First Eagle Global Value Team Annual Letter 2017

Review of holdings and markets

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Jan 17, 2018
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In 2017, two seemingly contradictory trends continued and, indeed, acceler-ated: the strong advance of global investment markets and the proliferation of geopolitical risks. For us, it was a challenging period in which pockets of value became harder and harder to find. We were reminded, once again, that patience is a key element in our investment approach. We drew heavily on our store of patience in the year just ended.

Economic Overview

The cyclical recovery in global economies continued through 2017. Unemploy-ment fell below the low levels seen in 2007—not only in the United States, but also in China and Japan.1 In many parts of the world, consumer confidence and business confidence rebounded, and business investment relative to GDP recovered to more normal levels. Overall, the last seven years look quite good when seen in a rearview mirror. As we have been saying for some time, the chal-lenge for investors is that this cyclical recovery in global economies is not ahead of us, but behind us.

Paradoxically, it is also true that geopolitical risks can rise as economies strengthen. The Brexit vote occurred after the British economy had recovered; Catalonia launched its latest bid for independence after the Spanish crisis had abated. In our view, this is a time when asset-market valuations are high around the world, and geopolitical risks are elevated. Despite these risks, investment markets remained complacent, and risk perception was very low. In the United States, implied volatility, as measured by the VIX, closely tracked corporate credit spreads, which were tighter than average.

United States

The United States was in a window of good economic momentum in 2017. The Institute for Supply Management’s New Orders Index was at a decade high, consumer confidence was at a decade high, and in the last two quarters, GDP grew at an annualized rate of more than three percent.2 Not surprisingly, stock valuations were generally at a decade high.3

Rather than getting carried away with the stock market’s rise, we would intro-duce a note of caution. While we do not attempt to predict the market’s direc-tion, low long-term interest rates, tight credit spreads and high PE ratios suggest that, in the medium term, the return from a broad equity and fixed income market portfolio may fall into the low- to mid-single-digit range.

Economic growth in this period was propelled, in part, by a decline in house-hold savings from greater than six percent in 2015 to under three percent at year-end.4 This kind of short-term boom in consumption at the expense of long-term savings is a familiar pattern in the United States. We suspect that it will not last. If their investment returns falter, people who hope to meet their retirement goals may need to boost their savings rate rather than cutting it. At some point in the future, an increase in savings could become a headwind for demand.

Corporate tax cuts are one of the factors fueling confidence in the United States, and in the short term, tax cuts can provide fiscal stimulus. But the Congressional Budget Office (CBO) recently forecasted budget deficits of five percent—and this was in a buoyant phase of the economic cycle. Fiscal stimulus has had a positive impact on sentiment and the stock market, but it’s also equivalent to borrowing from the future. At some point in the intermediate future, fiscal discipline will be required.

While the economy will likely grow in the next few quarters, it is less certain that the stock market will rise with it. Some psychologists define happiness as reality relative to expectations, and if stock market reality does not keep up with investors’ expectations, their disappointment could have a sizable impact. For example, the US dollar was quite expensive one year ago, and there was consensus that US interest rates would be going up. It was also clear that interest rates were not going up in Europe or Japan, where quantitative easing continued. Many predicted that the US dollar would be strong in 2017, but, in fact, it weakened. Why? Interest rates rose in the United States, but they rose less than investors expected. If the equity market fails to meet investors’ high expectations, it, too, could decline—an outcome unanticipated by many observers at the start of 2018.

China

From a global perspective, one of the most important events of 2017 was the 19th National Congress of China’s Communist Party, which occurred in October. In a three-hour speech to the congress, President Xi Jinping conveyed a sense of China’s strategic direction. One theme that came out time and again was the notion of building a moderately prosperous society. Xi seemed to be trying to set reasonable expectations for growth. He appeared to be less inter-ested in optimizing the economy than in raising it to a level that could help maximize Communist Party control.

Twenty years ago, many in the United States hoped that once China was admitted to the World Trade Organization and reached a more advanced stage of economic development, it would liberalize and become something closer to a Western-style democracy. Xi Jinping’s speech put that idea to rest. China’s leaders have no intention of following the Western model. They believe that they have a vibrant democracy, but it is a “consultative democracy” where people can have their voices heard without necessarily voting.

Another major theme was the goal of national rejuvenation. Xi referred to the humiliation that China suffered in the 1840 Opium War, when it fell into domestic turmoil and was subject to foreign aggression. Evidently, nearly 180 years later, this painful episode still drives the Chinese to protect and advance their national interests. Xi was explicit about the importance of investing in the military, and he stated that the military is built to fight. However, he also said that China will never seek hegemony. China wants to invest in its belt and road initiative, have its maritime routes to the Middle East clear, and build railroad lines through Eurasia, but, according to Xi, it is not looking to take over other countries. While this is reassuring, China’s military expenditure is growing at a high single -digit clip—a pace at which it will catch up to US military spending in roughly ten years’ time.5

China’s overall posture and Xi Jinping’s speech make it clear that China is charting its own course, which is, increasingly, at odds with the US course and the European course. To our minds, China is adding to the complexity of the world geopolitical backdrop. It also has substantial economic imbalances and high debt levels to work through.

European Union

The cyclical recovery in Europe continued through 2017, with fixed invest-ment improving, unemployment declining and economic confidence building. Europe’s recovery has lagged that of the United States, and the idea that Europe still has further to go has inspired optimism in some investors. Unfortunately, Europe’s recovery—whatever its stage—has already pushed the prices of quality businesses to high levels. Furthermore, the EU remains an incomplete political and economic union, and it continues to face generational political challenges that will shape the continent’s future. Angela Merkel, who had been the region’s dominant figure, lost significant power in Germany’s September elections, and a coalition government will limit her ability to act forcefully. Upcoming elections in Italy could also result in a coalition government. In the UK, Theresa May’s government has been weakened by Brexit proceedings. France’s Emmanuel Macron wants to put through reforms, but he has no strong leaders with whom to engage. On the political front, the EU is muddling through.

Japan

Japan’s economy grew strongly in 2017, supported by a pickup in consumption, investment and exports, and the country’s unemployment rate fell to a 25-year low. Core inflation still hovers around 0%. Under its monetary policy strategy of “Yield Curve Control,” the Bank of Japan (BOJ) has kept 10-year Japanese government bonds pegged at around 0% and the yen stable at a weak level, and it has made large purchases of Japanese government bonds, commercial paper, corporate bonds, ETFs and J-REITs. As other central banks gradually exit from quantitative easing, the BOJ is under pressure to clarify its strategy, but it may not do so until its new governor is announced in February or March 2018. Prime Minister Abe’s reelection in October 2017 provides scope for an accel-eration of structural reforms (the so-called “Third Arrow” of Abenomics), but it remains to be seen whether he will use his electoral mandate to push these reforms or, instead, to revise Japan’s pacifist constitution.

The Rise of Digital Currencies

One of the most striking developments of 2017 was the surge of Bitcoin and other digital currencies. In only 12 months, bitcoin achieved the kind of growth that took 30 years for the Dow Jones Industrial Average. We see Bitcoin as a beautiful piece of digital art that solves the problem of creating a transaction network with no central counterparty.

However, money is both a medium of exchange and a store of value, and as a medium of exchange, Bitcoin is far less convenient than cash. Many individuals do not accept Bitcoins in return for goods or services, and, because of high fees, it is an expensive transactional platform. Cash remains the easiest form of exchange.

Gold shines as a long-term store of value. The supply of gold is growing by far less than the supply of money. Historically, gold has often played a defen-sive role in negative environments. As a store of value, Bitcoin is, arguably, less attractive than gold. One impediment is that it is five times as volatile as gold.6 In addition, even though the number of Bitcoins that will ultimately circulate is limited to 21 million, the rate of supply growth in Bitcoin currently four percent—more than twice the rate of growth in the gold supply.7 Finally, Bitcoin has less than a decade of history, compared to gold’s time-tested role over millennia.

If paper money is a more convenient medium of exchange and gold is a more certain store of long-term value, one may wonder why Bitcoin is rising so fast. We believe part of the explanation is that Bitcoin offers something that cash and gold do not offer—complete anonymity. It’s an expensive transactional network on which people pay a premium to transact anonymously and accept more risk so they can store their wealth anonymously. These features have attracted a large enough constituency to build the volume of Bitcoin transac-tions, and this, in turn, has resulted in a longer block chain. The greater the length of the block chain, the higher the power requirement for miners and the more difficult it becomes to hack Bitcoin. In other words, the more Bitcoin has been used, the more secure it has become.

Bitcoin’s price has gone up far more rapidly than its transactional volume, as speculators have started to price its option value as a form of “digital gold.” In a period that has been favorable for risk assets, Bitcoin has performed like a growth stock. This is hardly the behavior an investor wants to see in a potential hedge asset.

We think Bitcoin faces a few key risks. First, it could be superseded by some more beautiful form of digital art—a better algorithm or more cost-effective cryptocurrency platform. Second, as mining for Bitcoin becomes increasingly complex, miners could become more oligopolistic. They could extract extra fees or even amass the computing power to steal money by hacking the block chain. Third, if regulators begin requiring transactional information, the anonymity behind Bitcoin may dissipate.

The stunning growth of Bitcoin in 2017 was in keeping with the prevailing mood of investor enthusiasm—a possible sign that investors should proceed with caution.

A Continued Focus on Patience

As value investors in the Benjamin Graham tradition, we believe that the most serious investment risk is permanent impairment of capital and that the leading source of this risk is overpaying for securities. This risk is heightened in a period like 2017. We keep a wish list of stocks that we would like to own at prices that offer what we consider a “margin of safety”—a discount to our estimate of their intrinsic value. When businesses that typically trade at 20 times earnings are trading at 25 times earnings, such opportunities are difficult to find.

For many years, we have believed that our key competitive advantage is our patient temperament. We may wait five to 10 years for the price of a stock on our wish list to fall to an attractive level, and we may wait just as long for the price of a stock in our portfolio to rise to its intrinsic value. In 2017, we exer-cised a great deal of patience. We sold shares of some companies—including stocks we had held for many years—as their value approached or exceeded our estimate of intrinsic value. We looked for opportunities to redeploy that capital, and early in the year, we found some in the energy sector—particularly in oilfield services companies whose share prices had declined with the fall in oil prices. Other than energy stocks, however, opportunities in 2017 tended to be idiosyncratic cases of individual companies that, for one reason or another, were experiencing their own bear markets. When we could not find investments that met our criteria, we held onto the cash and cash equivalents, and used a portion of it to buy gold-related investments.

Because, historically, our positions in cash and gold-related investments have grown during strong bull markets, we have often lagged the overall market while still capturing a considerable portion of its gains. When markets have declined, our positions in cash and cash equivalents, as well as gold-related investments have historically cushioned our portfolio against the full force of the downdraft. Sound upside capture potential and resilience in downside envi-ronments have been keys to our long-term performance.

We continue to believe that the current environment is one of above-average risks and below-average rewards. In our view, these conditions call for an active, benchmark-agnostic, risk-aware strategy like ours that focuses on owning stocks with a “margin of safety.”

We want to close by thanking our long-standing clients for sharing our commitment to patient and disciplined investing. We look forward to serving as prudent stewards of your capital in the years ahead.

Sincerely,

Matthew McLennan T. Kimball Brooker, Jr.

  1. Source: Bureau of Economic Analysis

2. Source: Bloomberg

3. Source: Bloomberg

4. Source: Bloomberg

5. First Eagle Investment (Trades, Portfolio) Management/Stockholm International Peace Research Institute (SIPRI)

6. Source: Bloomberg

7. Source: Blockchain (https://blockchain.info/charts/total-bitcoins)

The performance data quoted herein represent 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 are 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, Overseas, U.S. Value, Gold and Global Income Builder Funds give effect to the deduction of the maxi-mum sales charge of 5.00%.

The commentary represents the opinion of the Global Value Team Portfolio Managers as of December 31, 2017, 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.