The First Eagle Portfolio Management Team On The Trends Driving Global Opportunities
January 25, 2016
by Robert Huebscher
First Eagle’ Global Fund (SGENX) is its flagship fund, with over $45 billion in assets. Its mission is to seek long-term growth of capital by investing in a range of asset classes from markets in the United States and around the world.
Since inception (1/1/79), it has returned 13.35% annually, versus 9.50% for the MSCI World Index. Over the last 15 years, it has been in the top 2% of its peer group, as well as in the top 5% for 10 years and the top 15% for 5 years, based on Morningstar data. It was the winner of the Lipper Best Flexible Portfolio Fund Award for 2015. Its managers are Matthew B. McLennan and Kimball Brooker, Jr.
I spoke with Matt and Kimball on January 14.
In a panel discussion back in June, Bruce Greenwald, who is an advisor to your firm, made a number of assertions. I am going to ask you about each of them and how your portfolio is structured to benefit from them. The first one is that manufacturing is dying and that is creating chronic deflationary pressure.
First Eagle’s Matthew B. McLennan: Bruce was making the simple point that factory automation is reducing the need for labor in manufacturing. When he said manufacturing was dying, he wasn’t intimating that we are producing less things, just that it is taking less labor to produce those things. The analogy I draw here is if you went back in time a century or so ago, many people were employed in some form of agriculture. Today it is a low single-digit percentage of the economy, but we are all still eating well, perhaps too well. Jobs moved from the agricultural sector to manufacturing sector throughout the course of the early part of the last century. Of course, during the last generation, it has moved progressively to the services sector.
Factory automation is a very powerful source of ideas for our fund. We’ve seen that in the proliferation of robotics, pneumatic systems, electrical sensors and the like. In fact, if you look at our portfolios, we have benefited from this trend through the ownership of some of the leading franchises in this area, companies such as Fanuc in robotics, CNC in servo motors, as well as SMC in pneumatics.
The decline of employment in manufacturing is having a second-order effect on global systemic imbalances. Part of that is driven by the fact that many of the Asian economies have built their economic miracles on manufacturing models fueled in large part by subsidized exchange rates. As they’ve grown rapidly through manufacturing and moved a lot of people from poverty into employment in manufacturing, they prospectively face the headwind of jobs moving out of manufacturing into services. It takes time to retrain people. That has produced a persistent tendency for countries in that region to try and devalue their currency versus the dollar, which in turn has produced a structural current-account deficit in the United States. The quest for growth through manufacturing in Asia is fueling a savings shortfall in the United States.
But the essential point is that factory automation is really taking root. Initially it was robotics for cutting and welding tools and for basic things like painting. But as sensing technologies improved, and software and robotics capabilities improved, there is the prospect of automation creeping into the assembly stage of manufacturing where most of the jobs are. This trend is going to be with us for quite some time; we are still in the early days of those pressures.
Having said that, looking forward a generation from today, it will take a lot less people to produce what we are producing now, which will free up resources for other productive enterprises. It just won’t necessarily be a smooth journey, particularly for those economies that have built their economic strength on manufacturing.
The second trend is that service businesses are local in nature and therefore can grow to be able to earn superior rates of return.
First Eagle’s Matthew B. McLennan: I made the observation that employment is moving from manufacturing to services. When people think of services, often what comes to mind are very simple things like teaching, public relations, child care, private event management, restaurants, local IT services and the like. But those are not necessarily the kinds of businesses that generate superior returns, because they are competitive.
When we think about service businesses that have the ability to generate superior returns on capital, we are very focused on businesses that have local economies of scale. Those businesses are orders of magnitude larger than their nearest competitors, which makes it more difficult for new entrants to come into a market. We also focus on service businesses where there is a high degree of customer captivity, or stickiness, because it increases the cost of a new entrant coming into those markets.
We have a range of investments both overseas and in the United States in areas such as telecommunications, such as KDDI, a scaled provider of mobile and broadband connectivity in Japan, and Secom, also in Japan, which dominates in the commercial services arena for providing alarm, security services for corporations and homes. In the United States, we own Comcast, which dominates bandwidth provisioning essentially in the markets in which it competes. We own some of the big tech majors, like Oracle and Microsoft; even though they are global in nature, their dominance is local and rooted in sales force density and customer standardization.
When we look at businesses we try to identify those that have local economies of scale and sticky customers. Many of these businesses are not traditional manufacturing businesses. You may have elements of their business that don’t require tangible capital investment, but rather where things like brand and process know-how matter. These businesses can generate very attractive returns on their tangible capital.
Even in the world of what you would traditionally think of as industrials and manufacturing, local market dominance matters. Think of companies like Deere in combines for agriculture or Flowserve in pumps, valves, and seals. Even though you wouldn’t think of them as services, most of them have material aftermarket businesses that require density of distribution and dealerships, with aftermarket servicing capability that enable them to get superior returns on their capital.
The third trend is that the lower 85% of households in terms of wealth have a negative savings rate, and it’s the remaining 15% who are accumulating. That’s a catastrophe waiting to happen because so many households have a negative savings rate.
First Eagle’s Matthew B. McLennan: What Bruce was referring to is the fact that if you look at the overall savings rates, it has drifted up from the low levels of the mid-2000s to just above 5%. The debt-service ratios seem to have improved. But when you look beneath the surface, debt-service ratios look attractive because interest rates have been repressed. The actual level of debt-to-income remains fairly high.
Secondly, even though savings rates are above 5%, the top 15% of households probably save close to 40% of their income. All the savings is coming from the