First Eagle Global Value annual letter to investors for the year ended December 31, 2020.
Those who think it’s possible to predict the future of economies and markets with any sort of accuracy would have a hard time explaining 2020—a year dominated by a black swan event that descended upon the world with little warning and even less indication of the breadth and depth of its impact. In December 2019, no serious economist or public health official was predicting the emergence of a novel coronavirus that would cause nearly two million deaths worldwide and provoke a deep and widespread recession. Similarly, we know of no prognosticators who forecasted, at the depths of the Covid-19 selloff, that nearly all major equity markets not only would recover their losses by the end of the year but many would also close 2020 at or near all-time highs.
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At First Eagle, we have long accepted that the future is unknowable. As such, we orient our true north around the creation of resilient wealth in the face of complexity and uncertainty, striving to create all-weather portfolios that mitigate the permanent capital impairment no matter what surprises tomorrow may bring. We cast a wide net to identify businesses with scarce, durable assets that we believe have the potential to generate persistent earnings power over time, and we seek to acquire these businesses only when available at prices that represent a discount to our estimate of their intrinsic value.
First Eagle Global Value: A Banner Year for US Growth Stocks in the Teeth of a Pandemic…
Investors initially downplayed news of the identification of a novel coronavirus in China, and equity indexes continued to press higher for the first weeks of 2020 as they did for much of 2019, led by growth-oriented stocks in general and the popular new economy names in particular. Sentiment shifted violently midway through the first quarter, however, as it became evident the virus initially written off as a regional concern in fact represented an emerging global health crisis—one that ultimately would bring an end to the longest bull market in US history and trigger the deepest global recession since World War II and the most widespread on record.
A massive selloff in risk assets came to a halt in late March, even as the pandemic was building momentum in Western Europe and North America, with global central banks and federal governments acting quickly and forcefully to provide immense liquidity and other forms of support for financial markets, economies, businesses and individuals. In the US, the Federal Reserve rolled out all the facilities it implemented in response to the global financial crisis, including near-zero interest rates and largescale purchases of government securities, as well as additional programs to support the corporate bond market, the municipal market and small and medium-sized enterprises. Though the utilization of these new facilities was fairly low, their introduction had a significant impact, particularly in the bond markets, where the very existence of a Fed backstop attracted investors and contributed to pronounced spread tightening.
While growth stocks generally have outperformed value names in the nearly 12 years since the global financial crisis market bottom, 2020 was a generationally bad year for the value style relative to growth, driven in part by the dynamics that emerged in the wake of the pandemic-related disruptions of first quarter 2020.
Over the past decade, the MSCI World Index has compounded at an annualized rate of 9.9%, with the MSCI World Growth Index climbing 12.8% compared to the 6.8% increase in the MSCI World Value Index. While the difference between growth and value performance during this period is meaningful, it falls within the historical norms of cyclical variation. Relative performance in 2020 was far less typical. While the MSCI World Index was up 15.9%, the growth component returned 33.8% compared to a 1.2% decline in value; this 35% spread almost defies belief given that the growth and value indexes have a long-term historical correlation in excess of 0.9. Spreads between growth and value were similar in the US, as the Russell 1000 Growth Index posted a 38.5% return during 2020 compared to the 2.8% return of the Russell 1000 Value Index.1
Given the nature of the economic turmoil that emerged as Covid-19 widened its spread, a certain amount of value/growth bifurcation makes sense. The pandemic provoked a near shutdown of the more mature, physical components of the economy-such as commodities, manufacturing and real estate—whose participants tend to populate value indexes. In contrast, the pandemic-driven shift online for both business and personal commerce accelerated preexisting trends and provided a significant boost to the revenue and cash flows of new economy growth stocks with strong online presence. Not only did markets overwhelmingly favor growth stocks, they overwhelmingly favored a narrow cohort of mega-cap tech-related companies. As a result, the five largest stocks in the S&P 500 and MSCI World indexes—Apple, Microsoft, Amazon, Google (Alphabet Class A and Class C combined) and Facebook—represented 22% and 13% of these indexes in terms of market capitalization, respectively, as of yearend 2020 compared to 11% and 5% at end-2009.2 High concentration within indexes makes true diversification more difficult for benchmarked portfolios to achieve and in our view leaves such portfolios more susceptible to idiosyncratic risks.
While many of these companies posted impressive operating results in 2020, the incontrovertible problem for the high-flying growth stocks is that their market valuations in most cases have increased at a far greater rate than their fundamentals, suggesting investors have extrapolated 2020’s Covid-assisted metrics into the future. And with interest rates near zero, these high expectations for the future could be discounted back to the present at very low discount rates, resulting in significant multiple expansion. For example, the enterprise value/EBIT ratio of the MSCI World Growth Index relative to the MSCI World Value Index is at the highest level since 2000—a data point that might give investors pause.3
At the other end of the growth-stock spectrum, low discount rates also have heightened the appeal of more speculative names, as investors see less opportunity risk in taking a flyer on investments that may pay big rewards down the line—or nothing at all. We see this in “concept stocks” that trade at three- and four-digit and even infinitesimal earnings multiples. We also see this in the initial public offering (IPO) market, including offerings of special-purpose acquisition companies (SPACS or “blank check companies”), shell companies that raise investor assets in the public markets based on a commitment to acquire unspecified private businesses within a certain period of time. The 248 SPACs brought to market in 2020 have raised in excess of $83 billion, compared to less than $50 billion in aggregate proceeds over the previous 10 years.4
…But Is a New Day Rising for Value and International Equities?
As we’ve often cautioned, extrapolating trends is a risky way to commit capital, particularly when these trends reflect an extraordinary operating environment like 2020. Some of the factors that led to the extreme gap in valuation between growth and value last year have a natural elasticity to them and are likely to revert. The arrival of vaccines suggests there is a plausible path for economies to reopen within the next 12 months, to the potential benefit of the companies most directly impacted by 2020’s lockdowns—mature businesses operating in the physical economy. Further, morenormal conditions may make it difficult for certain growth stocks to maintain lofty valuation multiples as year-over-year sales and earnings growth comparisons become more challenging in 2021. In contrast, there are a number of solid, long-established companies in the mature economy—particularly in the materials, industrials and financial services sectors—that are trading at single-digit earnings multiples. Such companies generally do not need to post extraordinary growth rates to produce attractive returns; they simply need to bring their earnings power back to pre-pandemic levels, and many have track records of doing so after previous economic dislocations.
In fact, there were signs in the fourth quarter that investors had begun to take notice of these shifting dynamics. In what was a strong period for equities across the board, value outperformed growth both globally (15.7% for the MSCI World Value versus 12.5% for MSCI World Growth) and within the US (16.3% for Russell 1000 Value versus 11.4% for Russell 1000 Growth).5 Historically, such rotations from growth to more cyclical value stocks are typical of the early stages of a new business cycle, as investment flows to companies likely to benefit from a renewal in economic activity.
Also notable in the fourth quarter was a turnaround in the relative performance of non-US stocks, as the MSCI EAFE Index outpaced the S&P 500 Index 16.0% to 12.1%. Part of this sizable outperformance can be attributed to currency effects; in local-currency terms, the EAFE gained only 11.9%.6 A weakening dollar historically has boosted the performance of non-US companies and the performance of non-US stocks owned by dollar-based investors. Though the dollar was strong early in 2020 as investors sought perceived currency “safe havens,” it has weakened steadily since risk assets began to rebound in late March. This was due at least in part to the Fed’s slashing of its policy rate to near zero, which narrowed interest rate differentials between the US and other nations and diminished the appeal of the dollar carry trade.
While we don’t maintain a specific forecast for the dollar or any other currencies, we are mindful that the money supply in the US has been growing at a much faster rate compared to other developed markets. For example, M2 money supply in the US grew 25.1% in the 12 months through end-November 2020 while the broad monetary aggregates for Japan and the euro area grew 9.1% and 9.7%, respectively.7 The US also maintains the world’s largest current account deficit, while Japan and the euro area have surpluses.8 These factors suggest that further dollar weakening is a possibility, which could offer additional support for non-US equities. We have long observed that while the US is home to many excellent businesses, it does not have a monopoly on quality companies. Given relative performance trends in recent years, market valuations outside the US may offer opportunities to purchase quality international companies with a greater “margin of safety”9 in price than available domestically. We think now is a time when investors should closely consider the potential benefits of globally diversified portfolios.
These dynamics also impacted movements in the price of gold, which established a new record high in nominal US dollars during August. Real interest rates—that is, the difference between nominal interest rates and inflation—represent the opportunity cost of owning gold and are the most important driver of the gold price in the medium to long term. Since it pays neither dividends nor interest, gold is relatively expensive to hold when real interest rates are high and relatively inexpensive when real rates are low. As such, real interest rates and the price of gold historically have been negatively correlated. While 2020 was a tumultuous year for both real and nominal interest rates, gold exhibited its traditional behavior, rallying to its August high as real rates fell deeper into negative territory before leveling off.
Optimism Persisted Despite Abundant Risks
With the Fed and other central banks having committed to low interest rates for the next several years, it could be that the recovery from the Covid recession takes on a different shape than other recent experiences. Notably, policymakers this time around seem less likely to proactively respond to mounting inflation pressures as business activity picks up. In fact, the Fed’s August shift to a flexible inflation averaging mandate suggests it will gladly allow inflation to run at a rate above its 2% target to make up for the sub-target inflation that has prevailed since the global financial crisis. Higher inflation would help reduce bloated levels of sovereign debt relative to GDP, but it also may prompt investors to demand higher interest rates on Treasuries and put additional downward pressure on the dollar.
Historically, stocks have reacted positively to low, stable inflation and negatively to both deflation and high inflation. Markets priced for perfection suggest investors may be underestimating the risk of any outcome other than a perfect disinflationary recovery—the financial system equivalent of Captain Sully setting down safely in the Hudson River after a bird strike disabled the engines of his Airbus A320.
Inflation isn’t the only risk that could blow markets off course. Despite relief over the rollout of vaccines, the end point of the Covid era and its many economic dislocations remains uncertain. In the meantime, many businesses remain shuttered, and unemployment remains both high and bifurcated, highlighting the K-shaped recovery that appears to have taken hold. While the jobless rate nationwide stood at 6.7% at the end of December, this figure can be decomposed into a 7.8% rate for those with only a high-school diploma and 3.8% for college graduates.10 Following much partisan rancor, a second stimulus bill signed into law in late December will provide many struggling Americans with another $600 check.
After winning both seats in the January 5 Senate runoff in Georgia, the Democrats will control all three branches of the US government come Inauguration Day. While this improves the likelihood of ongoing fiscal stimulus in 2021, the Democrats’ slim advantage in the Senate—a 50-50 split with Republicans, with Vice President-elect Harris serving as a tiebreaking vote if necessary—may serve as a check on the type of massive spending that was earlier speculated to be a strong possibility in the event of a November “blue wave” and curtail very progressive, antibusiness policy tendencies.
Though the Biden administration is expected to take a more cooperative, predictable approach to foreign policy, geopolitical conditions remain tense. China, for example, finds itself in the midst of a multifaceted economic transition—from a command economy to a market economy, from a closed economy to an open economy, from an investment-based and export-led economy to a consumption-based and service-sector economy—as it continues to flex its vitality on an increasingly fractured global playing field. Significant obstacles stand in its way, including waning potential GDP and productivity growth, a rapidly aging population, massive indebtedness, the challenges of opening its capital account and deteriorating Sino-American relations. And though China’s economic activity has rebounded significantly from the early 2020 dislocations of Covid-19, the pandemic has increased the degree of difficulty for policymakers and highlighted the shortcomings inherent in China’s political and socioeconomic framework. If China mishandles its transition to a slower rate of growth, the impact could send ripples—if not waves—throughout the world economy.
Defining Value Stock by Stock
Earlier in this letter we noted that 2020 was a generationally difficult year for value. We should clarify that last year was a generationally difficult year for statistical measures of value; that is, for market indexes—and the passive strategies that seek to track them—composed of stocks considered cheaper than average by some fundamental valuation metric or combination of metrics like price-to-book-value or price-to-earnings. The primary flaw with such indexes and strategies is that the quantitative process used to build them assumes that, while price may diverge across securities, business character is homogenous.
In our view, a far better approach to value investment begins with defining the character of a business before assessing its price. By avoiding the assumption of homogeneity, the quantification of price becomes conditional to a comprehensive appraisal of a business and the concept of value becomes a much broader tent. Rather than being limited to only the statistically cheapest group of stocks, this approach centers on identifying the intrinsic value of a business based on the specific tangible and intangible attributes that can be expected to drive its cash flows over time. In this manner, any business available for purchase at a discount to our estimate of its intrinsic value should be considered for investment independent of the style bucket into which index providers have placed it.
The knowledge-based businesses emblematic of today’s economy increasingly are focused on the development of intangible assets rather than the property, plant and equipment investments that were the hallmarks of the old guard. However, these intangible assets for the most part are not captured by current financial accounting standards, which presents a challenge to investors seeking to identify undervalued stocks based on traditional metrics that seem to have become increasingly unmoored from the intrinsic value of many businesses. As a result, it seems more likely that indexbased value strategies would be skewed toward the stocks of cheap but flawed companies. These businesses may have falling market shares or be subject to adverse shifts in customer preferences. They may be in structural decline or at a persistent competitive disadvantage or even in financial distress. In other words, they may be cheap for good reasons, though ones not necessarily captured in their published financial statements.
We’ve found that high-quality intangible assets often manifest as an advantaged market position for the company in possession of them. Dominant players in their space—whether it’s bicycle gears or commercial ice makers or computer software—typically are able to scale fixed costs across a larger volume of production, which should result in lower production costs compared to the competition and thus greater free cash flow per unit. This cash flow generation allows these companies to steadily reinforce their already advantaged positions; that is, it may enable them to expand the moat around their business. The incumbency of such companies—typically already well-entrenched in their industries and in possession of the unique management and technical expertise that implies—can be difficult to unseat.
Seeking All-Weather Portfolios
We are confident that recent market conditions, while difficult for both quantitative and fundamental value investors, have reinforced the importance of business character, of which intangible assets are an integral part. Though balance sheets, income statements and cash flow statements remain essential to an analyst’s toolkit, intangibles in many cases can only be fully appreciated through rigorous and often personal due diligence: facility tours and meetings with managements, supply-chain check-ins and discussions with consumers. Though the potential benefits of intangible assets can be difficult to quantify, understanding their impact on business performance is essential to effectively estimating intrinsic value and to sidestepping the distortions that have emerged in traditional valuation metrics.
At First Eagle, we believe that ongoing and substantive investment in our fundamental research platform positions us to better appreciate the intangible assets and serves as a differentiating factor between us and other managers. First Eagle's Global Value team has evolved in a measured and deliberate fashion over the years, developing existing talent, broadening responsibilities, adding resources and building out discreet areas of competency with an eye toward supporting the needs of our clients now and in the future. While structural challenges have tested the resolve of many active value managers in recent years, our dedication to our investment philosophy has not wavered.
The portfolios managed by First Eagle’s Global Value team generally performed as we would expect in 2020. Our portfolios generally demonstrated resilience in the face of the first quarter’s selloff, and we took advantage of market dislocations to selectively allocate capital, on what we believed to be advantageous terms to what we viewed as wellpositioned, well-capitalized, well-managed businesses with the potential to demonstrate resilience over the long term. At the same time, remembering the guidance of our former colleague Jean-Marie Eveillard, we avoided conflating cyclical opportunism with blind contrarianism, resisting the temptation to double down on stocks that suddenly had become “cheaper” in the course of a handful of weeks. We lagged the broader market in the growth-led recovery that eventually took hold, as we maintained our commitment to our core investment philosophy and strict valuation discipline.
As we enter 2021, we believe our portfolios are appropriately positioned for the future while continuing to represent an attractive all-weather option for long-horizon investors. Our largest holdings tend to be focused on cash-flow generative, compounding businesses that have what we view as strong market positions and clear lines of sight into their forward prospects. Looking deeper, we have a range of smaller allocations that we believe are positioned to potentially benefit from the re-opening of the physical economy. And our big-tent approach to value investing, discussed earlier, has enabled us to gain exposure to stocks not typically associated with value-oriented portfolios from industries that have benefited from the transition to a virtual environment, including social media, online advertising, cloud software and factory automation.
Meanwhile, we maintain strategic allocations to gold and gold-related equities as a potential hedge, positions that served portfolios well in 2020 as real interest rates declined in the wake of massive central bank stimulus; in fact, price appreciation during the year prompted us to trim our gold holdings to avoid maintaining a position size that would represent a directional perspective. Gold continues to be an important source of ballast in our portfolios as well as a source of deferred purchasing power in the face of ongoing fiat currency debasement.
We want to close by thanking you for your continuing support. We look forward to serving as prudent stewards of your capital in the years ahead.
Head of the First Eagle Global Value Team
Global, Overseas, U.S. Value and Gold Strategies
T. Kimball Brooker, Jr.
Deputy Head of the First Eagle Global Value Team
Global, Overseas, U.S. Value and Global Income Builder Strategies