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First Eagle Investment Management Teams Discuss Investing for Income and Capital Appreciation
Posted by: Holly LaFon (IP Logged)
Date: January 8, 2013 11:26AM
The PMs' Perspective is a series of interviews with senior members of First Eagle Investment Management's investment teams. As a firm with a long tradition of independent thinking, we invite you to read these market views and strategic insights.
Q: Could you describe the challenges facing investors who are searching for income?
Giorgio: The compression of short and long-term interest rates to historically low levels has made traditional approaches to generating income through fixed income instruments very challenging. With the U.S. 10-year bond yielding less than 2%,1 one important avenue to obtaining investment income has all but disappeared.
In addition, global central bank currency printing heightens the risk of inflation in the future. As a result, purchasing power preservation has arguably become an even more important part of the income equation. Income-oriented investors must balance present and future needs by trying to find enough income to provide for today, while also making sure that their savings will buy the goods and services they need in the future.
Finally, with low yields in traditional fixed income, capital has flowed into equity income investments in the search for yield. Some of the more typical equity income sectors have seen valuations rise, especially in the United States. With a global, multi-asset approach to income, investors can avoid some of the more crowded areas. As value investors, we're not going to seek income in pockets where we feel valuations aren't attractive.
Q: Which traditional income-generating equity market segments are you finding overvalued?
Rob: Pure-play regulated utilities have seen their multiples expand over the past several years. In addition, the domestic REIT (Real Estate Investment Trust) market has appreciated significantly from its bottom three years ago—the Wilshire U.S. REIT Index has nearly tripled.2 Today, REIT valuations don't generally reflect discounts to underlying net asset value. In addition, many REITs embody historically low and potentially unsustainable capitalization rates on the underlying properties.
Q: There has been a lot of dialogue in the media regarding the potential for a bond bubble. Would you share your views about this?
Ed: Historically, investment grade bonds have often mimicked the performance of sovereigns. Central banks appear committed to zero interest rate policies and the past volatility in risk assets has heightened the "safe haven" aspect of these bonds. Right now, investment grade bonds have historically low yields. With risk assets performing better as of late, yields have started to slowly rise. In this environment, we feel that attempting to avoid interest rate risk is important. Given that investment grade bonds have more interest rate risk than credit risk, we feel this is an area to avoid.
Sean: Regarding the high yield segment of the market, we're in a much different place than in 2006 and 2007, when the high yield market was grossly mispriced. Today's spread levels are still close to their historical averages. Many companies are still coming to the primary market to refinance their debt. We have begun to see some more equity-friendly activity (such as debt-financed dividends), though to a much lower degree than five or six years ago. We would expect this to increase over time and for market fundamentals to slowly deteriorate. At this point, however, overall deal quality still remains fairly good. Management teams will continue to push the envelope to try to lower the protection afforded bond holders and give their companies a bit more leeway to take asset value protection away from the entity to which we are lending. But that's happening gradually and remains reasonable for now.
Many companies are still chastened by their near-death experience of 2008. So we are seeing a lot of companies that are allocating capital wisely, keeping a larger amount of cash on their balance sheets, and not pursuing unproductive strategies as far as investing their capital is concerned. The market is not levering up like we saw back in 2006, when we were at the height of the leveraged buyout craze. These factors support our view that the high yield market still appears to be evaluating risk appropriately at this point.
Q: Given the challenging market environment and the need to find what you believe to be attractively valued income investments, how would you describe your approach?
Giorgio: We believe that everything starts with valuation. We are trying to make good value investments. So from the standpoint of our underwriting and margin of safety criteria, the Global Income Builder's approach is no different from that of the other First Eagle Funds.
What is different about Global Income Builder is that we look for these investments to generate meaningful and sustainable levels of income as well as capital appreciation. In any market environment we're trying to support a material income stream while maintaining the focus on avoiding permanent impairment of capital that is central to our investment approach at First Eagle. It is our hope that through this focus on downside protection we can help our investors avoid the capital impairment that can result from reaching for yield. Q: Could you expand on the phrase, "meaningful and sustainable income?"
Rob: We mean an income stream that keeps pace with or outpaces inflation and that holds its real value over time. To us, "meaningful" means that it is material and—we expect—dependable. "Sustainable" means that the income the fund generates persists over time and holds its value in real terms.
The concepts are linked because there is a trade-off between income today and income tomorrow. We try to deliver as much income as we can today within the constraint of attempting to preserve and, hopefully, grow our shareholders' purchasing power over time. We are looking to deliver a moderate level of income that allows us the potential to retain enough of the return so that the asset base itself may have room to appreciate at or in excess of the inflation rate. If the asset base grows in real terms, this should translate into real income growth.
On the other hand, targeting an unduly high level of current income can force reliance on investments that themselves have a very high distribution level. A fund being managed with income goals that are too ambitious may be forced to consider investments that promise a lot of current income but may not make sense from a value perspective. Potential examples of these could include levered financial companies such as mortgage REITs (investments that, due to their high leverage, may not offer what we consider to be an adequate margin of safety) or telecom businesses that distribute more than their underlying free cash flow yield as dividends in order to attract investors.
Q: What other considerations do you focus on when seeking current income?
Giorgio: We don't want to own investments where there's an elevated risk of income interruption. While we are value investors, we do have current income as a co-objective along with capital appreciation. An income interruption event—such as a dividend cut or a coupon holiday—can often lead to selling pressure, and we don't want to face the unpleasant choice of either having to sell a position (thus converting what might only have been a temporary loss into a permanent one through the sale) or to have an inadequate income level.
Sean: Building on that, over the course of the history of the high yield market, over 100% of total return has been provided through the coupon.3 The bottom line is: Attempt to buy bonds that don't default. Although we do invest in lower tiers, we generally attempt to stay in the higher-quality sub-sectors of the high-yield market—the BB and B credit tier. CCCs, by definition, tend to be cash flow consumers and are dependent upon the primary market for their funding. So, when the primary market closes, as it does from time to time, CCCs tend to bear the greatest jump to default risk.
Q: There is much discussion about the potentially inherent strength of companies that grow dividends over time. Could you share your thoughts?
Giorgio: While growth of dividends over time is an attractive outcome, securities offering steady income growth can be very expensive. As a result, purchasing these securities may run counter to our tenets of not chasing yield and insisting on a margin of safety. First and foremost, we are value investors who try to avoid over-paying for our investments. To us, valuation is the foundation—it is where we start and end in terms of allocating capital.
What we're trying to achieve with the Global Income Builder Fund is an income stream that grows, in real terms, over time. To accomplish this we attempt to make solid investments with a margin of safety in price that can drive long term capital appreciation, rather than specifically targeting securities that we believe will have high rates of dividend growth.
Q: There's shareholder pressure for companies to begin or to re-engage in paying dividends. What's causing this?
Giorgio: Part of the pressure stems from the somewhat lackluster performance of equity markets over the past decade. Investors are looking at their portfolios and saying, "What do I have to show for my investment?" The volatility of the markets over the past several years has probably also altered the perception of dividends. We think there is a bit of a newfound appreciation for investments that consistently deliver cash returns. In addition, there have been serious questions raised about the efficiency of capital allocation at the corporate level. There are numerous examples of mergers and acquisitions having destroyed value and also of large investments in capacity that now sits idle. A commitment to returning capital to shareholders may put pressure on management teams to scrutinize their capital budgets carefully and to focus on their highest return projects.
There is also the reality that we have been living with a slow recovery in developed economies since the financial crisis. Many companies have had to restore their balance sheets and right-size their cost structures, and have been able to extend their debt maturities at attractive interest rates. With this period of restructuring behind them and in the absence of strong economic growth, there is growing recognition that investments in new capacity may not be worthwhile and that returns of capital make the most sense.
Q: How does the legislation passed in connection with the resolution of the fiscal cliff impact income-oriented investors?
Rob: Congress has essentially re-affirmed and perpetuated the concept of qualified dividends first introduced during the Bush administration. With the January 2013 fiscal cliff deal, it appears that both long-term capital gains and qualified dividends will continue to be taxed at 15% for many investors (all married couples with total income less than $450,000 per year and single filers with less than $400,000). Taxpayers above these thresholds will pay 20% plus the additional 3.8% levy associated with the healthcare legislation4—a meaningful increase, but a tax rate that is about half of what it otherwise would have been had Congress not acted.
The information is not intended to provide and should not be relied on for accounting or tax advice. Any tax information presented is not intended to constitute an analysis of all tax considerations.
Q: Can you talk about any differences between dividends and share repurchases? Are they both equal, or is one preferable to the other?
Rob: They actually work well together. Paying a dividend may represent a more durable commitment to returning capital to the owners of the firm (the shareholders) than a share repurchase program. Share repurchase programs tend to be temporary, whereas, historically, there's an unspoken commitment that many boards make to equity holders that there will be some stability and longevity to a dividend. On the other hand, a dividend is not a contractual obligation, like a debt commitment, so it does give the company flexibility in periods of distress to retain capital for other purposes or to absorb a decline in earnings.
Share repurchases, on the other hand, offer the advantage that an investor can elect to monetize the capital return by selling shares at a time of his or her choosing. For long-term, value investors like ourselves, a well-executed buyback program conducted at attractive valuations can be a very significant driver of investment returns.
Q: Can you describe some dividend practices outside the U.S. that you find attractive?
Giorgio: In many countries outside the U.S., there's often a stronger commitment to return cash to shareholders via dividends. In many European businesses, a holding company or family-controlled entity can be found at the top of the shareholder register. That holding company or family, like our investors, often wants income. This shared objective can lead to a very good alignment with other shareholders seeking income.
This manifests itself somewhat in cyclical industries. Typically, in the U.S., the higher dividend payers can be found in historically stable market segments. But outside the U.S., you can find examples of economically sensitive industrial businesses, for instance, that have a stronger commitment to dividends often due to these shareholder dynamics. We hold a global building products company domiciled in Ireland that is an example of a more economically sensitive business that pays a very attractive dividend yield. In contrast, U.S. building product peers offer relatively modest payouts. The Irish company's strong balance sheet and substantial asset value allow them to feel confident in their dividend commitment across the economic cycle. Similarly, Bouygues SA of France, whose largest shareholders are the Bouygues family and employees, also has a strong commitment to its dividend despite some cyclical exposure to construction and advertising activity. Q: When investing outside the U.S., are there currency issues to be considered?
Giorgio: We view it as our goal to deliver income in U.S. dollars. As a result, we typically repatriate our dividends into dollars when we accrue them, and we have historically attempted to hedge much of our foreign bond exposure due to the contractual nature of the payments. However, there may be market scenarios in which we elect to hold foreign currency balances, such as potentially choosing to diversify the currency exposure of our deferred purchasing power.
Q: Are there any specific sectors you're avoiding now?
Rob: We feel that among the least interesting investments across the capital markets are long-term sovereign bonds such as the U.S. 10-year Treasury bond. In this area, we believe there is a very asymmetric risk/reward profile. Long-term rates appear to us to have very little potential to move much lower, whereas if they revert to levels that were seen as recently as five years ago, we could witness significant purchasing power losses in those instruments. And these are instruments that are owned and viewed as safe haven investments.
It's not just sovereign bonds. It's also long-dated, investment-grade securities that mimic the properties of sovereign bonds with very narrow spreads on top of Treasuries. And, as mentioned, we've seen parts of the equity market where the valuations may depend upon this very low long-term interest rate environment continuing well into the future.
Ed: I would add that mortgage-backed securities certainly have a lot of interest rate sensitivity, and their credit convexity is even more negative than high yield. So, given where mortgage-backed yields are and the fact that you really don't benefit very much from credit improvement there, it's not an area that we find attractive.
Q: Where are you finding opportunities?
Giorgio: Our tendency is to gravitate towards sectors or geographies that are suffering from negative sentiment or that are out of favor with other investors, precisely because this is when securities become attractive in our view. Over the course of the past year a number of such opportunities have arisen. Specifically, in equities, certain European cyclical/industrial businesses have, at times, offered compelling value. One example of this were the shares of Total SA, which—despite being a global integrated oil company—performed significantly worse than U.S. peers during the May/June 2012 European crisis flare-up. We feel this is due in no small part to the company's French domicile. We have also found equity opportunities in the tech sector, where anxieties about the success of tablets and the threat from new forms of computing have brought valuations down to what we feel are attractive levels. When we see companies such as Microsoft that have strong balance sheets, generate substantial cash flow and have been steadily increasing their commitment to dividends, we become interested because there appears to be the opportunity for both income and capital appreciation.
Sean: In fixed income, we feel that in a benign credit environment like today, the high yield sector offers attractive risk-adjusted return for our investors. Right now, we are better compensated for taking on credit risk rather than interest rate risk. The credit market (and specifically the high yield market) may provide an offset to the enormous interest rate sensitivity of so called risk-free assets, as high yield bonds have historically tended to be much less interest rate sensitive than higher-rated fixed income instruments.
The lower you go down the rating spectrum, the more credit-sensitive you become and the less interest rate sensitivity there has been historically. So, in the past, high yield spreads have provided a buffer in the event of the yield curve shifting higher.
Ed: Even within high yield, we are cautious about exposure to low-coupon 10-year paper. We're more comfortable in the B space rather than the BB space, opting for greater credit risk and reduced interest rate sensitivity. However, just because we're in a very low absolute yield environment, we are not going to change our investing style to "chase yield." We're always going to stick to our investing discipline, and by seeking to avoid defaults we attempt to maximize total return in the long run.
To that point, we have found some attractive opportunities in the loan space. As the attractiveness of the high yield market gradually erodes, with tighter spreads and higher absolute prices, the upside to bond investments becomes more constrained. In this environment, we are giving up a little bit of yield by investing in loan opportunities which occupy a higher position in the capital structure and, therefore, provide a greater margin of safety. The floating rate nature of loans may also help insulate a portion of the portfolio from interest rate risk.
Q: What about high yield outside the U.S.?
Ed: The European high-yield market has grown significantly over the last several years. We expect this to continue as European banks de-lever and offer less financing to European companies. Alternate forms of financing—notably high yield bonds—are filling this void. There are opportunities in euro-denominated issues and also European companies coming to the domestic high yield market with dollar issues.
To date, we've generally focused on Northern European issues in the chemical, manufacturing and telecom industries. Generally, we have invested in higher-quality companies within Europe versus the United States. One example is the bonds of HeidelbergCement, where we were able to invest in a rapidly deleveraging, improving credit. The company's substantial asset value, including a controlling stake in its publicly quoted Indonesian subsidiary, offered what we consider to be a substantial margin of safety to bondholders, not to mention, in our view, substantially underappreciated equity value.
Q: Why do you feel income investors should hold gold and cash?
Rob: We believe that investors should consider holding gold in a broad-based portfolio as a potential hedge against extreme outcomes. When income is an investment objective, gaining exposure to gold through dividend-paying gold miners represents an interesting option to own some "gold with a yield."
Cash is fundamentally the residual of the investment process and is—in our opinion—a critical component of a disciplined investment approach. It is deferred purchasing power that investors can put to work when opportunity arises during windows of market distress. Conversely, our cash levels tend to build during periods when we believe risk assets are less attractive.
Under different circumstances, this cash might be invested with some duration (for instance, in Treasuries) where it could also contribute some yield to the overall portfolio. But, given the risks to interest rate exposure that we've discussed, we don't feel comfortable extending the maturity of our cash. So today that cash is contributing very little to income generation.
Q: What's one piece of advice you have for investors thinking about sources of income or income funds?
Ed: Be very aware of the risk that you may be taking. Many people think of Treasuries as being a risk-free instrument, but in today's low interest rate environment, we believe these investments have significant interest rate risk with little return potential.
Rob: Don't confuse yields with return or yield with value. Yield is an element of total return, but high dividend yields may or may not be associated with sound equity investments, just as high yields to maturity in the bond market may or may not be associated with good credit investments.
Sean: Echoing what Rob said, there is no such thing as a free lunch. You have to look through the valuation to see the true hidden risks of each investment. If you are evaluating a higher-yielding investment, be aware that there are risks associated with that, which you need to balance against your income needs.
Giorgio: Don't ignore price. Especially today, when it's so hard for an investor to find an acceptable income stream from traditional sources, there is a really strong temptation to chase yields and that will risk capital impairment.
Q: What do you think is the least understood income risk in the marketplace?
Giorgio: I think the consequences of latent inflation risk are actually pretty well understood, so it's really more reaching for yield that is the biggest risk today. It is such a struggle for investors. The siren song of a high income level or a high dividend yield is very hard to resist when the 10-year Treasury is trading below 2%. One should never forget that: Wherever you invest, you are always putting your capital at risk.
Sean: I think dividend growth is not well understood as far as the embedded risk of reaching ever further down the quality spectrum to provide that dividend growth. And it's akin to more of a "momentum investing" type strategy. You see it in the credit markets all the time: As the credit cycle moves along and credit conditions erode, spreads paradoxically tighten, and people reach for ever-increasing yield by investing lower in the credit spectrum at the worst possible time.
Q: Any parting thoughts about resisting the temptation to reach for yield in this challenging environment?
Ed: We've all learned that you must stick to your investing discipline, regardless of market conditions. As long as you do that, you can minimize defaults and therefore hopefully avoid the permanent impairment of capital.
Sean: It all starts with the question of margin of safety. In any investment that we consider, we ask ourselves, does it have an adequate margin of safety? Do we have a level of comfort with management and feel that they will treat us fairly as stakeholders? What is our attachment point to the enterprise? Does it afford us an adequate buffer to protect us from permanent impairment of capital? How sustainable and how volatile is the free cash flow generation?
Rob: Building on that, valuation comes before everything—both when purchasing and selling securities. The Global Income Builder Fund has a dual purpose. We're not singularly focused on income. We're also focused on capital appreciation. Once an investment that we made at what we believe was a discount to intrinsic value is no longer cheap, that investment becomes no different from all other potential investments that we think fail to embody a margin of safety.
Beyond margin of safety at the security level, like all First Eagle Funds, the Global Income Builder is managed with a focus on attempting to avoid downside risk at the portfolio level. This is illustrated by the exposure to gold as a potential hedge, cash as deferred purchasing power and constructing a portfolio we believe provides an adequate level of diversification.
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.
Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer's ability to make such payments may case the price of that bond to decline.
The Fund invests in high yield securities (commonly known as "junk bonds") which are generally considered speculative because they may be subject to greater levels of interest rate, credit (including issuer default) and liquidity risk than investment grade securities and may be subject to greater volatility. High yield securities are rated lower than investment grade securities because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities.
The holdings mentioned herein represent the following percentage of the total net assets of the First Eagle Global Income Builder Fund as of December 31, 2012: Bouygues SA., 1.73%, Total SA, 1.66%, Microsoft Corp, 1.67%, and HeidelbergCement, 1.30%. The portfolio is actively managed and holdings can change at any time. Current and future portfolio holdings are subject to risk.
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. Income generation is not guaranteed. All investments involve the risk of loss.
The commentary represents the opinion of the Global Income Builder Team Portfolio Managers as of December 31, 2012 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.
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 asking your financial adviser, visiting our website at firsteaglefunds.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.
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