
asset like a strong market position in an eclectic slice of the world economy, the scarcity
has to be in the price. So we do have some more mundane businesses in our portfolio,
but the scarcity, therefore, has to be in the price.
CONSUELO MACK: Another characteristic that you've described to me that you look for at
First Eagle is resiliency. So what is it that makes a company resilient?
MATT MCLENNAN: Well, it's a combination of all the things we've spoken about. It's the
strength of their market and the stability of their market position. It's the capital
structure that enables you to endure crises.
CONSUELO MACK: And when you're talking about the capital structure, again…
MATT MCLENNAN: We're looking at the level of debt relative to cash flow. And also the
term structure of the debt. We like companies that have got well-turned out debt. So if
we get into a window of crisis-- let's say we go over the fiscal cliff in the United
States. There's a fiscal crunch in the south of Europe, and markets actually go down 20
or 30% over the next 12 months. It's possible. If that were to happen, if we were going to
lose access to the issuance market for debt, then what would be able to endure that? Many
of the companies we've talked about today would go down in price, but they would survive
through that period, and, in fact, they'd come out the other side thriving, because
their competitors might fail. And the final factor is really the management D&A. We like
managements that tend to run their businesses within the free cash flow generation of the
CONSUELO MACK: So what does that mean? Within the free cash flow generation of the business?
MATT MCLENNAN: Absolutely. A good business generates free cash flow.
MATT MCLENNAN: And a disciplined management spends not all of that free cash flow. They
return some of it to shareholders.
CONSUELO MACK: In the forms of? Is there a preference?
MATT MCLENNAN: Dividends. Repurchase.
MATT MCLENNAN: But the point being that if they're returning a meaningful portion of
that capital to us as shareholders, it means that they're being disciplined about how they
expand the business.
CONSUELO MACK: So is there a company in your portfolio that kind of personifies that?
MATT MCLENNAN: Well, a good example of a company that's done all of that is a company that's
really going through its own Pepsi Challenge right now, which is Microsoft. People love
to hate Microsoft. Yet, it's a truly embedded company. If you think of the IT departments
of most world companies, they're based around supporting Microsoft software- be it office
products, be it the email systems, be it the service. Microsoft powers not only the majority
of operating systems in the world, but 75% of all servers in the world. So they're truly
embedded in the enterprise, and a lot of their revenues are recurring. And if you look at
their EBIT stream, or their operating profit stream over the last decade, it looks more
like a consumer staple than it does a tech company.
So there's a business that has a dominant position. That dominant position has translated
through to its earnings power growing with the world nominal economy. It's listed in
the U.S., but it's truly global. It's not in a play in one part of the world economy.
And during that period of time, they've shrunk their share account quite dramatically, so
the intrinsic value is accreting on a per share basis, and you have a dividend yield
that's nearly twice that of the Treasury.
CONSUELO MACK: Right. So is that your One Investment?
MATT MCLENNAN: I think it's a good place to start.
CONSUELO MACK: It's a very good place to start. A couple of more things, and one of the things
that you've mentioned to me in the past as well is that with fear seeming to have subsided,
and you consider fear to be your friend, so does that mean that there are fewer investment
opportunities because the markets are not as fearful as they have been in the past?
MATT MCLENNAN: It's a great question. I mean if you look at what we've done this year,
I would characterize it as a period of aggressive reflection and selective action. And most
investors, by the way, do the opposite, aggressive action and selective reflection. We've had
very low turnover this year. As the asset prices have moved up, it's been harder to
find the kind of businesses we've been talking about at the kind of margin of safety that's
attractive to First Eagle as an investor. So we have been doing less purchasing this
year. And the cash levels in our portfolio have drifted up as a residual of our underwriting
discipline. And so we've seen our cash levels from low double digit levels over the last
couple of years to closer to 20 percent of our portfolio. So if you take the cash and
the ten percent in gold, we do have material ballast in our portfolio. And so we don't
think the world is perfect. We own assets that we think are the least worst, decent
businesses at decent prices.
But, you know, when the markets are complacent, you know, when credit spreads have come from
very wide to more normal levels, when the high-yield markets are open for issuance,
when implied volatility has gone from very high levels to the below average levels, when
equity markets have kind of clearly come out of distress, that's not a time to be bold.
It's the time to be a little bit patient. Even though we're not being paid on the cash,
we know, given the fault lines that we've talked about, there could be things that pressured
the markets in the months or the years ahead, and we'll be able to take advantage of that.
And we'll be able to commit capital at the stress valuations, and we won't be a fore-seller.
And so we're willing to kind of do what's in finance seen as theoretically suboptimal,
to run with some excess liquidity, so that we can put it to work on advantage terms in
a more distressed moment.
CONSUELO MACK: Time to be reflective. Matthew McLennan, First Eagle Funds, thank you so
much for joining us.
MATT MCLENNAN: It's really been a pleasure. Thank you for having us.
CONSUELO MACK: At the end of every WealthTrack, we try to leave you with one suggestion to
help you build and protect your wealth over the long term. This week’s Action Point
follows a key theme of Matt McLennan’s. It is: consider owning some scarce resources
in your portfolio. The laws of supply and demand are alive and well. And there are areas
where supply is constantly constrained. They are not making any more gold, or land for
A widely held ETF is SPDR Gold Shares, symbol GLD. Timber growing companies are another
favored by both First Eagle and the Harvard Endowment among others. There are index funds
that specialize in timber companies and there are a few ETFs that track them. One is the
iShares S&P Global Timber & Forestry Index. That symbol is WOOD. How appropriate it that!
I hope you can join us next week. Financial Thought Leader Jim Grant takes on the Fed,
calling its unprecedented involvement in the credit markets, “price controls” and “central
planning, not banking.” And to see this program again, please go to our website,
It will be available as a podcast or streaming video. You can also see additional interviews
with WealthTrack guests exclusive to our new and improved WealthTrack Extra feature. And
that concludes this edition of WealthTrack. Thank you for watching. Have a great weekend
and make the week ahead a profitable and a productive one.
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