First Eagle Global Value Fund commentary for the third quarter ended September 30, 2016.
In the third quarter of 2016, the MSCI World Index rose 4.87%, while in the United States the S&P 500 Index increased 3.85%. In Europe, the German DAX Index was up 9.79% and the French CAC 40 Index rose 6.19%. In Japan, the Nikkei 225 Index rose 6.99% over the period. Brent crude oil increased 1.24% to $48.24 a barrel, and the price of gold fell -1.75% to $1313.30 an ounce. The US dollar weakened -1.36% against the yen and fell -0.94% against the euro.
First Eagle Global Value Fund
[drizzle]During the third quarter, stock prices and volatility statistics indicated that risk perception in the markets was modest overall. Just before the start of the quarter, the Brexit vote had caused risk aversion to spike, but soon after, most world markets other than the UK rebounded. Implied volatility, as measured by the VIX, was below average, and investor capital continued to flow into equity ETFs. As we have been stating for some time, we do not share the market’s complacency toward risk.
Events in the third quarter reminded us once again of the strange things that can happen in economies where interest rates are repressed and where central banks pursue policies of quantitative easing (QE). When QE was first implemented in the wake of the financial crisis, it was seen as a temporary measure. But since that time, the debt accumulated by central banks around the world has not been unwound, and it still sits on central bank balance sheets.
Where can monetary policy go from here? In the third quarter, the Bank of Japan (BOJ) revealed one possible direction. Early this year, the BOJ introduced negative interest rates, which drove the front end of the Japanese yield curve down to roughly -40 basis points. Since commercial banks cannot pass negative rates on to their customers, this development squeezed bank profits and limited private sector credit creation. To address this problem, the BOJ announced that it was targeting a 10-year interest rate of zero. By keeping shorter-term interest rates negative, it hopes to maintain a positively sloping yield curve, which may give Japanese banks a chance to earn some profits.
The fact that the yield curve going out a decade has now been targeted by one central bank and the fact that excess sovereign debt is being purchased by central banks around the world lead to a troubling conclusion: Increasingly, in economies around the world, the price of money is being distorted.
The supply of money is another source of distortion. Despite the fact that interest rates around the world are close to zero, monetary aggregates continue to grow. M2 is growing 3% to 4% a year in Japan, 5% to 6% a year in Europe and 7% to 8% in the United States.1 Essentially, this means that holders of long-term sovereign obligations are being diluted by increases in the monetary supply relative to the yield that they are receiving. Investors who owned a stock in a company that paid a 1% dividend but issued 5% more shares every year would know intuitively that they were being diluted. In the sovereign debt market, too, dilution poses a structural challenge for investors who are trying to obtain real returns.
In today’s markets, with interest rates that may be negative in real terms and very negative relative to money-supply growth, and with price/earnings ratios that are above average, there may not be an immediate, top-down, macro solution to the problem of low real returns. We believe the only solution in this kind of era is bottom-up stock selection. The key is to identify securities, one at a time, that may demonstrate resilience in the face of macroeconomic challenges.
In a world where overall valuations are high, demanding a bottom-up “margin of safety”2 in valuation is one way to help reduce risk. Equally, in a world where sovereign debt continues to mount, buying companies that do not have excessive leverage can make a difference. And at a time when policy experiments continue to proliferate, finding management teams that are prudent and sound allocators of capital can be part of the solution. We think this environment, while challenging from a top-down, passive standpoint, lends itself to an active, disciplined, bottom-up approach.
First Eagle Global Fund
In the third quarter of 2016, the Global Fund Class A shares (w/out sales charge)3returned 3.92% versus the MSCI World Index return of 4.87%.
Leading contributors for the quarter represented a range of industries and included HeidelbergCement, Linear Technology, Microsoft Corporation, SMC Corporation and Teradata Corporation. HeidelbergCement released results in July that showed a sound cyclical improvement in its fundamental profitability. The company’s operations in North America, Scandinavia, the Netherlands and Germany continued to perform well, but there was softness in its Canadian oil sands business and in parts of Asia. Overall, though, the company displayed admirable cost discipline. HeidelbergCement is among the world’s largest holders of aggregates, but this component of its business, buried inside a cement company, has not been awarded the kind of higher valuation that the market confers on stand-alone aggregates companies. This now appears to be changing.
Linear Technology is a California-based analog semiconductor company that has long product life cycles and high margins. The company is being acquired by Analog Devices at what we consider a full and fair price.
Microsoft Corporation did well in the quarter, based on continued momentum for its cloud-distributed software business and its Office products, as well as promising signs for its customer relationship management business. Microsoft’s management has maintained control over operating expenses while at the same time making sizable investments in many areas, such as cloud software, machine learning and artificial intelligence.
SMC Corporation, a Japanese firm that is a leader in pneumatic controls for industrial automation, also added to returns. Sentiment on SMC had taken a particularly negative turn after Brexit, but the stock bounced back as concerns about the business cycle eased. Major detractors in the third quarter were Barrick Gold Corporation, Goldcorp Inc., Oracle Corporation, Sanofi and Orbital ATK. As the market transitioned to more of a risk-on environment, the gold price moderated and so did shares of Barrick Gold and Goldcorp.
Shares of Oracle Corporation fell—modestly, in our view—but because our position in the stock is large, it registered as one of the larger detractors. Oracle continued its transition to providing its software via the cloud, and this entails a change from upfront license revenues to subscription-based license revenues. In the short term, the impact on results has been negative, but over the longer term, we believe this transition should be positive because of the annuity-like stream of payments the company is expected to receive. We remain comfortable with our position in Oracle.
Sanofi is a French pharmaceutical company that experienced softness in its diabetes business in the United States. The company’s US patent for Lantus, its primary insulin drug, expired in 2015, and competition from less expensive biosimilars weighted on Sanofi’s share price. At the same time, Sanofi’s vaccines business and the specialty