Matthew McLennan likes to compare himself to a gardener—one who cultivates stocks that will grow over the long term.
Without doubt, First Eagle Global (SGENX) has thrived under McLennan’s care. The $51 billion fund, which earns a five-star rating from Morningstar and has below-average fees, has outperformed its world-allocation peers in the past decade, returning more than 9% per annum.
That’s a good period in which to judge the fund, because it about matches McLennan’s investment horizon. Moreover, September marked a decade since he took over, just a few days before Lehman Brothers filed for bankruptcy. His performance, which spans the worst of the Great Recession and its recovery, demonstrates the value of his approach and makes his perspective all the more valuable as we near the 10-year anniversary of the bull market.
The fund’s holdings reflect McLennan’s large-cap value bent—he favors companies with strong competitive advantages and market positions and conservative leverage—no matter where in the world they may be. About 37% of assets are in U.S. stocks, with a similar amount overseas (much of the remainder is in cash and other assets like gold). His patience is reflected in the fund’s small 10% annual turnover.
So what should investors do to prepare for 2019? Curb their enthusiasm, for one. With threats ranging from increasing debt to tightening fiscal policy, McLennan believes that investors should be “realistic,” rather than “too optimistic” about the coming year. That said, volatility can offer an opportunity to buy solid stocks at reduced prices, he notes. McLennan looks for companies that have “resilience” across their businesses, from corporate culture to balance sheets. Read on for his picks.
Q: You took over the fund at a tumultuous time. With the 10th anniversary of the bull market coming up, what similarities and differences do you see between now and then?
A: This year in some ways is reminiscent of 1998 or 2007, because in both those market environments you started to see an element of risk aversion creep into prices. There was the Asian crisis in 1998, and in 2007 we were starting to see some troubles in housing and subprime borrowing. But it was a moment in both that I would describe as a Schrödinger’s cat moment, where you have a paradox of something being simultaneously good and bad. After the crisis in 1998, we had a bull market in 1999 before the markets truly collapsed in 2000, and likewise in 2007 there was a window in 2008 where stock prices were going up, where we thought the crisis was behind us. We don’t try to predict what markets will do. But there is a sense of déjà vu, because both 1998 and 2007 were difficult environments for value funds, a precursor of the market starting to discount more structural issues. More recently, markets have rallied a little bit on the hope that the Federal Reserve will pause, that oil prices are lower, that there’s some element of fiscal accommodation in the U.S. and China, and perhaps even in Italy. Likewise, we saw those relief rallies in 1999 and 2008.
Q: Is something worse coming?
A: While [relief rallies] can be short-term trading opportunities, we are late in the cycle. Perhaps the simplest way to think about that is that profits are at peak levels, very elevated, and if we look at a measure of the slack in the world economy, the unemployment rate is quite low around the world. U.S. unemployment rates are actually below 2007’s; they are below the late 1990s’. And so, we have a generational low in unemployment, which tells you that a lot of the cyclical recovery is behind us. Unemployment rates are low in Japan and China; even in the European Union, they are approaching their 2007 lows. And so, one has to recognize that this is a very complicated market environment. As prices came down and there was a lot of damage beneath the surface of the market, we were able to put some money to work. Our cash has drifted down modestly from the 20%-ish level to the mid-teens. But we are certainly investing in a measured way, given the longer-term question marks that we have. Our gold has come up a little bit during this period of gold weakness into the 12% to 13% range, if you include bullion and gold miners. And so, we’ve put a bit of capital to work, but, by and large, we still have a fairly conservative positioning as we think about the decade ahead.
Q: What is your outlook for 2019?
A: If you go back to the idea of this period being reminiscent of 1998, we’ve had an emerging market crisis this year with Turkey and Argentina. We’ve had a risk-off environment—it was only a 10% correction in the U.S., but we saw 20% corrections in the international markets, nearly 30% in China, and some meaningful currency adjustments. But even in the U.S., we had 75% of stocks trading below their 200-day moving average. You can make a case that there may be a trading opportunity for markets to be less risk-averse if the Fed pauses or oil prices stay low. But in 2019 and beyond, we don’t feel that there’s a lot of latency in fundamentals, just given how far advanced the business cycle is around the world. Even though price/earnings multiples look reasonable in many markets, margins are very high. One of the things that has driven margins to high levels has been very easy fiscal policy. We’ve brought forward profitability. If we look bottom-up at stocks on an enterprise-value-to-revenue basis, they are not so cheap. So we have modest expectations beyond any sort of short recovery in sentiment.
Q: Is debt a worry for you, too?
A: Debt levels are high around the world. Take household debt, nonfinancial corporate debt, and sovereign debt, and compare them to gross domestic product in the U.S., Europe, China, and Japan. We’re at higher debt levels than we were in 2007. It’s like if you borrowed a lot of money to build a bigger house than you need: In the short term, that’s good for growth and confidence, but once you’ve taken on the debt and built the house, you’re essentially stuck with the fact that you have to maintain a house that is bigger than what you need. This is essentially the problem with the Chinese economy. On top of that, if you have already levered up, you can really only grow through savings and retained earnings, and you have more modest growth. We face that challenge in the world economy as a whole.
Q: Do you subscribe to the idea that value investing might take the lead from growth?
A: It is difficult to make top-down calls on markets or sectors or styles of investing, broadly speaking. We don’t think about value and growth in purely statistical terms. If you are just buying statistically cheap businesses, often you are going to find businesses that are vulnerable. Value investing is a much more common-sense approach whereby you try to identify companies that have an element of resilience in their market position, their culture, their capital structure. But you wait for a moment for that resilience to be masked by more difficult external factors so that you have the ability to buy that resilience at a modest price. But a common-sense approach of buying good businesses at modest prices is a sustainable formula for outperforming over the long term.
Q: Let’s talk about some holdings that embody those ideas.
A: Let’s start with Exxon Mobil (XOM). As a value investor, we start with the balance sheet, but we also look for the important off-balance-sheet assets, like market position and culture. Exxon is not only a leading upstream producer of oil and gas; it also has unusually good upstream assets. It is well-positioned on the cost curve, and is long-duration in nature, relative to the industry. It is very well positioned in midstream and downstream assets. Even though we’re in a really tough energy environment, this is a company that still has the capacity to generate good cash flow, and that cash flow is supporting a 4%-plus dividend yield while you wait for a better environment. CEO Darren Woods is pursuing a countercyclical strategy, while a lot of the other energy companies are cutting back on capital expenditures: Exxon is taking advantage of the weaker oilfield-service environment to actually build out some of its key resources.
Q: Given your long-term outlook, that’s not a call on near-term oil prices, then?
A: We don’t have to bet on oil prices in the next six months, but what we can say is that if the best companies in the industry are not that profitable, at some point the oil price needs to be at a higher level.
Oracle (ORCL) is another big holding. The market views Oracle as cyclical because it’s a technology company. But the vast majority of Oracle’s earnings power comes from maintenance fees on its installed base of relational databases and enterprise resource-planning software. That makes it actually a very resilient cash-flow stream. The cash-flow stream of Oracle historically looks more like a consumer-staple than a tech company. Oracle has been out of favor because it’s transitioning from selling most software through upfront licenses to selling it in subscription format via the cloud, similar to what Microsoft (MSFT) has gone through. Oracle is arguably earlier in that transition. Investors have started to reward Microsoft because they now see the stability in the growth in that earning stream, but they have yet to reward Oracle. While we wait, the company has a free-cash-flow yield in excess of 6% that is being distributed to shareholders. We are getting a dividend yield of nearly 2%, and in the past year they bought back about 5% their stock. It has a strong balance sheet and very strong market position in the key areas where they compete.
Weyerhaeuser (WY) is another example of what we like. The company is valued at less than $2,000 an acre; it has been out of favor because timber prices are soft, given softness in the housing market. But long- term, timber is one of the few commodities that has gone up in real terms because of declining acreage, as urban areas and environmental restrictions grow. This is a company that has a 5% dividend yield, and it has the best assets in the industry and is, in most locations, well integrated with lumber mills. Even in a tough environment, Weyerhaeuser is able to generate good cash flows and has extremely long-duration assets. The land value is perpetual, and often when it’s harvested, Weyerhaeuser has the option value of not just replanting, but selling the land for higher and better use.
Q: What role does gold play for you? A hedge?
A: We do own gold as a potential hedge. Gold has been pretty weak since its peak in 2011. Yet the supply growth of gold has been less than any other form of money. Sovereign debt has gone up, relative to GDP. The next time we have a crisis, arguably gold could be more valuable than it was the last time, because there is more money and worse debt dynamics and worse geopolitics.
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