First Eagle Investment Management

Matthew McLennan and Kimball Brooker are the heads of the Global Value Team at First Eagle Investment Management. Matt joined First Eagle Investment Management in 2008. He started his career with Queensland Investment Corporation (Australia) in 1991. In 1994, he joined Goldman Sachs in Sydney before moving to New York to Goldman Sachs Asset Management GSAM. In 2003 he founded Global Equity Partners. Matt received his Bachelor of Commerce with first-class honors from the University of Queensland.

Kimball joined First Eagle Investment Management as a senior research analyst in 2009 covering banks, commercial services, financial services and holding companies. He joined the Global Value portfolio management team in 2010. Kimball began his career in 1992 as a financial analyst at Lazard Frères & Co. From there, he joined J.P. Morgan as an associate in the Corsair private equity funds. He was named Chief Investment Officer of the Corsair Funds and managing director in 2005. Kimball received his BA from Yale University and his MBA from Harvard University.

Graham & Doddsville (G&D): Tell us about your respective backgrounds and how you became interested in investing. Were there any major influences or mentors along the way?

Kimball Brooker (KB): I grew up in Chicago and had a number of family members who worked in the securities industry, spanning a few generations. So I was around financial markets and knew about them, but gained more in-depth knowledge later in my career. I’d say that the generational differences were important in shaping my views. I grew up with two strains of thinking: one of total trepidation from my grandparents who lived through the depression and one of optimism about the markets and the US, more broadly, from family who grew up post-war.

It wasn’t until college that I became more interested in investing. A friend of mine gave me a copy of The Intelligent Investor, which was really my first systematic exposure to investing. Some key ideas really resonated with me. For one, Graham, in some ways, bridged the gap between these two competing ways of thinking about investing. He lived through the roaring ’20s with a lot of enthusiasm, speculation, and leverage. He also lived through what came afterward, so he had the benefit of personal experience, with both the boom and the bust experiences in his rear-view mirror.

Graham’s distinction between investing and speculation really caught my interest intellectually. He defined an investment as something in which, once you had done your research, you could have a level of comfort based on the level of risk you are taking. What was even more interesting to me was that his work, with concepts like margin of safety, incorporated a sense that mistakes could be made, and that you could face obstacles. For me, that was a very realistic way of thinking.

After college, I worked in an investment bank and learned quickly that investment banking wasn’t for me. After a few years, I landed at J.P. Morgan and worked for a fund set up to invest in distressed situations, particularly in financial services. I was there for about 15 years, only leaving for two years to attend business school, and then I joined First Eagle Investment Management in 2009.

Matthew McLennan (MM): I was born in Rabaul, Papua New Guinea. After moving to Australia at age six, I spent most of my childhood in the state of Queensland in Australia. I’d say my interest in investing stemmed from a desire to provide a sustainable platform for wealth creation. I grew up in a house that was full of love, but without electricity. We had a wonderful home surrounded by the woods, but it wasn’t connected to the grid. I guess those were formative years: you start to think about what you can do to evolve your circumstances over time.

I had the benefit, early on as a high school student, of being interested in markets, of seeing all the “right” mistakes made. I had one teacher who wanted to create an investment club that would predict the Dow futures using Elliott Wave Theory. You can imagine how well that ended. It was also a time, in the 1980s, when corporate raiders were doing M&A, and consolidations were all the rage in Australia. Most of those stories ended very badly; stretched businesses overpaying and overleveraging.

college, a group of friends and I created an investment club. I received a small amount of stock in a small regional bank from my grandfather, who always had an interest in investing. While I watched people trying to get rich quickly losing money quickly, this small regional bank compounded in value at a nice clip. It taught me the importance of a well-positioned business, prudently managed and purchased at the right price.

I was fortunate to have mentors in college such as Don Hamson, a professor at the University of Queensland, who taught me early on about anomalies, such as the value effect, and a lot of theory around capital structure, which I found very interesting. I took my first job with Don at the Queensland Investment Corporation, where I ultimately ended up being responsible for the company’s global equity portfolio. The Queensland Investment Corporation was a state pension fund, a CalPERS-like entity that had quasi-privatized. Working there provided me a great opportunity to look at asset allocation as a whole and taught me about the different styles of equity investing, because we also used external managers. The experience was formative.

I joined Goldman Sachs in 1994, and in my 14 years there, was fortunate enough to have many mentors. A few truly shaped my thinking during that period. Paul Farrell, who managed the small cap funds, had worked previously with Lou Simpson at GEICO. He introduced me, broadly, to the readings of Warren Buffett and Charlie Munger. Also, Mitch Cantor, who ran the large cap funds, had previously been at Alliance Bernstein, and introduced me to Ben Graham’s theories of paying low prices and looking for businesses with low multiples of normalized earnings power.

Later on in my career at Goldman, I was fortunate enough to be a co-founder of the high net worth investment strategy group. I worked with Sharmin Mossavar-Rahmani, who was the head of fixed income business at the time. She taught me a lot about fixed income investing and episodic investing in high yield during liquidity crises. By that point in time, I was managing a global equity portfolio and in that role we also had to make value judgments about equities and other economically sensitive assets, such as commodities, high yield bonds and currencies.

Here at First Eagle Investment Management, we are able to make all of those decisions on a single platform. Since I joined the team, Jean-Marie Eveillard and Bruce Greenwald have been very valuable mentors — Jean-Marie teaching me the value of patience and gold’s role in a portfolio and Bruce distilling a mental model for competitive analysis and explaining how to synthesize valuation-thinking across businesses that do or don’t create value.

While at Goldman Sachs, I hired a few talented analysts who had graduated from Columbia University’s Value Investing program where Bruce’s book, Value Investing: From Graham to Buffett and Beyond, was required reading. His valuation thinking really resonated.

I have also been mentored by John Arnhold who astutely repositioned the First Eagle business over time with his father, Henry Arnhold, who co-managed our first fund in 1967 with George Soros. Both John and Henry have taught me the benefit of being a fiduciary outside the world of investing.

When you look back on your journey, there is often a combination of internal motivations and external mentors who help inform your mental models over time.

I joined First Eagle in September 2008, a week before the financial crisis. Sometimes great things emerge out of crisis. We’re in a business where temperament is a key asset — being patient, maintaining a long-term perspective, staying mentally flexible. Working together at First Eagle through the financial crisis reinforced the importance of maintaining prudent underwriting standards for Kimball and I. As difficult as the environment was to navigate, it created investment opportunities and also generated solidarity for the team around its underwriting standards. It was a blessing in disguise.

G&D: Could you discuss other ways your philosophy might have changed over time? Did the financial crisis in ’08 and ’09 cause you to think about things differently today than you would have otherwise?

MM: The past decade underscored principles that we individually believed in already. As a value investor, you want to buy assets cheaply. You have to view equity as a residual claim on a business, so capital structure is very important. Identifying and normalizing earnings power as a reflection of the underlying assets and market position are very important.

Through the financial crisis, investors’ learned about the nature of equity as a residual claim as there were opaque portions in the balance sheet assets of many financial firms that were large relative to the thin equity sliver. Many of these businesses had tangible equity that was only 2–3% of assets, so if you bought a business at book value, no matter what you paid for the equity, you still paid 97 cents for the assets. If the opaque portion of the assets was more than the tangible equity, you didn’t have a margin of safety.

It brings one back to basic principles of investing: the true value added is often in acts of omission. I think if you look at the history of First Eagle as a whole, some of the key turning points in the track record were acts of omission: we were not in Japan during the late ’80s, even though Japan was the largest component of the MSCI World Index; we were out of tech in the late ’90s, even though it was the largest component of the markets; avoided financials in the last cycle; had a limited presence in the BRICs over the past few years.

The thematic growth trends — all of those were great at the time — often attract a lot of capital, flowing indiscriminately to indices and index funds and worse still among competing firms. For us, the rubber meets the road one security at a time. If you look at the underwriting decisions that Jean-Marie made, or those that Kimball and I and the team have made, the acts of omission occurred when we couldn’t find good businesses at good prices. It’s the ability not to force capital to work that makes the difference. I think the crisis really underscored those lessons.

KB: I would also add that, coming out of the crisis, generally a number of the businesses we owned not only survived, but really improved. They were relatively well-financed, with no contingencies in capital structure, well-positioned within respective industries, and well-managed. Many of these companies were able to take advantage of the dislocations during that period at the expense of their weaker competitors. When selecting securities, it’s important that investors underwrite defensively to help protect capital. But during difficult periods, those same defensive characteristics often allow businesses to take advantage of those circumstances.

MM: One of the great lessons of the crisis was learning the difference between volatility, which most people perceive as risk, and a permanent impairment of capital, which is what we believe is risk. Many of the great businesses Kimball referenced were actually down 30% — 50% during the crisis. These businesses experienced negative volatility, but no permanent impairment of capital. As a result, generally the businesses were able to gain a stronger market position, to buy back stock at very low prices, and to emerge with more earnings power per share. Even though the businesses’ stock prices went down during that period of time, intrinsic values accreted. On the other hand, there were many stocks that looked cheap, such as the financials, but because the businesses had so much leverage, the equity was wiped out by the crisis. Not only was there volatility, but there was also permanent impairment of capital.

G&D: When Graham & Doddsville interviewed Jean-Marie Eveillard in 2007, he commented on his evolution as a value investor, from a Graham and Dodd approach to a Buffett investment style. Has there been another evolution in the philosophy at First Eagle with you managing the portfolio?

MM: I think both Kimball and I stand behind by the adage, “if it ain’t broke, don’t fix it.” However, there have been minor areas of evolution. For example, we’ve been very focused on making sure we have the best trading execution. Markets have changed, too, in terms of how trading occurs. I think that’s given us a bit more flexibility. We’re not high trading frequency: the average holding period for the Global Value Team is about six or seven years. Still, we build big positions gradually, and work our way out gradually. Having a talented and experienced trader like Doug DiPasquale heading First Eagle’s trading desk has been invaluable.

The evolution from Graham to Buffett continues. Many companies we own embody business model scarcity, have a degree of pricing power, and by virtue of their market position are resilient. In crisis, these businesses can be opportunistic. In good times, they can distribute cash flow to shareholders. We have sharpened the saw, if you will, in terms of how we think about business model duration.

The big change, to a certain extent, has been exogenous. If we look at debt in the world — household, corporate, sovereign debt relative to nominal GDP around the world — it’s higher today than it was in 2007. The financial architecture of the world is less healthy than it was a decade or two ago. That implies that we’ve had to become more aware of the role of currencies and sovereign risk. Jean-Marie casts a wary eye to what can go wrong from a top-down standpoint. We cast that same wary eye given how the world’s financial architecture has evolved.

G&D: Talk about your idea generation process: how much of it is informed by a top-down view versus specific bottoms-up analysis?

KB: We keep an eye open to macroeconomic events and conditions around the world, but it doesn’t really drive our decision to buy anything. We’re not thematic investors; we’re much more focused on security-specific decisions. I will say, however, there have been circumstances where we have been uncomfortable with an entire industry as a result of macro concerns, in which case we move on. As a result, the macro view might inform a decision to not do something.

MM: To add to Kimball’s point, I believe a core problem in the world is monetary superabundance. It has reinforced the need to seek scarcity in businesses in which we invest. We don’t make top-down calls on which country or which sector, as Kimball said, but we seek scarcity in a business model, a market position, or in tangible assets that are hard to replicate.

We look at the market as if it is a block of marble and we chip away at the pieces we don’t want. If the business doesn’t embody the right characteristics, if the capital structure has excessive contingency, if management behavior is imprudent, or if the price is wrong, these are all reasons not to own it.

At First Eagle we chip away at the 90% of the universe we don’t want. The residual we feel, incorporates a margin of safety that gets represented in the portfolio. No individual investment is perfect. In the context of Graham and Dodd, Kimball alluded to how important it is to create a process that’s error-tolerant. By seeking what we believe to be a multi-dimensional margin of safety, we hope to implement that process over time.

KB: When you hear people talk about risk management or portfolio management, it’s often at a 50,000-foot view. What often seems lost in the defense of capital are really the individual companies in the portfolio and the managements running those companies. You know that some challenges will emerge and management will have to confront them. By investing in businesses that are well-positioned, with an element of scarcity and what we believe to be a margin of safety, we improve our chances of handling the inevitable challenges.

G&D: Are there any particular practices that have helped you key in on distressed areas? How do you think about that?

KB: At various periods of time, there will be an industry, country, or region that has hit an air pocket. You can often find businesses that have been sold somewhat indiscriminately without regard to valuation. Sometimes those periods can last for years. Take Japan for example, which until recently, had been neglected or ignored by investors because of concerns about the economy, demographics, and corporate governance.

MM: At First Eagle, we tend to take an incrementalist approach to capital allocation. We have roughly 150 securities in our portfolios. The world of concentrated investing often has negative behavioral side effects. People tend to have commitment bias to their ideas. When an idea is either in or out of a portfolio the logic structure is binary, it can force people to be desensitized to disconfirming evidence when they’ve made an investment.

Charlie Munger often claims that the best opportunities are those already under your nose. We often source opportunities from what we already own. From a bottom-up perspective, we can pinpoint which securities are out of favor and allocate capital at the margin to those securities. We also trim capital off the securities that are closer to, or in excess of, what we believe to be intrinsic value. So we employ a natural “opportunity-recycling” process.

G&D: Would you give an example of a security that you currently own where you feel it’s undervalued and you’ve reallocated capital to that?

MM: National Oilwell Varco (NYSE: NOV), a business held in the First Eagle Global Fund and Strategy, has a very strong market position. It provides high technology components, rig subsystems, and after-market equipment to the drilling rig market around the world. It is highly-regarded for more complex fracking or ultra-deep water extraction solutions.With the price of oil moving from over $100 to under $50, we believe NOV’s prospects for the next 12 to 18 months will suffer pretty dramatically. Despite challenging short-term fundamentals, the company has a leading market position and about $12 billion of backlog and net cash on the balance sheet. We believe it is well-positioned to emerge stronger from this crisis.

National Oilwell Varco has the potential to improve its position both in its core wellbore and rig systems segments as well as the after-market segments of its business. For example, it may be able to buy good companies to supplement these segments at low multiples of cash flow in a distressed situation. It could also continue to buy back its stock at depressed levels.

We can’t predict the bottom of the energy market or the bottom of National Oilwell Varco’s order book. However, because of its strong position in segments of the energy capital expenditures that are growing and unconventional, we are comfortable with the company’s long-term prospects and its potential to be an even stronger force over the next decade. NOV trades at a single-digit earnings multiple based on trailing peak earnings and around 5x trailing peak EBITDA. If you think this is a business that in five to seven years could have higher peak earnings and higher peak EBITDA, and you look at where the private market multiples have been for energy M&A, this is an example of time arbitrage where we may experience further downside volatility in the short term, but where we feel comfortable possibly owning a security for the next five to ten years and where we’ve added a little bit on weakness here.

G&D: How do you think about intrinsic value? What methodologies do you look at and at what discount to intrinsic value do opportunities begin to interest you?

KB: First we try to determine the sustainable level of earnings for a given business. There are many businesses that, for various reasons, are either under- or over-earning their sustainable levels. To ascertain intrinsic value, we assess what we believe normalized earnings will be and the sustainability of those earnings.

From there, it’s really a triangulation. We review past transactions, like the National Oilwell Varco example, that involved well-informed buyers acquiring businesses. We also look at what multiples produce sensible returns relative to the nature of the business.

MM: Benjamin Graham made it clear that intelligent investing is all about arithmetic. We spend a lot of time thinking about how to reconcile the multiple we’re paying with the underlying arithmetic of the investment return. There’s a willingness to pay higher multiples for franchise businesses. By going in at 10x — 12x EBIT, you could get a 6%normalized free cash flow yield that can potentially grow 4–5%sustainably over time, and thus you may achieve the prospect of a double digit return. If it’s a businesses that is more Graham in nature, with no intrinsic value growth, we may be inclined to go in at 6x — 7x EBIT, where we get our potential return through a low double digit normalized earnings yield. Having those simple mental models and looking for the arithmetic to work also gives us the fortitude to deploy cash in crisis. We had our lowest cash levels in early 2009, not because we correctly timed the market bottom, but because we saw businesses available at the right prices.

G&D: To what extent do you attribute your cash position to a lack of current opportunities, versus optionality on future opportunities?

MM: We can’t predict what the future will bear. At First Eagle, we view cash as a residual of a disciplined underwriting approach and as deferred purchasing power. Typically, it arises because we’re selling stocks that are close to what we believe to be intrinsic value or that have gone through intrinsic value. In more expensive markets, it’s more difficult to identify new ideas that meet return hurdles, thus the cash builds.

We don’t feel the need to force cash to work just because it is a zero-cent yield today, because the return to cash has two components: it has the current yield, and it has the option of redeployment in distress. We feel, given the state of the financial architecture, there will be more windows of opportunity over the coming years to buy businesses that offer potential return hurdles in windows where the markets are less complacent.

G&D: Can you talk about your sell discipline?

KB: There are two main reasons to sell. First, if your investment thesis is inaccurate or you own something that wasn’t what you thought it was. Second, the sell decision can be linked to intrinsic value. Once a stock price converges with what we believe to be the

value of the business, we’ll discuss it in the context of trimming. In many cases, intrinsic value is not a static number. It can grow. When we feel a stock is at or above intrinsic value, we’ll trim the position. If the stock price rises far north of intrinsic value, we may have to exit the entire position.

G&D: Are there any common themes in past investments that have been very successful? What about those that have not worked according to plan?

MM: We’re very process-oriented at First Eagle. We believe in systematically analyzing our mistakes, as well as our successes. In fact, we have an annual offsite where we do a post-mortem to review what’s worked best over the last five years and where we have seen permanent impairment of capital. Then we perform the “should have, could have, would have” analysis. So given what we knew at the time, we discuss the filters we could have applied differently to reach better outcomes.

Certain threads of continuity emerge from that analysis. On the positive side, we’ve found top-performing companies that were not necessarily in hot growth categories, but rather they have business models that persisted over time, and the companies have held strong, stable market positions.

One pattern we’ve seen is the involvement of a founder or a family that is also generational in their capital allocation perspective. That combination of a persistent cash flow-generating business, and stewards that share a long-term horizon, has tended to produce some of our best long-term investment ideas.

On the other hand, if we look at the less-attractive tail of the portfolio, there haven’t been many mistakes where we went in at elevated prices. Instead, it’s typically been a more asset-intensive business, where there’s a legacy issue to some of those assets which imputes declining profitability, and the company needs to reinvest to sustain its earning power. Unfortunately, asset-intensive businesses often lack pricing power. What sometimes occurs is a need to reinvest during a time of weak pricing power, and this results in balance sheet deterioration and reduced earnings power.

Also, asset-intensive businesses tend to have longer tail assets. With those come management teams that promote their desire to reinvest and grow the business. As a result, there’s less return of capital.

If you think about those two classes of business, with the cash-flow business, the passage of time shrinks the enterprise value, because it’s generating cash and can pay down debt or buy back stock. The asset-intensive business has poorer positioning and legacy assets. As a result, the passage of time actually increases the business’ enterprise value, because it may need to replace the legacy assets, and may not have the pricing power to generate the earnings, so it needs to borrow.

A bad case has a combination of diminished earnings power and greater enterprise value. While the starting valuation may have been good, the terminal valuation was less attractive. In the former is a business with earnings power grinding higher, while enterprise value is shrinking, producing an increase in the real value.

G&D: What about errors of omission? Have you noticed any patterns in businesses you’ve consistently avoided that, in retrospect, would have been great investments?

MM: At First Eagle, we’ve likely been too frugal when it comes to great businesses. For example, we’ve typically looked to buy 70 cent dollars. I think the mental model of paying 70 cents for a business makes great sense; if the normal equity is priced for 7% returns, and you’re going for 70 cents on the dollar, you’re starting with a 10% ROI. Closing that valuation gap over five to ten years may generate a low-teens return. If it’s a great business, there’s an argument to be made, not necessarily for paying 100 cents on the dollar, but for paying 80 to 85 cents on that dollar. As Charlie Munger would say, it’s a fair price for a great business. Your time horizon’s long enough that you’re capturing less spread day one, but if the business has a drift to intrinsic value of 4–5% a year, held for a decade, you may potentially reclaim that and then some. The more patient you are, the more you’re potentially rewarded for holding good businesses.

I think there have been a number of great businesses we invested in that, with the passage of time and benefit of hindsight, should have had a more substantial position size and where we could have seen adequately rewarded even with slightly higher entry multiples.

KB: There is a school of thought, which I believe Charlie Munger has expressed, that the margin of safety is embedded in the quality of the business. You have to weigh that against discipline on valuation.

MM: I think there’s a subtle addendum to that discussion. Traditional Graham investing has, arguably, a lower return on time invested. If the business is not growing in intrinsic value, once it gets to what we feel is intrinsic value, the investment needs to be replaced in the portfolio. There’s an element of maintenance capital expenditures in terms of research, which tends to be higher for those kinds of businesses than ones that you can own for a decade or longer while intrinsic value improves.

Obviously, if you own a great business, and it gets too expensive in valuation, you should replace it. If it’s starting to price that future growth, you’ve mortgaged that value-creation drift. Unfortunately, there is no maintenance capex-free investment strategy at all. The return on time invested is also an important consideration.

G&D: First Eagle is known for using gold as a potential hedging mechanism. Is there an investment case for gold or gold mining stocks?

MM: I think that gold is still broadly misunderstood in the investment community. People often say to us, “If you want a hedge, why don’t you buy credit default swaps or do a put option on the S&P 500 Index?” First, all of those instruments have some degree of counterparty risk.

Second, most forms of option-based hedging are expensive. If you look at the cost of implied volatility, it’s typically greater to buy at-the-money options than the risk premium for the underlying assets.

Third, those instruments are time-definite. I remember buying puts on the S&P 500 Index in 1999 that expired worthless about a month before the market collapsed.

We believe that the best potential hedge has to be a real asset outside the world of man-made securities and counterparties. This is where I believe gold is most often misunderstood. Warren Buffett is an investment hero of ours. And he has criticized gold because he believes it is useless. But it’s precisely gold’s chemical inertness that makes it useful as a potential hedge.

Consider useful commodities such as oil or copper, which tend to have a sensitivity to the market and broader economic activity that’s close to one-for-one. Those are not actually hedge assets, but market- and economically-sensitive assets. In order for something to have limited sensitivity to crisis, it has to be close to chemically inert and not that useful in an industrial context. In fact, if you look at the historical price of gold, it’s had close to no correlation with equities, and in extreme states of the world, has been negatively correlated with the valuation of equities.

Because of gold’s inertness, it is resilient. The stock of above-ground gold is over 50 years of one year’s mining supply, which means that, not only is gold the most resilient real asset from a demand sensitivity standpoint in our opinion, but it’s also the most resilient in terms of its supply character. If mining supply is only 2% of the stock of gold and that supply was to increase by 30% due to some unexpected technological development, it would only increase the rate of growth of the stock of gold from 2% to 2.6%.

For pretty much every other commodity, silver being an exception, the stock of those commodities is a fraction of a year. Those commodities are produced for use because they’re useful. The supply of those commodities will vary with the annual extraction. We’ve seen the impact on oil markets this year.

Gold is unique in terms of its demand-side resilience and its supply-side predictability. We can know with virtual certainty what the supply of gold will be in 5, 10, or 15 years. What other commodity can we say that about?

We look for scarcity in securities, and gold is one of the scarcest elements on the periodic table, with less than one ounce of it per capita in the world. The stock of gold has been roughly constant the last 40 years at about 0.8 of an ounce per capita globally. Gold is also very dense. In fact, people often joke that you could fit trillions of dollars of wealth in a swimming pool, or a hundred million dollars of wealth on a library shelf full of gold bars. Low storage costs increase gold’s attractiveness. If you think of the opportunity cost of holding a real asset, the higher the economic sensitivity, and the less the density, the higher the opportunity cost of storage, because you’ve got to pay to store it, and you should get a risk premium. But if something’s naturally economically insensitive, naturally resilient and naturally dense, the opportunity cost of storage is very low. That’s why, if you go through a process of elimination, there’s no other element on the periodic table better suited to be a monetary potential hedge than gold.

Since the breakdown of the Bretton Woods agreement in the early ’70s gold traded at trough valuations during the peaks of systemic confidence like the late ’60s or the late ’90s. During periods of systematic concern, such as the early ’80s, pre-Volcker, after the second oil shock and large inflation; or even a couple of years ago when Standard & Poor’s downgraded United States debt, and the Euro was on the verge of collapse, gold traded at its peak valuations. It’s interesting to note that, over a 40-year period, both gold and equities have roughly maintained values relative to world nominal GDP per capita, but in inverse cycle time.

People often criticize gold because they believe it has no expected return. If the supply of gold per capita is constant but the money supply and world GDP per capita is growing, then the equilibrium price of gold has a positive drift because the assets you’re hedging, and the income you’ve built to purchase that hedge, are growing in value. Gold has had a return which is expressed in capital gains over the long term, as opposed to yields. The irony is that it is sovereign debt today that has no return.

Gold is an important part of First Eagle portfolios and an important part of our philosophy of humility. If we knew with certainty that the system was resilient, we wouldn’t need a potential hedge. But to the extent that 70% of our portfolios are invested in enterprise that’s sensitive to the state of the world, and to the extent that we see generationally high levels of debt and complicated geo-politics, we value that potential hedge.

G&D: Would you take us through other investment ideas?

KB: We own Bank of New York (NYSE: BK) in the First Eagle Global Fund and Strategy. It’s a combination of asset management and what we refer to as “Wall Street plumbing” — custody, clearing, and administration of assets. Those two fee streams account for just over 80% of Bank of New York’s business, as opposed to most banks, which rely on credit intermediation and interest income.

We bought Bank of New York a few years ago because we believed it was under-earning in a few dimensions as a result of interest rates and operational expenses which had room for improvement. Bank of New York waived fees on its money market funds because interest rates were too low. And, due to the timing of the Mellon merger, which happened just before the financial crisis, the company never really had a chance to attack its expense base until now. In addition, the company was re-segmenting its customers in an effort to enhance profitability. When we bought the company — and we still think there’s a discount to intrinsic value — it was earning returns on tangible capital that were attractive. We believed the balance sheet was clean and liquid.

One long-time position in First Eagle Global is Groupe Bruxelles Lambert (GBLB.BB), a holding company owned by two families that have a strong investment history. It’s a simple company to understand because it owns half a dozen publicly traded large European blue chip companies. Our view is that it continues to trade at a double discount, in the sense that if you do a sum of the parts comparison with the public price, that’s a discount. Additionally, a number of the businesses it owns have been trading below intrinsic values.

MM: With multiples and margins at historic highs today, the scarcity and resilience that we seek out are not obviously available. Many great consumer staple companies are trading at 25x earnings, so you have to look for the unobvious. Take for example, Oracle (NYSE: ORCL), in First Eagle Global, an idea originated by Manish Gupta and a position we’ve built over the last few years. It’s the leading provider of relational databases, with a very dominant, stable market share position. It’s also a leader in the applications that attach to that database: enterprise resource management applications, middleware that helps those applications communicate with the database, and some of the underlying hardware.

With Oracle, people were worried about the threat from the cloud. Yet the company has such scale economies in R&D that it was able to play “fast-follower”. It doesn’t need to invent every new technology because its platform is already entrenched in the corporate world and can be built out over time.

In a world where consumer staples are expensive, we’ve sought out corporate staples. A relational database is an extremely difficult thing to change and thus falls into the latter category. Mark Hurd, the Oracle CEO, gave the analogy that changing a database is like performing a heart transplant on a marathon runner while he’s running a marathon. This is a mission-critical application that the whole business IT architecture is built around.

If you look at the historical profit stream of Oracle, it’s more like a Colgate Palmolive than a volatile semi-conductor or software company. It’s very stable because the vast majority of EBIT comes from installed maintenance, not from new license revenues. With multi-year maintenance contracts, 90% plus retention rates, and built-in inflation escalators, Oracle is a cash flow machine.

It’s also chaired by founder Larry Ellison, so its management has a long-term focus. Since management gets paid in equity-related incentives, their incentives are aligned to ours, as shareholders. This is a company that’s buying back stock, has traded at a mid- to high-single-digit free cash flow yield over the last few years, and has underlying EBIT from the maintenance stream that can compound out at a 6% or 7% clip. The arithmetic works for us.

G&D: You mentioned a double discount with respect to GBLB. Is the thesis that there’s a perception gap that should close over time? How much do you care about catalysts if so?

KB: There’s a related question: “Why should there be a discount?” We don’t see a reason. Normally, you could apply a discount to a company like that if the assets it owns weren’t that good, if there were tax-leakage, or if the management were bad. We think none of that applies to Groupe Bruxelles Lambert. It’s in an advantageous position, similar to Berkshire Hathaway, where it can take advantage of investment opportunities that others won’t.

MM: On that point, I would add that Groupe Bruxelles Lambert has a model of soft control. It has board representation, and has exhibited discipline by making sure that its companies are distributing cash flows and healthy dividends.

KB: We don’t need a catalyst, because it’s almost always built in the price. From our perspective, if the company continues to buy back stock, which is what it’s been doing, at a discount to what we think it’s worth, which is what Groupe Bruxelles Lambert has been doing, that’s value-added.

MM: Going back to the 70 cent dollars discussion, if you can buy in through the holding company at a 30% — 40% higher earnings yield because of the discount, the internal economics just compound at a more attractive rate.

G&D: Do you have any advice for aspiring investors or other students at Columbia Business School who would like to sit in your seat one day?

MM: Read voraciously. Learn more broadly about behavior, philosophy of thinking, biographies, and history. Get a sense of the possible. Look at the repeating cycles in human history. There’s an abundance of material out there, so you can build your own invisible board of directors, if you will. That’s incredibly important.

The second piece of advice I’d give is to persist. Ultimately, as an investor, you will make mistakes despite best efforts. It’s a very humbling business. The people I’ve seen succeed in this business have stuck to it and have been obsessive about learning from their mistakes. This improves the value of their human capital over time.

G&D: Anything else you might recommend reading?

MM: I’d recommend biographies on John Law and Richard Cantillon by the Professor Antoin Murphy. I suggest those books because this was the point in time, historically, where we had the evolution of paper money in Europe. One sees some of the benefits of paper money, in that it frees up capital for investment and productive enterprise, but one also sees the risk of paper money, in the intrinsic agency risk embedded in the political process, where there’s an excessive issuance at the bank level, or the central bank level of such currency. John Law and Richard Cantillon were fascinating characters, because they both had different mental models of how the economy worked and were both leading theoreticians.

Their mental models are well captured in these books. In some ways, John Law was pre-Keynesian, and Richard Cantillon was pre-Austrian school of economics. Richard Cantillon wound up wealthy, John Law destitute.

G&D: Do you have any parting words to share?

MM: Jean-Marie Eveillard has often spoken about the fallibility or the limits of knowledge. I think it’s important to focus on controlling what you can control, such as your own behavior and temperament. At First Eagle, we spend a lot of time thinking about how to improve our approach to investing. If you’ve studied history, you can see the recurring mistakes in human behavior through hubris, dogma or haste.

At First Eagle, we also strive to embody the inverse of those behavioral defects into the way in which we allocate capital. We recognize that the future’s uncertain, that’s why we stick to a margin of safety approach, why we’re willing to own some gold as a potential hedge, and why we’re willing to own cash and not force the cash to work if the arithmetic doesn’t make sense. All of that stems from the temperament variables rather than a crystal ball.

G&D: This has been great. Thank you very much for taking the time to meet with us.