1. What is the investment philosophy of First Eagle? And what sets you apart from other asset managers?
First Eagle Investment Management focuses on generating real returns for its clients through the business cycle while trying to avoid permanent impairment of capital. One thing that sets us apart is the amount of attention we pay to the potential downside risk of our investment decisions. We view risk not as volatility but as the permanent impairment of capital in real terms. We seek to create resilient portfolios by focusing on companies around the world with strong balance sheets, persistent competitive advantages, sustainable earnings and conservative management. And we commit capital to these companies only when we see a meaningful “margin of safety” in price; that is, the difference between our estimate of the intrinsic value of the security and its market price. Value investing principles are deeply ingrained in our investment philosophy.
We have a long investment horizon and try to make decisions based on the next decade rather than the next year. We understand that, due to the way compounding works, avoiding losses during certain periods of time may be as critical for long-term performance as generating returns during other periods. We have sometimes lagged in runaway bull markets, when we believed security prices and business fundamentals were misaligned. While the positioning of our diversified funds2 may have resulted in short-term underperformance, it has generally protected clients’ assets against the full force of a number of pronounced market selloffs. For example, our Global Fund held no Japanese stocks when the Japanese stock market bubble burst in the early 1990s.3 It also had very limited exposure to telecoms and technology when dot-com stocks crashed in 2000 and to financials as the 2008 Global Financial Crisis took hold.
Our focus on resilience means that our portfolio composition differs from many of our competitors’. While equities predominate in our diversified funds, we typically hold relatively high levels of cash and cash equivalents as a residual of our disciplined, bottom-up approach; if we cannot find undervalued securities that fit our investment criteria, our position in cash and cash equivalents may grow to 15% or 20%. This position is not strategic: it represents deferred purchasing power that we can deploy countercyclically when security prices become more favourable for us. In addition to equities, cash and cash equivalents, we hold between 5% and 15% of our diversified funds strategically in gold and gold-related securities. These act as a potential hedge against the many known-unknowns and unknown-unknowns in the market, adding greater resilience to our portfolios.
2. Can you tell us about the First Eagle Gold Fund?
In addition to our diversified portfolios, we manage a gold fund.4 Here too, we focus on providing downside resilience and avoiding permanent impairment of capital. The Gold Fund is highly concentrated on a small number of securities and, due to our long-term investment horizon, our portfolio turnover rate has been as low as 9.3%.5 The structure of the portfolio does not resemble any index. To the extent that we cannot find undervalued gold-related equities, we tend to own a significant amount of gold bullion –17.9% as of 30 June 2019. Unlike the diversified funds, the Gold Fund holds very little cash and does so solely for working capital purposes. Apart from a few exceptions, we generally avoid owning pre-production miners, which don’t have self-funded balance sheets. Instead, in an effort to reinforce resilience, we try to own long-duration and, in our view, higher-quality gold-related stocks. We don’t give the benefit of the doubt to any gold stock because of a speculative expectation of a higher gold price. Rather, we aim to provide solid, risk-adjusted, real returns through the cycle, and our Gold Fund has exhibited resilience, even during periods of distress in the gold sector.
3. How does gold fit into First Eagle’s overall strategy?
We have a distinctive philosophy around gold. We believe gold has unique risk/reward characteristics that enable it to help preserve real value over the long term. We use gold as a potential hedge and do not speculate on its price over the next six to 12 months. We believe it is not possible to forecast the price of gold or, for that matter, the price of other investment assets. This, in fact, is why we have a potential hedge, and why we believe investors should consider using the Gold Fund as a potential hedge rather than as a speculative vehicle. In addition to our US$1.12bn6 Gold Fund, we hold approximately US$9bn7 in gold and gold-related investments as a potential hedge in our diversified funds. We leverage our research for the Gold Fund to actively manage the exposure to gold for the overall First Eagle organisation. As one of the largest long-only, active shareholders in the gold sector, we spend significant time and resources meeting with and evaluating gold companies, and examining the broader trends affecting gold companies and the gold bullion market.
4. What do you think makes gold stand out from other assets?
Gold’s unique risk/reward characteristics mean it has the potential to preserve its value in real terms under both inflationary and deflationary conditions. Several assets – commodities, for example – may provide a potential hedge against inflation, while others – such as cash and bonds – may provide a potential hedge against deflation. But what happened to commodities during the deflationary shock of 2008? And what happened to cash following central banks’ countercyclical fiscal and monetary policies in the aftermath of the 2008 Crisis? Gold is different because, despite potential short-term volatility, it has historically done well in real terms under the greatest variety of macro-economic dislocations.
An additional quality that we like in gold is that it is a long-duration potential hedge. Gold doesn’t rot or rust or tarnish, and it is virtually indestructible. Unlike futures or options, gold does not have to be rolled forward or properly timed in order to serve as a potential hedge. Moreover, gold ownership doesn’t entail counterparty risk. It is a liquid asset, with an exceptionally long track record to support the above-mentioned qualities.
Over time, gold has also provided uncorrelated returns to the stock market. The long-term correlation of gold to stocks is practically zero, which means that gold adds true diversification to an equity position. Historically, the gold price has moved countercyclically to the stock market, and the more stocks have dropped, the more, on average, the gold price has generally risen. So, gold can provide value, especially to a long-only equity portfolio. By adding diversification and potential resilience, it can help investors maximise overall returns on a risk-adjusted basis through the cycle.
Historically, one of the biggest drawbacks of owning gold has been its lack of yield. In our view, this is less important now. With yields from sovereign bonds currently at extremely low levels (and negative in Europe and Japan), despite a record amount of sovereign debt and potential sovereign risks around the world, the opportunity cost of owning gold is minimal. Furthermore, although gold does not provide a yield, it has delivered a return over time because growth in the stock of gold from 1900 to 2017 has been less than 2% annualised,8 whereas growth in the supply of man-made money – and thus nominal demand for gold – has been much higher.
Overall, therefore, we believe gold’s underlying long-term price stability, versatility, resilience, countercyclical relationship to stocks and duration make it the most compelling form of potential hedge.
5. Do you consider gold a strategic asset, a tactical asset, or both?
Gold is a strategic asset for us. We believe it is impossible to time the market in a consistently profitable way by buying and selling gold tactically. Moreover, uncertainty and complexity are increasing around the world, as many potentially disruptive issues, from monetary and financial developments to political and geopolitical tensions, remain unresolved. We take the humble view that, as it is impossible to predict such events, we cannot know in advance when we will need to own a potential hedge on a tactical basis. This means we have a strategic need for a long-duration potential hedge that can perform satisfactorily under the greatest variety of events disruptive to the financial marketplace. Gold fits that position for us.
It is also important, however, to consider the appropriate capital allocation to gold. In the diversified funds, we believe a level significantly higher than 15% is more of a directional bet on the gold price than a potential hedge, and a level significantly below 5% is probably too small to be material if it is needed for potential hedging purposes. By the same logic, we believe investors should consider gold as a strategic allocation within their overall portfolios rather than as a tactical play.
This is part one of a two part article, read part two "First Eagle on the outlook for gold".