First Eagle Global Fund: Gold Has No Intrinsic Value, But Still Has ValueVW Staff
Market Overview In the calendar year 2013, the MSCI World Index rose 26.7%, while in the U.S. the S&P 500 Index increased 32.4%. In Europe, the German DAX increased 25.5% and the French CAC 40 Index rose 18.0% during the year. The Nikkei 225 Index increased 56.7% over the period. Crude oil rose 5.7% to $98.42 a barrel and the price of gold declined 28% to $1,205.65 an ounce by year- end. The U.S. dollar rose 20.8% against the yen and declined 4.3% against the euro.
When we consider the markets’ strong performance in 2013, it might appear that we have an all-clear signal based on higher equity valuations, declining credit spreads, normalizing longer-term interest rate expectations and lower gold prices. But despite the sense of relief implied by asset and commodity price movements, we believe that there are still vulnerabilities in the financial architecture. In particular, when we look at household and sovereign debt levels in the U.S., the country carries more debt than can be naturally paid down through domestic household savings without having to resort to either liquidating assets or imposing higher taxation on assets. Through a generational illusion of policy-induced macro-economic stability, we have built a system dependent on capital markets liquidity and repressed interest rates which camouflage the debt’s full impact. This system is vulnerable to confidence shocks, particularly since broker-dealers now hold fewer securities in inventory in the wake of reforms imposed after the 2008 crisis. We believe that what we are witnessing is a Keynesian mirage. Easy monetary and fiscal policy has helped sustain corporate profit margins and valuation multiples, which, in turn, has had a positive ripple effect—boosting net worth and job prospects, encour – aging investment and consumer spending (which otherwise would not have occurred) and lowering household debt service ratios (the percentage of one’s income spent paying off interest and amortizing loans).
While the Federal Reserve’s commitment to low interest rates has enabled U.S. household debt service ratios to fall below average, overall debt levels remain above average. Furthermore, part of the surplus debt has moved from the household balance sheet to the government balance sheet through fiscal laxity aimed at sustaining demand. Now, part of the surplus government debt has moved to the Fed’s balance sheet through quantitative easing. When the Federal Reserve buys government bonds, it creates new cash which otherwise would not have been available and which ultimately trickles down to the tacit purchase of risk assets, further raising valuation levels. The lack of overt debt restructuring masks the debt write-off through repressed interest rates over time, rather than writing down the principal during any one period. This is an obscured restructuring of debt where responsibility ultimately falls on prudent deposit holders rather than imprudent borrowers. In our view, the long term effects of subsidizing imprudence cannot be good.
Meanwhile, the Federal Reserve’s obligations are growing at a double-digit rate by virtue of the Fed expanding its balance sheet in an environment where private sector credit growth is tepid and the growth rate of government debt is slowing to the mid-single digits. So the debt in the system has not disappeared; it has simply moved elsewhere. It is like a debt bean bag. When you sit on one corner, the beans do not disappear, they simply get redistributed.
In Europe, there are different sorts of imbalances. In the absence of exchange rate flexibility, countries with current account surpluses need to inflate wages, while highly indebted countries with current account deficits need to deflate wages, in order to restore competitive equilibrium. Spain, for example, has eliminated its current account deficit, but at the cost of Depression-era unemployment levels. Meanwhile, the French have not adjusted sufficiently, and face competitive pressures from both Germany and peripheral European economies that have become more competitive through wage deflation. Investors, who are now positive on recovering growth trends, may one day be unsettled to discover trouble in the core of Europe, rather than the periphery.
Japan has been a source of strong returns for us over the past year. We were buyers of securities representing material ownership stakes in many fine global franchises that happen to be listed in Japan after a two-decade bear market brought valuations for even the best businesses down to bargain levels. A lot has changed. Optimism over reflation has meant that we became a net seller of Japanese securities in recent times as their valuations quickly reached or even exceeded our sense of intrinsic value. Printing money is easy to do, but structural reforms are harder. The market has reflected the benefits of the former without its potential costs. Japan must still deal with a dizzying level of government debt as it faces challenging demographics and increasing geopolitical tensions with its neighbor, China.
Turning to the emerging markets, China has again been experiencing liquidity shortages in the interbank market as it embarks on a complex series of reforms aimed at liberalizing shadow banking and stamping out elements of corruption. China is also trying to evolve the composition of its growth away from subsidized exports and urbanization-related construction to broader consumption and services growth. The markets seem confident about China’s ability to walk the narrow path, but managing change in an increasingly complex economy after a massive credit and investment boom, at a time when competing currencies such as the Japanese Yen, Indonesian Rupiah and Indian Rupee have all been devalued, will be challenging to say the least. Not to mention growing geopolitical tensions with Japan. Beyond China, countries like Brazil, Russia, South Africa and Saudi Arabia are facing pressures from softer commodity price trends, and countries like Turkey are facing pressures from their current account deficit. Finally, across the emerging markets there is increased political uncertainty with many elections looming on top of a more complicated macro- economic dynamic.
While we hope the rising tide of corporate and labor productivity, when combined with an extended period of financial repression, helps solve some of the world’s debt problems, we remain focused on preparing for less favorable outcomes.
We still prefer to own equities (despite our macro concerns) because of the steadily growing asset of human potential which enables us to muddle through. Even so, higher valuations have made returns from a muddle-through scenario less appealing. With repressed fixed income markets and more modest return expectations for equities, finding out of favor assets offering a margin of safety is extremely difficult at present.
Our weighting in gold related investments and our cash and cash equivalents holdings hurt us in relative terms in 2013. Fortunately, in absolute terms, our overall real return in 2013 was in double-digit territory.
Even so, our relative underperformance serves as a reminder that our ability to call the short-term zigs and zags of the markets is limited at best, and that we should keep our focus firmly on creating an all-weather portfolio for the long term.
We do not invest based on top-down themes; we have a bottom-up, security-by-security strategy that reflects our focus on scarcity, resilience, and margin of safety at the business level, and aims to avoid permanent capital impairment. As such, we’re more likely to err on the side of missed opportunities by not being fully invested. This is what occurred in 2013.
We continue to view cash and gold holdings as providing ballast to our portfolio at a time when risks are still abundant in our eyes and it is more difficult to find bottom-up opportunities. Gold’s recent weakness reflects the perceived end of easy money and the recovery in systemic confidence. However, it should not be lost on us that real interest rates remain negative, even at investment to GDP levels that are close to mid-cycle and are above our national savings levels.
The system remains very far from operating in normal conditions. We believe the Federal Reserve must face a difficult choice to either unwind its excess asset holdings or de facto monetize them by holding them for an extended period of time. One scenario is arguably good for cash, if it produces deflationary fears. The other is potentially good for gold, if it produces fears that we are debasing the currency. Calibrating the balance sheet unwind against the assumption of improving private sector confidence is a policy challenge requiring great nuance—arguably akin to the Apollo 13 manual re-entry challenge.
If we look at the price of gold relative to world nominal GDP per capita, in dollar terms, it is trading close to its average level since the early 1970s, and relative to equity values it is actually on the cheaper side of normal. We refrain from any spurious attempt to value gold as, ultimately, gold reflects the reciprocal of confidence in the human-made system. But we note the derating of gold, and in this context, we have been a buyer of both gold bullion and gold miners over the past 12 months in order to maintain a normal sizing for our potential hedge—the gold bullion, as prices have gotten lower of late; the gold miners, earlier in the year as they started to discount at lower prices.
The Global Value Fund’s top five contributors for the quarter were Cintas, Oracle, Comcast, KDDI Corporation and American Express.
The Fund’s top detractors were Gold bullion, Newcrest Mining Limited (TSE:NM) (OTCMKTS:NCMGY), Goldcorp Inc. (NYSE:GG) (TSE:G), Penn West Petroleum Ltd (NYSE:PWE) (NYSE:PWT) and Fresnillo Plc (LON:FRES) (OTCMKTS:FNLPF). Newcrest, Goldcorp and Fresnillo all suffered along with other gold miners as a result of the decline in the gold price during the year. Bangkok Bank’s performance reflected the decline in the Thai SET Index which fell 11% during the quarter in dollar terms as a result of political issues in Thailand.
First Eagle Global Fund’s portfolio holdings
For 2013, First Eagle Global Fund’s top performers were KDDI Corp (TYO:9433) (OTCMKTS:KDDIF), Keyence Corporation (TYO:6861) (OTCMKTS:KYCCF), Comcast Corporation (NASDAQ:CMCSA), Cintas Corporation (NASDAQ:CTAS) and Microsoft Corporation (NASDAQ:MSFT). The Fund’s lowest performers were Gold bullion, Newcrest Mining, Gold Fields Limited, Fresnillo and Goldcorp. In addition, in 2013, our largest additions to the Fund were Compagnie de Saint Gobain SA (EPA:SGO) (OTCMKTS:CODGF), Oracle Corporation (NYSE:ORCL), Canadian Natural Resources Limited (TSE:CNQ), Teradata Corporation (NYSE:TDC) and Barrick Gold Corporation (NYSE:ABX) (TSE:ABX). Our largest eliminations from the portfolio were, Texas Instruments Incorporated (NASDAQ:TXN), Canon Inc. (ADR) (NYSE:CAJ) (TYO:7751), Phillips 66 (NYSE:PSX), Chocoladefabriken Lindt & Spruengli AG (SWX:LISN) and NTT Docomo Inc (ADR) (NYSE:DCM) (TYO:9437).
Finally, as mentioned, we are keeping deferred purchasing power at hand in low- or no-yielding cash in order to take advantage of value opportunities that may emerge in a less complacent market environment. We do not intend to hold the cash forever. It is a reflection of our patience as we await better bargains.
We remain confident that over the long term, investors should be rewarded for selecting equities purchased with a margin of safety in price, business model and management. We take the long view by owning these sorts of businesses, and are prepared to invest more if the environment turns cloudy, and wait patiently with cash on hand if markets get overly exuberant—as they appear to be today.
We appreciate your confidence and thank you for your support.
First Eagle Investment Management, LLC
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 princi – pal 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 www.feim.com or by calling 800.334.2143. The average annual returns for Class A Shares “with sales charge” of First Eagle Global 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.
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.
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. All investments involve the risk of loss.
The holdings mentioned herein represent the following percentage of the total net assets of the First Eagle Global Fund as of December 31, 2013: Cintas 1.64%, Oracle 1.85%, Comcast 1.50%, KDDI Corporation 1.32%, American Express 1.05%, Gold bullion 4.10%, Newcrest Mining .55%, Goldcorp .73%, Penn West Petroleum .31%, Fresnillo PLC. .45%, Keyence 1.50%, Microsoft 1.74%,Gold Fields Limited .17%, Compagnie de Saint-Gobain SA .71%, Canadian Natural Resources Limited .97%, Teradata Corporation .56% and Barrick Gold .48%. The portfolio is actively managed and holdings can change at any time. Current and future portfolio holdings are subject to risk.
The commentary represents the opinion of the Global Value Team Portfolio Managers as of December 31, 2013 and is subject to change based on market and other conditions. The opinions expressed are not necessarily those of the entire 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. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The Index provides total returns in U.S. dollars with net dividends reinvested. The Index is unmanaged, and the results include reinvested dividends and/or distribu – tions but do not reflect the effect of sales charges, commissions, account fees, expenses or taxes.
First Eagle Global Fund
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 contacting your financial adviser, visiting our website at www.feim.com or calling us at 800.334.2143. Please read our prospectus carefully before investing. Investments are not FDIC insured or bank guaranteed, and may lose value.