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Winning by Not Losing: Understanding the Long-Term Outperformance of the First Eagle Overseas Fund

The First Eagle Overseas Fund has a 27-year history. What is its mandate and investment process? What are its risk controls?

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Kimball Brooker, Jr.: The fund was established in 1993, and the idea was to provide clients with the means to invest internationally using the same investment principles that we had been using for our Global Fund, which was established a little bit earlier, in 1979. The same philosophy, mandate and processes apply. We think of ourselves as value investors, and although the primary mandate of the fund is preservation of purchasing power, we look to achieve that in a way where the goal is avoiding losses. We're looking to find companies that have durable characteristics, and we're looking to acquire those at enough of a “margin of safety” in valuation that can prevent permanent impairment of our capital and our investors' capital on the downside.

When it comes to underwriting individual securities, which is central to our investment process and risk control mechanism, we're looking to identify companies that embody a “margin of safety” in two different dimensions: price and the business itself. The first is fairly simple to understand. It's around valuation, and we're looking for companies that are trading at a discount to our sense of intrinsic value. Typically, we'd look to commit capital only when that discount is in a double-digit range. Our typical rule of thumb is that there must a minimum 25% price discount.

The other dimension to create a “margin of safety” in our investment activity relates to the characteristics of the business itself. We're looking for companies that are durable, and that we believe are persistent and capable of withstanding the vicissitudes of macroeconomic changes and trends, as well as competitive changes and trends. That typically involves companies with reasonably strong competitive positions in the industries that they operate in. They don't need to be the most glamorous businesses, but they need to be well-entrenched in terms of their role within their economic ecosystem. Further, we like the balance sheet to be as clean as possible, more or less unencumbered by debt and/or other sorts of contingencies like unfunded pension liabilities. Finally, we like to have a competent and realistic management team making decisions, and we spend quite a bit of time evaluating the capital allocation skills of the teams that we consider.

We also have quite a broad level of diversification within the portfolio. It's not uncommon for us to have more than 100 positions in the portfolio. It would be very unusual for a position to reach a size north of 3% or 4%. As we'd rather not risk any material diminution in the value of the portfolio, diversification is quite important to us.

Then there are two other elements essential to our portfolio construction process. We're very happy to hold cash if we're unable to find opportunities. We view cash as a default position. But it's a byproduct of the investment process; when there aren’t companies that meet our criteria, the size of our cash position may grow. Conversely, when we're finding businesses that fit the bill, cash will be deployed in equities and our cash position will be lower.

Gold is a fourth area and is meant to serve as a potential hedge for the portfolio. We have a combination of both gold bullion as well as gold-related equities, which include gold mining companies as well as gold royalty companies.

Matthew McLennan: We don't view risk as tracking error. We think of risk as the permanent impairment of capital. And that's what we're seeking to avoid with our bottom-up approach.

The fund has an exceptional long-term track record. As of March 31, its annual return since its inception in 1993 was 9.15% versus 4.03% for the MSCI EAFE index. That's an outperformance of 512 basis points. To what do you attribute that outperformance?

Matthew McLennan: These points are going to follow on from what Kimball has said. If you look at our performance over the decades, it's been a tale of winning by not losing, of practicing what Ben Graham would refer to as the “negative art” of avoiding permanent impairment of capital.

The core engine for our returns has been our equity investments. And while we are equity investors, first and foremost, we start out more like bond investors, being focused on what can go wrong. We focus first on the balance sheet and avoid businesses that have excessive capital-structure risks, and those that are subject to other contingencies or excessive accruals. It’s helped us avoid many companies that went out of business or had to dilute or heavily recapitalize in business downturns.

One of the reasons the broader MSCI EAFE index has suffered is that entire sectors have been beset by financial recapitalizations. As a team, we've managed to sidestep some of those key issues, such as technology in the late 1990s, some of the problems with financials in the mid-2000s and later on some of the boom-and-bust enthusiasm for the BRICS.

Read the full article here Robert Huebscher, Advisor Perspectives


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