Buying Income Within a Margin of Safety

Transcription

1 R E P R I N T E D F R O M F E B R U A R Y 1 6, Buying Income Within a Margin of Safety ROBERT HORDON, CFA, has been Portfolio Manager of the First Eagle Global Income Builder Fund since its inception in 2012, and he joined First Eagle Investment Management in 2001 as a Risk Arbitrage Analyst, covering a wide range of eventdriven investments. In addition to his portfolio management duties, he is currently a senior analyst on the First Eagle Global Value Team, which he joined in Prior to joining First Eagle Investment Management, Mr. Hordon worked in the equity research department of Credit Suisse First Boston. Mr. Hordon received a BA in politics from Princeton University and his MBA from Columbia Business School. EDWARD MEIGS, CFA, has been Portfolio Manager of the First Eagle Global Income Builder Fund since its inception in 2012, and he joined First Eagle Investment Management in September 2011 as a Portfolio Manager of the First Eagle High Yield Fund. Prior to joining the firm, Mr. Meigs was a portfolio manager of the Dwight High Yield strategy at Dwight Asset Management Company LLC. Previously, he spent four years at Mount Washington Investment Group as a high yield portfolio manager. Prior to that, he served as Vice President at Falcon Asset Management. Mr. Meigs began his career at Wheat First as a credit analyst. Mr. Meigs received his AB from Occidental College and his MBA from the Kellogg Graduate School of Management at Northwestern University. SECTOR GENERAL INVESTING TWST: Please start by telling us about First Eagle Investment Management. Mr. Hordon: First Eagle Investment Management is a privately held firm. We have approximately $100 billion in assets under management. The vast majority of our assets are concentrated in a handful of funds that follow an absolute-return-oriented, longterm value approach with a clear focus on avoiding permanent impairment of capital. I would describe us as cautious bottom-up investors who require a margin of safety in price, balance sheet and business quality across all of our holdings. TWST: The First Eagle Global Income Builder Fund has two sides: the equity side and the fixed income side. Why did you decide to combine those two pieces in one fund? Mr. Hordon: The fund was created in response to feedback that we received from clients who were interested in an investment option that had a material income component in addition to all the other attributes that our clients typically look for in our funds. We saw this as reflecting a structural change in the investment preferences or requirements of our client base. As the world ages, and more and more savers approach or enter retirement, there is a shift in emphasis from capital accumulation toward capital distribution. At the same time, we now live in this ultralow interest rate environment where traditional approaches to generating income through investments such as CDs or government bonds have become relatively ineffective. Although our funds have never had a specific income mandate, we have always been investors in high-dividend- M O N E Y M A N A G E R I N T E R V I E W

2 paying stocks. That stems from our preference for cashgenerative businesses that trade at low valuations and are run by prudent capital allocators who believe in returning capital to shareholders, either through dividends or share buybacks. We have also always been investors across the capital structure and have always looked to buy debt instruments that might offer an attractive, relatively secure return with lower downside risk potential. So in 2011, First Eagle Investment Management recruited Ed and his partner, Sean Slein, and the other members of what is now the First Eagle credit team with the idea that they would help us identify attractive margin of safety opportunities within fixed income, especially high yield, which is their area of expertise. They shared our focus on fundamental bottom-up research as well as our emphasis on careful valuation work. They also had a demonstrably successful track record applying this value-based approach and have done a solid job preventing permanent impairment of capital in periods of volatility, especially the financial crisis in TWST: What is your actual process or strategy for deciding what goes into the portfolio? How do you come to that decision? Mr. Meigs: As Rob mentioned, everything really is done from a fundamental bottom-up basis, either on the equity side or the fixed income side. We like to say that the securities are considered because they generate income, but Highlights Robert Hordon and Edward Meigs discuss the First Eagle Global Income Builder Fund and their investment philosophy. The fund invests in both equity and fixed income, and Mr. Hordon and Mr. Meigs use a bottom-up process to select investments. In addition, they look for securities that generate income within a margin of safety in price, balance sheet and business quality. Mr. Hordon and Mr. Meigs manage the fund with a benchmarkagnostic position and aim to buy securities at a discount to what they believe the business is actually worth. Companies discussed: ACCO Brands Corporation; MeadWestvaco Corporation; Mandarin Oriental International Limited; Jardine Matheson Holdings Limited; Plum Creek Timber Co. and Microsoft Corporation. for long-term capital appreciation. The fixed income side is there to anchor the income stream that is distributed to owners of the fund, although income generation is not guaranteed. So as such, the allocation of the fund is not done from a top-down basis. We don t predetermine that we are going to have a specific split between equities and fixed income. We generally spend around 50% in equities, hold some cash as deferred purchasing power and also some dividend-paying gold mining stocks, perhaps some gold bullion, and then the balance in fixed income instruments. TWST: Do holdings in one part of the fund impact holdings in another part, or are the decisions made separately? Mr. Meigs: We certainly are going to be cognizant of industry exposure. We aren t operating in separate silos, and we would want to be aware of industry exposure in each portion. In general, it is a little bit of apples and oranges because of the nature of equities versus fixed income, but yes, we are aware of selections on both sides when we make decisions. Clearly, there s only a set pool of assets. So if we do determine, as a team, that we are seeing more value in fixed income classes, then the equity percentage may come down a little bit and vice versa. If we are not seeing value in fixed income areas, and we are seeing value on the equity side, then that percentage would increase. On the other hand, if we were in a situation where we are viewing all asset classes as overvalued, we probably would defer to a larger cash position. On a case-by-case basis, we are able to find dividend stocks often in more cyclical companies, holding companies or out-of-favor sectors where we think the dividend yields are high, but the valuations are more reasonable. That has been an important theme for us. they will only be purchased because they have an appropriate margin of safety. The fund has a dual mandate of seeking current income generation but, at the same time, providing capital appreciation over the long run. So you ve got the two pieces. The equity portion should provide a certain level of income, and it should provide the basis TWST: You have about 5% cash right now. What do you evaluate when you re looking at how much cash to hold? Mr. Hordon: Cash can be thought of as the residual of our bottom-up approach. To the extent we are finding attractive value opportunities, we will be investing the cash, and to the extent that s more difficult, the cash will tend to build. This

3 actually relates to what Ed was just talking about in terms of the broader asset-allocation question. In periods of distress when risk assets are attractively valued, you would likely see the fund own more risk assets, especially equities. The idea with cash is that it is available to be deployed in periods of real dislocation in the market and to take advantage of that. On the other side, in periods where risk assets have become expensive, where there is a lot of complacency in the market or a lot of optimism priced into securities, you could see the cash portion build, and you could see the higherquality fixed income part of the portfolio also grow. It s really a reflection of the extent to which we re finding opportunities in risk assets in the market. TWST: On the fixed income side, where are you seeing some interesting opportunities right now and why? Mr. Meigs: We really think there is more value in credit right now, and we ve been concerned about taking duration risk. The bulk of the fixed income portfolio is currently invested in high yield bonds and leveraged loans. We do focus on the higher-quality end of the spectrum so that we are really BB and B players. There is not a prohibition on owning CCCs, and there are a couple in the portfolio right now, but we think the ones we own generally have more of the characteristics of a low-b credit. We are not looking to chase yield by taking undue risk and purchase a lot of CCC or distressed securities. Mr. Meigs: Those two names are interesting because the investment thesis is different in those two names. ACCO Brands (ACCO) is one of the world s largest suppliers of branded office products. They make Swingline staplers, Day- Timer planners and those types of supplies. They issued bonds to lever up to purchase the office products division of MeadWestvaco (MWV), which was a strategic acquisition that we viewed very favorably, a situation where they clearly would be able to recognize significant synergies. Management has been focused on delevering over the last few years. The great thing about this situation is that you have a management that both has the ability to delever and also has the desire to delever. This is a company that generates over a $100 million in free cash annually on a base of net debt of just over $800 million and, at this point, also has strong interest coverage of over five times. The company is focused on reducing debt. Bi-Lo is a southeastern U.S. supermarket chain. They purchased Winn-Dixie stores and have done a good job improving the profitability of those stores, so we ve been happy with management. The equity sponsors have been relatively aggressive as far as taking dividends out, which is something that we don t tend to view favorably. We are also cautious about roll-ups or especially acquisitive companies, but Bi-Lo proved that they could do a good job as far as bringing in the Winn- Dixie stores and increasing profitability there. We look to avoid those pockets of overvaluation, and with every individual investment we are making, we try to control risk by making sure that the price we pay reflects a discount to what we think the business is really worth. TWST: What is the geographical exposure right now in fixed income? Mr. Hordon: Right now, it s about 25% non-u.s. That is where our bottom-up fundamental analysis is leading us. Mr. Meigs: In recent months, high yield as an asset class has not performed particularly well, and that was largely driven by the impact that the sharp selloff in oil has had on the credit market. A large portion of recent high yield issuance has been in the energy sector. So we have actually added to our exposure to high yield in the past few months where we have seen some dislocation, not just in the energy sector but across the board in the asset class. The goal is to take advantage of spillover effects from the more severe impact on energy credits. TWST: Looking at the top 10 holdings on the fixed income side, you have ACCO Brands and Bi-Lo. Why do those two bonds match your philosophy and strategy? They continue to be acquisitive, and they hit a little bit of a speed bump this year as, I think, maybe they bit off a little more than they could chew by making a couple of acquisitions at the same time as they were transitioning their distribution network. So the company, in 2014, had a tough time in making all those changes. We do still have confidence in the company, and they actually just brought on board a new CEO who looks to be very accomplished, and we believe that once again the company may be able to improve margins and, therefore, delever. TWST: What types of equities are attracting your attention right now? Mr. Hordon: To build on the theme we talked about on the fixed income side, where we are favoring credit over duration, on the equity side, when we are looking at the universe of income-producing stocks, we see more value in names that don t have a lot of interest rate sensitivity. So

4 traditional equity income sectors, like utilities or real estate investment trusts, generally strike us as being potentially fully valued or overvalued. On a case-by-case basis, we are able to find dividend stocks often in more cyclical companies, holding companies or out-of-favor sectors where we think the dividend yields are high, but the valuations are more reasonable. That has been an important theme for us. At the same time, the divergence of performance between the U.S. equity market and international equity markets was quite pronounced in Along with the sharp depreciation of many foreign currencies, which has had a big impact on valuations, we think on the margin this creates some more interesting opportunities internationally. TWST: The top 10 equity holdings include Mandarin Oriental and Plum Creek Timber. Can you talk about those two? Mr. Hordon: Mandarin Oriental is an interesting security in our eyes. It is differentiated among the other names you will see in the top 10 because it is a more illiquid small-cap name, which has about a $2 billion market cap, but only about $500 million of that is available in the public float. The company is about 75% owned by a Hong Kongbased holding company, in which we are also investors, called Jardine Matheson, and we ve really come to know the Mandarin Oriental business through our ownership of Jardine Matheson over the years. Mandarin Oriental is a high-end luxury hotel chain that has an attractive valuation. On top of the real estate value of the company, which we believe exceeds the enterprise value, they have a successful and vibrant hotel management business where they basically collect fees without extending capital. It s a very high-margin income stream, managing hotels and residences under the Mandarin Oriental brand for other landlords who are the owners of the property. There is a strong backlog of opportunities there. It is a growing part of the income stream that has nice traction in mainland China. So they are building up their brand in China without risking much capital, which is important, because Chinese tourism abroad is growing at a healthy clip and is expected to be an important source of demand for the global tourism industry in the future. On top of this, we are getting about a 4% dividend yield out of the stock. Plum Creek Timber is one of the largest private landowners in the United States with nearly 7 million acres of timberlands across 19 states. It is now one of the top 10 holdings of the Global Income Builder Fund. As a firm, we have been involved with it for many years. We find Plum Creek Timber attractive for several reasons. First, from a valuation perspective, we think the prices that are currently being paid for timberlands in the private market would support a materially higher valuation for the company as a whole, along with the potential for selling land for higher and better use purposes, such as real estate development. Additionally, over time, we think the company s earnings power may trend up thanks to a strengthening timber market that is going to be driven by both the ongoing recovery in the U.S. housing market but also supply constraints in Canada. And finally, capital return is an important part of the Plum Creek Timber story. The dividend yield here is about 4%, and the company is committed to share buybacks and has an ongoing share buyback program. TWST: How often you make changes to the portfolio, and what is the sell discipline? Is it the same on both sides, or is it different? Mr. Hordon: I will start on the equity side. One of the really important features of how we manage money at First Eagle Investment Management is we are long-term in our approach, and historically, we have had relatively low turnover. The First Eagle Global Income Builder Fund had less than 20% portfolio turnover in the past year, so we are patient. We do a lot of work before we become involved with a name, but we give the investment time to develop. When we are selling a stock, it s typically one or two things. First, that the valuation of the stock has reached a level where we think it s either fully valued or overvalued. For all of our investments, we have a sense of what we believe is the intrinsic value of the business, and we like to buy into the stocks at a discount to that. When they reach our intrinsic value or exceed it, that s typically when we would be trading out of the position. Another reason for selling a stock could be in less happy circumstances where something has changed about the business or in our investment thesis. This is a scenario where we ve really just changed our perspective on the business and the margin of safety it offers us. This is usually in response to new facts that have emerged, whether or not we have made any money on the stock. Mr. Meigs: It s actually very similar on the fixed income side, where there are really two possibilities. One is the change in investment thesis, perhaps due to management that has lost focus on delevering. All of sudden, there could be a change in some of their capital-allocation policies, and they are perhaps taking on a more equity-friendly point of view. It may be the case where we re still comfortable holding the debt, but in other cases, we will go ahead and sell. Another possibility is that we simply identify a better use of capital. On the fixed income side, we may conclude a bond is fully valued and that there is a better opportunity elsewhere. TWST: How do you manage risk inside a portfolio? Mr. Hordon: It is important to understand how we define risk. It is perhaps a little bit different from other money managers. We think a value investor s definition of risk is really the threat of permanent capital impairment, so losing

5 money not because of temporary fluctuations in market prices but because the business you owned destroyed capital for one reason or another. This is in contrast with other investors who may think about risk more as the volatility of the security or even as the possibility of poor performance relative to an index. We are benchmark-agnostic. We are trying to generate positive absolute returns as opposed to simply outperforming another group of investments. That being said, the first line of defense in risk management is the price you pay for a security. So not overpaying for a security, not buying overvalued securities and being aware of parts of the market that are overvalued are all important to us. We have seen many examples over the decades where certain sectors or geographies think of the tech bubble in the late 1990s were very much in favor and came to represent large portions of indices, but share prices were completely unsustainable. We look to avoid those pockets of overvaluation, and with every individual investment we are making, we try to control risk by making sure that the price we pay reflects a discount to what we think the business is really worth. So if we are wrong about our assessment of what the business is really worth, or if the facts change in a way that s harmful for the company, at least we are protected by the fact that we had what we felt was a margin of safety going into the investment in terms of the price we paid to own the stock. TWST: Tell us about both of your backgrounds. Mr. Hordon: I joined First Eagle Investment Management in 2001 directly from Columbia Business School, where there is a strong value-investing tradition. I joined with a group here that managed funds with more of an event-driven style. At the beginning of 2008, I moved over to the Global Value Team, which manages the bulk of the assets of the firm and the First Eagle mutual funds. In 2010, I started to focus on the development of the income strategy with my colleague on the Global Value Team, Giorgio Caputo. Along the way, we ve had a great deal of support from other members of the global value team and across the entire organization. Mr. Meigs: I graduated from the Kellogg Graduate School of Management at Northwestern University and entered the fixed income market as an analyst with Wheat First Securities in I became a high yield portfolio manager with Falcon Asset Management in 1996, continued in that role with Dwight Asset Management from 2001 to 2011 and then joined First Eagle in 2011 as Rob had mentioned. TWST: What do you each think are the real strengths of the fund? Mr. Hordon: I think it s important to clarify that there are four portfolio managers on the First Eagle Global Income Builder fund. I mentioned Giorgio Caputo as being one of the other co-portfolio managers, who like me is also a Senior Analyst on the Global Value Team and has an equity background. Sean Slein, who co-manages our credit team, is a co-portfolio manager of the Global Income Builder Fund as well. Sean and Ed have worked together for many years. To your question about our strengths, I think, first, this is a strategy that grew out of the First Eagle Global Value Team. So we are taking advantage of a robust platform to pursue investment objectives, which because of the income emphasis are a bit different from what our other funds pursue. It s not only a strong organization, with a keen sense of purpose and sense of fiduciary responsibility, but one where the ideas are being generated across our investment team by an accomplished group of experienced research analysts. So I think it s the people but also the somewhat unconventional approach we have the freedom to apply. We are very much practicing a value discipline. We are not interested in chasing yield. We are not buying income for income s sake. We are buying income because it comes with what we feel is a margin of safety. We have an unconstrained approach to the portfolio and a lot of flexibility as to how we are able to pursue our dual objectives. We are able to invest more or less in any geography around the world. We are able to invest across the market-cap spectrum from something as small and illiquid as Mandarin Oriental to something as large as Microsoft. We can invest in high yield. We can invest in investment-grade. We can really invest in any income-producing security around the world. And we are willing to exercise that flexibility to avoid parts of the market that are unattractive to us. This is only possible because we are in an organization that focuses on absolute returns and takes a long-term perspective on performance. We are able to keep the focus on putting money into what we view as the most interesting value opportunities that exist at any given time, without worrying about what other people are doing. TWST: Thank you. (LMR) ROBERT HORDON, CFA Portfolio Manager EDWARD MEIGS, CFA Portfolio Manager First Eagle Investment Management 1345 Ave. of the Americas 48th Floor New York, NY The Wall Street Transcript, 622 3rd Avenue, New York, NY Tel: (212) Fax: (212) Website:

6 Average Annual Returns as of 09/30/2015: Year to Date 1 Year 3 Years Since Inception (5/1/12) Expense Ratio* First Eagle Global Income Builder Fund - Class A (w/o sales charge) (FEBAX) -3.28% -6.38% % First Eagle Global Income Builder Fund - Class A (w/ sales charge) (FEBAX) % The performance data quoted herein represents past performance and does not guarantee future results. Market volatility can dramatically impact the fund s short-term performance. Current performance may be lower or higher than figures shown. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Past performance data through the most recent month end is available at feim.com or by calling The average annual returns for Class A Shares "with sales charge" of First Eagle Global Income Builder Fund give effect to the deduction of the maximum sales charge of 5.00%. * The annual expense ratio is based on expenses incurred by the fund, as stated in the most recent prospectus Had fees not been waived and/or expenses reimbursed in the past, returns would have been lower. The commentary represents the opinions of Robert Hordon and Edward Meigs as of February 2015 and is subject to change based on market and other conditions. The opinions expressed are not necessarily those of the firm. These materials are provided for informational purpose only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security. There are risks associated with investing in funds that invest in securities of foreign countries, such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer s ability to make such payments may cause the price of that bond to decline. The Fund invests in high yield securities (commonly known as junk bonds ) which are generally considered speculative because they may be subject to greater levels of interest rate, credit (including issuer default) and liquidity risk than investment grade securities and may be subject to greater volatility. High yield securities are rated lower than investment-grade securities because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. Bank loans are often less liquid than other types of debt instruments. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower's obligation, or that such collateral could be liquidated. Investment in gold and gold related investments present certain risks, and returns on gold related investments have traditionally been more volatile than investments in broader equity or debt markets. The principal risk of investing in value stocks is that the price of the security may not approach its anticipated value or may decline in value. Income generation is not guaranteed. If dividend paying stocks in the Fund's portfolio stop paying or reduce dividends, the fund's ability to generate income will be adversely affected. All investments involve the risk of loss. The information is not intended to provide and should not be relied on for accounting or tax advice. Any tax information presented is not intended to constitute an analysis of all tax considerations. The holdings mentioned herein represent the following percentage of the total net assets of the First Eagle Global Income Builder Fund as of September 30, 2015: Acco Brands Corporation 6.75% 04/30/ %, MeadWestvaco Corporation 0.00%, Mandarin Oriental International Limited 1.55%, Jardine Matheson Holdings Limited 1.09%, Plum Creek Timber Co. 1.26%, Microsoft Corporation 1.70%, Bi-Lo LLC 9.25% 2/15/ %

7 The First Eagle High Yield Fund commenced operations in its present form on December 30, 2011, and is successor to another mutual fund pursuant to a reorganization December 30, Investors should consider investment objectives, risks, charges and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the Funds and may be obtained by asking your financial adviser, visiting our website at feim.com or calling us at Please read our prospectus carefully before investing. For further information about the First Eagle Funds, please call The First Eagle Funds are offered by FEF Distributors, LLC, 1345 Avenue of the Americas, New York, New York