Why this $80bn fund manager won’t touch Australian banks

Why this $80bn fund manager won’t touch Australian banks


Won’t invest in Australian banks … Matthew McLennan with his wife Monika in New York City. Photo: Trevor Collens


Australia’s biggest international fund manager believes Treasurer Joe Hockey should be taking the possibility of a housing bubble more seriously and worries money-printing by central banks is creating asset bubbles. Matthew McLennan, who manages $80 billion of assets in New York for First Eagle Investment Management, revealed to AFR Weekend he won’t invest in Australian banks because they are too risky and is concerned about the levels of private sector debt in Australia.The publicity-shy Mr McLennan, 44, was selected to run the privately held fund manager’s global equities funds in 2008 after 14 years as a fund manager at Goldman Sachs in Sydney, New York and London.

Read more | Full transcript of Christopher Joye’s interview with Matthew McLennan

His Global Value Fund has returned 14.7 per cent annually after fees since its inception in 1979, almost 5 per cent each year above the relevant MSCI World Value Index.

While First Eagle Investment Management and Mr McLennan are virtually unknown in Australia, the company has a storied history on Wall Street. Hedge fund maven George Soros and his partner Jim Rogers were employees early in their careers.

Mr McLennan studied at Brisbane Grammar School and the University of Queensland, worked briefly at the QIC and was appointed a managing director at Goldman Sachs at the age of 33.

He may now be the most influential Australian investor in the world.


Mr McLennan said he was unimpressed with Mr Hockey’s recent defence of Australian property inflation, which is currently three times the rate of wages growth.

Mr Hockey told CNBC last week that some US commentators do not understand the Australian housing market.

“Australia is a long way from a bubble,” Mr Hockey said.

Mr McLennan, whose father worked as a land surveyor, responded that he could not fathom “why people felt the need to say a market is not in a ­bubble” given the high relative property prices.

“I don’t think that’s a prudent approach when you see large levels of leverage and fairly low rental yields,” he said. “I don’t know what the upside is in talking down legitimate risks.”

Mr McLennan said he thought ­Australian house prices were “on the full side of fair value in a situation where the marginal buyer is already quite levered”. Australia’s house price-to-income ratio is less than 10 per cent below its all-time peak.


In a reference to the federal government’s position view on rising prices, Mr McLennan said investors felt “far more confident when a management team tells you what it is worried about than when it displays ­complacency”.

Asked if he had invested in Australian banks, which are highly profitable by overseas standards, Mr McLennan said he was put off by the major banks’ lofty leverage, which averages 27 times their underlying equity capital, and their exposure to fickle wholesale bond markets.

“We haven’t been investors in the Aussie major banks, because the raw equity-to-asset ratios . . . are lower than our comfort zone,” he said.

While the banks have profited from a “fair amount of cumulative credit growth over the last generation” Mr McLennan said their “reserves-to-loan losses” appeared to be “pretty low in the scheme of things”.

He warned the Australian economy, which was dubbed by The Economist magazine as the “wonder Down Under” for 22 years of uninterrupted growth, may soon start to struggle.

“I have a few question marks over the Australian economy and think the ­outlook could be potentially quite challenging,” he said.

He said Australia’s low government debt-to-GDP ratio – long a point of pride for the previous Labor government – was a function of “a lot of excess debt in the private sector”.


“If you had a crisis in the private ­sector, the sovereign finances would ­deteriorate quickly,” he said. Mr McLennan added his concerns centred on two areas. China is shifting from an export-based economy that had powered Australia’s boom in iron ore, coal and gas investment to greater domestic consumption.

“This is happening at a time when you are seeing material weakness in the Indonesian, Japanese and Indian ­currencies, which means that “competitive pressures are ramping up on China,” he said.

“Currency instability in some of ­Australia’s largest neighbours . . . could portend a more difficult period ahead for both us and Asia.”

The second challenge is Australia’s “internal shift from structural tail-winds to structural headwinds”.

“Notwithstanding the mining boom, several decades of pretty large current account deficits in Australia have ­produced a very highly leveraged ­private sector,” he said.

“If we have the private sector in balance-sheet repair mode at a time when the government goes into fiscal restraint, this could give us a fairly soft underlying pulse, ­especially if China is chugging along more slowly.”


The fund manager attacked “financial repression” by central banks which had cut real interest rates to record lows, and the policy known as “quantitative easing” whereby they print money to buy government debt, corporate bonds and shares, to bid up their prices above natural market levels and reduce the implied cost of capital.

“The problem with that mental model is that it assumes you are starting from a point of view of asset prices being below their equilibrium values and savings being excessive,” he said.

“So you are seeking to stimulate new investment, dissuade savings, and get asset prices back to their normal values. But if asset prices are already at ­reasonably elevated levels relative to long-term history, and savings are close to generational lows, it is not clear to me that repressing interest rates and engaging in quantitative easing is prudent policy.”

Mr McLennan said he thought an end game would arrive if people “start to realise that the quality of money has become impaired”.

“If we blow another bubble now that bursts, and the sovereign is forced to step in again with its higher level of starting debt, at a certain point the system has to become unsustainable,” he said.

“You either have to print more money or accept deflation. My fear is that the risk in the current global financial system is that you get one of these extreme corner solutions.”


Interview transcript: First Eagle portfolio manager Matthew McLennan



This interview was recorded at 8am on October 15 between The Australian Financial Review’s Christopher Joye and Matthew McLennan. Mr McLennan, 44, runs $US80 billion of (primarily) global equities, cash and gold at First Eagle Investment Management, which is a privately owned fund manager based in New York.

George Soros started his investment career at First Eagle, where he worked between 1963 to 1973 as a vice-president at what was then known as Arnhold and S. Bleichroeder.

Mr McLennan was previously a managing director at Goldman Sachs in New York in London where he ran various value-based investment strategies. He was appointed a managing director at Goldman Sachs at the age of 33. He started his career managing international equities at the state sovereign wealth fund QIC in Brisbane following studies at the University of Queensland, where he won the university medal in finance.

Believed to be the largest individual Australian money manager in the world, Mr McLennan confirmed this is the first Australian media interview he has given. He agreed to the interview to improve awareness around Advance, which is a leading not-for-profit organisation representing the Australian professional diaspora that he and his wife, Monika, actively support.

Mr McLennan has interests in the field of education, being a member of the Board of Dean’s Advisors of the Harvard School of Public Health. He serves as a Member of the Trinity School Board of Trustees. He also serves on the Board of the University of Queensland in the United States of America, and joined the Advisory Board of Advance after returning to New York in 2008.

Q: So how much money are you actually responsible for running?

At First Eagle, my role is to serve as the head of the Global Value team overseeing $80 billion in assets as a portfolio manager on the Global, Overseas, US Value and Gold Funds. We believe in alignment of interests so senior employees are both owners of the funds and firm’s equity.

Q: What fees do you charge?

Unlike the hedge fund community charging 2 per cent management fees and 20 per cent performance fees for absolute returns, we have a flat pricing structure for most of our institutional clients, which typically pay a 0.75 per cent annual management fee. Some of international clients also pay a performance fee.

Q: How is the $80 billion allocated overall? Can you short stocks?

We are weighted around 70 per cent to global equities, a bit over 20 per cent in cash as the residual of a disciplined approach to buying and selling businesses which serves as a source of deferred purchasing power in both market crises and deflationary scares, and just under 10 per cent in gold bullion and gold equities as protection against purchasing power debasement or inflation.

We describe our cash and gold exposures as “ballast”. Only a very small percentage of our portfolio is invested in Australia through gold equities companies. We do not short stocks like a normal hedge fund. I personally think the reward per man-hour invested trying to short stocks is very limited.

We hedge deflationary and inflationary distress through our holdings of cash and gold, and our preference for buying cheap yet strong companies with a significant margin for valuation error.

Q: You seem to be Australia’s biggest-ever funds management export, but almost nobody here has ever heard of you. Why do you think that is?

I like to keep a low profile . . . and spend my spare time thinking!

Q: Did George Soros work for you guys?

Yes, Mr Soros started his investing career with us, as did Jim Rogers. And John Arnhold, our chairman, was on the board of Soros’s Quantum hedge fund for many years. Mr Soros and Henry Arnhold launched our first fund in 1967. John Arnhold, Henry’s son, and our current chairman, sat on the board of Soros… And was a successful arbitrage investor.

Q: You are running an extraordinarily large amount of money. How many people do you have in your team?

We have approximately 20 investment staff. We are firmly of the belief that no one has a monopoly on the truth, and as such we operate with a true partnership spirit between our portfolio managers, analysts, traders and senior advisers

Q: What do you think Janet Yellen’s nomination as the US Federal Reserve Chair means for global capital markets?

[NB: Quantitative easing represents central banks buying government bonds and other private assets, including mortgage-backed securities, corporate bonds and equities, to bid up their prices and lower the implied cost of capital and thus market interest rates]

I am not a believer in quantitative easing or nominal GDP growth targeting as policies, which seem to be key Yellen prescriptions.

I think if you are in a world where the private sector is deleveraging and you are essentially trying to force monetary growth through quantitative easing, you can only do it through the government expanding its stock of debt.

You therefore either reinflate another bubble in the private sector or you compromise the solvency of the sovereign in the long term.

At a certain point even just the whiff of the Fed “tapering” its government bond purchases in June was enough to seriously spook financial markets. One has to ask the question: will the Fed be able to realistically unwind these policies? Does what was ostensibly intended to be a temporary purchase of government securities as an emergency policy measure end up becoming a permanent monetisation of those assets? I guess we will find out the answer to that question in the next five to 10 years.

Q: So is it your view that global central banks are now effectively blowing new bubbles in response to the bursting of various housing and equities imbalances back in 2008?

I believe so. I believe that central banks are trying to reinflate asset values to encourage so-called “animal spirits”. The problem with that mental model is that it assumes you are starting from a point of view of asset prices being below their equilibrium values and savings being excessive.

So you are seeking to stimulate new investment, dissuade savings, and get asset prices back to their normal values. But if asset prices are already at reasonably elevated levels relative to long term history, and savings are close to generational lows, it is not clear to me that repressing interest rates and engaging in quantitative easing is prudent policy.

The end game is you start to realise that the quality of money has become impaired. If we blow another bubble now that bursts and the sovereign is forced to step in again with its higher level of starting debt. At a certain point the system has to become unsustainable. You either have to print more money or accept deflation. My fear is that the risk in the current global financial system is that you get one of these extreme corner solutions, although it may take a long time to get there.

Since democracy and deflation are like oil and water, I suspect the odds are skewed towards higher inflation and perhaps an unanchoring of inflation expectations, which could lead us to question the entire monetary mechanism, perhaps with a few deflationary shocks along the way.

Q: What is your outlook for the Australian economy?

I have a few question marks over the Australian economy and think the outlook could be potentially quite challenging.

The first issue is regional stability. Recent generations have benefited from China’s huge urbanisation process and the mining boom that has gone alongside it in Australia.

But China is now experiencing a transition that is gradually moving away from an urbanisation and export-based model to one that is more consumption driven – and that’s unlikely to be a linear development.

This is happening at a time when you are seeing material weakness in the Indonesian, Japanese and Indian currencies. So competitive pressures for China are ramping up.

I think currency instability in some of Australia’s largest neighbours, like Indonesia, Japan and India, combined with our own exchange rate volatility, could portend a more difficult period ahead for both us and Asia.

A second challenge is Australia’s internal shift from structural tailwinds to structural headwinds. Notwithstanding the mining boom, several decades of pretty large current account deficits in Australia have produced a very highly leveraged private sector.

While the new government is clearly pro-business, if we have the private sector in balance-sheet repair mode at a time when the government goes into a period of fiscal restraint, this could give us a fairly soft underlying pulse, especially if China is chugging along more slowly than she has in recent years.

Although the sovereign debt ratios in Australia are currently pretty good, that’s mainly because there is a lot of excess debt in the private sector. If you had a crisis in the private sector in Australia the sovereign finances would deteriorate quickly.

Q: Australia’s banking sector accounts for about 30 per cent of the sharemarket index and the majors rank among some of the most profitable institutions in the world. Are you investors?

We haven’t been investors in the Aussie major banks because the raw equity-to-asset ratios, as opposed to the ratios calculated using risk-weighted assets, are lower than our comfort zone. We also haven’t been there because there is an element of dependence on wholesale funding in the business model.

We’ve felt that it’s been a pretty good time for Australia – there has been a fair amount of cumulative credit growth over the last generation – and if you look at the reserves-to-loan losses inside the banks it’s pretty low in the scheme of things.

A lot of people would argue it’s been a successful, oligopolistic, and well-regulated market. But the risk-reward for us investing in an environment where the private sector has built fairly high levels of debt and the structural tailwinds for the economy are becoming structural headwinds, has made it non-compelling for us to spend a lot of time there. There are better non-brainer opportunities for us around the world.

We’ve also had limited investments in banks as a whole because we’ve had a fairly healthy scepticism for the world’s financial architecture. Where we have invested in banks they typically have conservative loan-to-deposit ratios, high equity-to-assets ratios, and lower leverage than what you find in Australia.

We like banks that focus on regional lending with wide net interest margins and which have big fee earning businesses attached to their balance sheets. Those are hard to find, and so banks have not been a big feature in our portfolio.

Q: You are clearly very knowledgeable on the Australian economy – what are your views on the resurgent Aussie housing market?

It is interesting to me when you hear a politician [recently Joe Hockey] saying this is not a housing bubble – that is just a supply-constrained market.

At the end of the day, I think the Australian housing market is instinctively on the full side of fair value in a situation where the natural constituency, the marginal buyer, is already quite levered.

I don’t understand why people feel the need to say a market is not in a bubble. I don’t think that’s a prudent approach when you see large levels of leverage and fairly low rental yields. While I get it that you want to support confidence, I don’t know what the upside is in talking down legitimate risks.

We’ve always made money by not losing money. Ultimately you feel far more confident when a management team tells you what it is worried about than when it displays complacency.

Q: Central banks around the world have lowered interest rates to record levels, directly purchased unprecedented quantities of their own government bonds and other private assets, in a bid to stave off recession. Warwick McKibbin recently told me central banks are moving away from inflation targeting to so-called nominal income or GDP targeting whereby the policymaker is trying to keep the economy running at a specific rate of activity. Do you have any thoughts on this?

I happen to believe that one of the fundamental problems in the financial architecture today is central banks pursuing the so-called “Taylor Rule”, where they are trying to get to a subjective assessment of targeted inflation and “full employment” by cutting real interest rates to levels that deeply distort savings and investment decisions.

If you look outside Australia – say at the US and Europe – we have in many ways lost the “risk-free” investment option that many people assume exists.

Because of a combination of high sovereign debt levels relative to GDP and central banks imposing financial repression, whereby real interest rates are pushed into ultra low or even negative territory, your ability to get a return commensurate with productivity in the economy is compromised.

And so I am not a fan of ultra-easy monetary policy as a general principle. We’ve all bought this notion that 2 per cent inflation is the “chosen land”.

Suppose gold were money. Consumer prices would go gradually down care of say 2 per cent annual productivity growth. So the money you had in the bank that was sitting in gold would earn a 2 per cent real return – given it retains its value and you have mild deflation. Is that such a bad thing – modest, persistent deflation?

The problem is we have had so many years of policymakers and central banks trying to fix “nominal” GDP growth that we have produced corporate capital structures that are predicated on continuing inflation.

If the central bank can credibly promise 5 per cent annual nominal GDP growth, then people will take on personal debt-to-income ratios over 100 per cent and governments will end up having higher structural deficits because the debt ratio becomes asymptotic, or starts to flat-line, at about 50 per cent to 70 per cent of GDP assuming you have 5 per cent nominal GDP growth and a 2.5 per cent to 3.5 per cent annual structural budget deficit.

So the policymakers’ illusion that you can create stability in nominal GDP growth perversely creates, I believe, less stable capital structures and more overall financial system instability. I am therefore a big believer in the Minsky way of thinking – that stability breeds its own instability.

I frankly think that if you have less monetary intervention and less monetary growth, ultimately you would have more equity rich (and debt poor) capital structures, and it would be easier for people to earn a real return on their investments.

Unfortunately, what we see happen in practice does not always reconcile with what might be optimal in theory.

Q: Do you think policymakers are making the mistake of trying to diversify away the business cycle through concepts like nominal GDP targeting?

I could not agree more. And if you start from a US perspective, there is a fundamental flaw in the financial architecture and that is the US dollar reserve standard.

In order for countries outside the US to accumulate dollar reserves they have to run current account surpluses. Because the US is less than one quarter of world GDP it has to run a structurally large current account deficit. So in the US you have an economy that is, by virtue of the global monetary architecture, structurally short savings relative to investment.

If you then overlay this notion of nominal GDP targeting, it creates a real problem. Because pursuing easy money and quantitative easing to cure for a local output gap [below trend growth] in the US, the central bank is trying to do everything it can to discourage savings.

But the fundamental dis-equilibrium that is being caused by the flaws in the overall monetary architecture is a shortage of savings relative to equilibrium investment.

Targeting nominal GDP exacerbates the savings and investment imbalance, to my mind. You have these long periods in well managed economies – be it Australia or the US – where we have had persistent current account deficits. On a cumulative basis, this is like a company being free cash-flow negative.

This in turn generates excess credit somewhere in the economy. In the US, it was originally in the private sector with the corporate boom in the late 1990s, and then the residential boom in the mid 2000s. Once the private sector started to deleverage, all of that debt had to transition to the sovereign – to the public sector.

You almost have this accounting identity where if the current account deficit is 3 per cent at the bottom of the cycle – maybe 4 per cent mid cycle – then the structural fiscal budget deficit is going to be larger than that, as long as the private sector is retrenching.

The central bank then has every incentive to grow nominal GDP slightly faster than the budget deficit so that the nation’s debt to GDP ratio caps out below 100 per cent.

The key problem is that if the US, which is the reserve currency of the world, is targeting 6 per cent nominal GDP growth, the rest of the world has to grow its money supply even faster in order to cure the root cause of the savings and investment imbalance.

We’ve therefore created a system that is skewed towards fairly rapid monetary growth. You look around the world and where is it that you can get a rate of interest commensurate with the rate of monetary growth? We all know that when we buy equities we want a dividend yield that is more than the rate of the company’s equity issuance – otherwise we get diluted.

But when it comes to sovereign money right now you have a problem where the rate of interest is well below the rate of monetary growth because of our financial architecture. And I don’t think this well appreciated. But it is a real problem.

Originally, central bankers would provide liquidity as a means of last resort. Now we have created a world that is dependent on, or addicted, to central bank liquidity. That’s the issue.

When the crisis hit in 2008, governments did succeed in stopping a nominal depression by virtue of unprecedented fiscal and monetary interventions. My problem is that governments have never really let the global economy “clear”, or rectify the savings and investment imbalances that the 2008 crisis highlighted.

Put another way, government interventions via quantitative easing and unprecedented public purchases of privately traded assets have led to us obfuscating and amortising the structural adjustments we arguably need to have.

We have had an unprecedented messing of the private price mechanism, and the valuable signals that market prices infer over the medium term, through efforts by governments to thwart the adjustment process.

The underlying concern is that you have had a series of “fake prices”. First, the price of money has been faked through central banks lowering interest rates to artificially low levels.

Second, the most important exchange rate in the world – between the dollar and the renminbi – has been a quasi-pegged currency.

Third, the yield curve in the US is a seriously distorted entity with the Federal Reserve seeking to buy more bonds than the Treasury is actually issuing. The two most important prices in the world – the US treasury yield curve and the US dollar-renminbi cross – are effectively fake prices.

So how can you expect to have real economic adjustment, and a proper allocation of scarce capital to its most productive purpose, when the price of the money has been faked?

The consequence is that current account surplus economies are generating – by dint of the wrong exchange rate – more savings and hence more investment than they ought to if their currencies were clearing at the right rate.

This is giving us White Elephant mal-investment in economies like China with excess construction and manufacturing capacity that would not have existed were it not for the exchange rate.

In the deficit countries you ended on the liability side of the balance sheet having an excess stock of debt somewhere in the economy, which also leads to White Elephant mal-investment.

The problem is that to get to equilibrium from where we are is actually quite a deflationary prospect. If you were to mark the Chinese currency to market you would cut investment to GDP from 50 per cent to a more normal 35 per cent. So there is possibly a very deflationary adjustment in prospect in China.

And if you didn’t have the quantitative easing we have seen in the US – and you tried to boost local savings to balance investment – you would have a very deflationary equilibrium there too.

If you try to unwind excess monetary growth you have serious deflationary risks.

My own view is that we live in this world of “quantum uncertainty” where you know that the system’s skew is to excessive monetary creation. You also know that the longer that happens the greater the risks of episodic deflationary shocks.

Q: Are you more worried about inflation or deflation?

I am worried about both inflationary and deflationary risks. The cumulative effect of central banks trying to produce price stability is that the forward outlook for price stability is actually poor. By trying to target nominal GDP growth there is a skew over the medium term towards a rising nominal tide in the world economy.

But because the price of money has been fake, and we have had mal-investment in surplus countries, and excess credit in deficit ones, we are going to have periodic deflationary shocks in market prices, like we saw in 2008.

You have to structure yourself for a world that is almost alive and dead at the same time. That’s why we have 70 per cent of our portfolio in good businesses at good prices, the current 20 per cent in cash, which has that liquidity value or deferred purchasing power for us to tap to pick up cheap businesses in the next deflationary crisis, and the 10 per cent allocation to gold is a very long-dated hedge against the risk that the man-made financial system breaks at some point because it is not on a sustainable trajectory.

And if you want to own a potential hedge against frailties of the man-made system you have to own something that occurs in nature – and the reason gold is useful in that context is because it is chemically inert.

The paradox of gold is that its utility as a monetary reserve is its uselessness as a commodity. Because it is not very useful, its demand is more resilient in the face of business cycle crisis than other commodities. And as it does not rot, rust or waste, it is not just resilient but also a natural resource perpetuity, out-lasting corporate fads and sovereign regimes.

It also helps that it is scarce with less than one ounce of gold per capita in the world. We believe the antidote to monetary abundance is real assets, be they businesses or gold, that are resilient, long in duration and scarce in nature.

Q: You argue that the notion of a “risk free” asset, which underpins so much academic literature and professional investment practice, does not really exist, given today’s distortions. What do you mean by this?

In a nutshell, things that people assume are risk free – government bonds or bank deposits – are actually instruments of credit. And credit metrics for what people deem to be risk free assets like the US treasury yield curve are in some cases at their worst levels in a generation if you consider, for example, the stock of US government debt relative to gross national savings.

Similarly, a bank deposit is only as good as the bank’s loan portfolio, or the willingness and ability of the sovereign to backstop it. A true risk-free asset is one that does not have a credit risk per se.

Historically you got positive real returns that tracked the economy’s productivity over time, with pretty impeccable credit quality from some government bonds. But now we are in a world where central banks are repressing real interest rates relative to monetary growth and you are not getting those real returns. In fact, some of the real returns on government bonds have been negative.

I think that the combination of the decline in sovereign creditworthiness and quantitative easing has pushed you into territory where you do not have a proper risk free asset any more.

Q: A few geopolitical questions. Are you worried about major power conflict in our increasingly polarised world; do you think financial markets are underclubbing the risks of conflict following a long period of relative peace since WWII; and are you focused on the possibility of existential military tensions emerging between China and Japan?

My answer is yes to all those questions. The best analogy for today is 1913 because that came after the period of strong economic growth during the gilded age in North America and La Belle Époque in Europe between the 1870s and the turn of the twentieth century.

That growth started to produce imbalances, like changes in geopolitical relativities and changes in social norms. You also had in 1907 a large stock market crash that was a liquidity-induced crisis.

While the market sort of recovered, the political pendulum swung to the left and you started to see “economic progressivism” and a movement against big business. You also saw the formation of British intelligence prior to 1910, and MI5 specifically, as people started worrying about German spying a little like rising concerns about cyber-espionage today.

I think we are in a state of nature right now where the rules of the game are changing: it’s not a uni- or bi-polar world anymore – it has multiple poles. And there are conflict fissures that are bringing various major powers together – be it Syria or the Senkaku Islands.

And I do think the Japanese are becoming nervous. If you look at the history of war – fear of war is often the cause of it. You have Prime Minister Abe speaking publicly in recent weeks about Japan wanting to change its constitution to remilitarise. And they are clearly worried that the Chinese are spending twice what Japan is on defence. Meanwhile everyone else is cutting back on defence spending in Europe and the US.

So I do worry about the state of the world – I do think that we underestimate the risk of existential military conflict. And I think the recent period of secular growth has changed relativities and produced new geopolitical insecurities that could create the Balkans of the 21st century. I worry about all this stuff.

The problem is that markets are not currently priced for distress – they are not pricing in the fault-lines triggered by financial repression and geopolitical pressure.

Q: You joined First Eagle right at the epicentre of the global financial crisis. What was it like?

I joined in the beginning of September 2008, or a week before Lehman Brothers filed for bankruptcy. On the one hand there were some stark moments of structural uncertainty because financial markets had come to the brink. On the other hand it was a blessing in disguise to come in and head a team at that unique juncture because it really helped unify us all around the principles of “conservative underwriting”. I think that’s what has distinguished First Eagle historically.

The most dangerous environments are late cycle environments when you have been in a bull market, because hubris creeps in. If you can get a team to agree on a set of values in a moment of humility like the 2008 crisis, where you see so much fragility in the financial eco-system, I think you can forge a stronger process for allocating capital out of that searing experience. While intellectually it was very demanding, and I worked very hard, it was a blessing in disguise.

Q: Were there times during the GFC when you were professionally scared witless?

This might sound like we are undertakers here, but there were actually moments where there was a tingle of excitement. We’re structurally buyers of business – we think the best way to produce real returns over the long-term is to own good businesses at good prices. And in a window of true distress like the 2008 crisis you are frankly like a kid in a candy store – you can go in and buy the businesses you want with a wide valuation margin of safety if you are willing to take a long term view. So it was actually a good environment for us as long horizon business buyers. And while it was a constructive environment for the system in terms of purging some of the excesses, the purge did not go far enough.

Q: Your career looks like a fairy tale of success. Have you ever had any big set-backs?

One of the toughest moments in my career would have been during the late 1990s as a value investor where the tech boom made us all feel like dinosaurs. We were not investing in any of the hot tech IPOs because we could not find the valuation margin of safety. And I was watching our assets under management shrink – they were under material pressure – and frankly it was one point in my career where I felt my job was genuinely at risk.

The bottom line was I was not willing to participate in an opportunity that to everyone else seemed like free money. It was a really tough and soul-searching part of my career and I recall it being quite painful, to be honest.

As a long term value investor you have to be willing to be “short” social acceptance from time to time. And that was probably a stage in my career when I felt it most.

While that was a very dark moment for me I’d add that having a partner and wife who has been there for so long — since 1986 in the case of Monika — was really crucial to giving me the confidence to weather those difficult times.

Q: And you never relented? You never bought into the tech bubble?

No we did not. And I think demonstrating that resistance to an almost overwhelming market indulgence was crucial to me ultimately being hired by First Eagle and my very successful predecessor, Jean-Marie Eveillard, who ran First Eagle’s funds for over a quarter of a century.

Q: Why do you guys dislike the notion of “alpha” of risk-adjusted returns in excess of a benchmark?

We don’t think you can systematically manufacture alpha. We think long term excess returns are a function of being a disciplined buyer of businesses and a counter cyclical liquidity provider. And those activities do not produce a smooth and linear stream alpha – just like we don’t target a given level of beta [or correlation to an index].

We tend to have low beta because we hold cash and gold, and the kind of businesses we own usually have less leverage — they tend to be longer duration and more stable businesses. We also avoid targeting a specific “tracking error” [deviation away from the index]. In short, we don’t think of risk in relative terms like many other asset allocators – we are focused on absolute returns.

Interestingly, if you did a backward-looking return analysis on us to identify how we added value at different times, it has usually been acts of omission — that is, what we did not own — and the ability to avoid the permanent impairment of capital that has helped us.

Q: You have talked about the importance of acknowledging that you cannot forecast the future when investing. What did you mean by that?

When you realise that you cannot predict the future it totally changes the way you invest, because it makes you hunt for a margin of safety in your investments rather than trying to leverage yourself to one specific view or another. And that is kinda of what defines us here: having the humility to say, “You know what, the future we face is unknowable”. And we really believe that.

The essence of this view is accepting that we are dealing with complex systems, which are being amplified today. First, we don’t currently have normal unfettered economic forces at work. We have a distorted financial architecture. Second, there is a complex and polarising geopolitical equilibrium that you need to layer on top of that. If I had to look at a historical parallel, 2013 is probably closer to 1913 than other periods in time.

Finally, few people understand or recognise that a lot of the change that happens in the world is attributable to marginal productivity and innovation — that is, new ways of doing things – which by definition is very hard to anticipate in advance of it happening. And that process of innovation and productivity compounds out in a very diffuse fashion.

Q: If you cannot forecast the future how do you then value a company’s a future stream of cash flows to discount them back to the present day?

That’s a very good point. We never think we can predict which one of our stocks is going to work best. It is kind of like cooking popcorn — you know most are going to pop, but not when. And a few will burn out.

So we’ve never been a believer in these very concentrated, high conviction portfolios because it presumes that ability to divine an individual company’s future.

What we do try to do is buy businesses that have “persistence” to them, or what we call franchise duration. We love businesses that have been around for a long time. We like businesses that have things that ought to make them persist–relative scale advantages, customer captivity and so forth.

We are mindful of the fact that a business that can take market share quickly can lose it quickly. So we look for evidence of historic durability in a company’s market position. And we like to pay low multiples for cash-flow around the single digit multiples of earnings before interest and tax.

So when we invest we are not paying for growth – we’re ideally getting that growth for free and have put in place an error-tolerant investment system that can participate in the upside of human enterprise.

Q: You sound Australian, and you and Monika grew up here. Any desire to return?

We love Australia, and I am proud to be an Australian and try to embody the values the nation stands for. But whether or not we return is hard to say at this point, given my professional engagements. I keep involved in Australia through Advance, which is a leading not-for-profit organization representing the Australian professional diaspora, and the Australian Wildlife Conservancy through my wife’s membership of its US board.

Q: Did your Australian schooling or university education have any impact on your subsequent progression?

Well I spent the first six years of my life in PNG. I ended up going to Brisbane Grammar School because we moved to a town called Montville in Queensland. At the time it was a thriving metropolis of 400 people — we had no electricity. I will never forgot when my father, who is a land surveyor and has been involved in creating software companies for the title industry, got our first TV, which was hooked up to a car battery. He pulled away to work one day and that was the end of our new colour TV! My mother subsequently taught me the love of reading and learning. Dad taught me to take what I do seriously – but never to take myself too seriously.

There was no high school in Montville and so I had to board at BGS. And it was transformative for me because I had always had a lot of freedom as a kid in PNG, which I think is important if you want to live a global existence and feel comfortable in different environments.

BGS was, in contrast, a very rigorous academic environment, which I enjoyed. It was a defining experience, insofar as it helped me learn to fend for myself and stand on my own two feet.

The University of Queensland was really about transitioning the learning process from rote to discovering how to actually “think”. For me, the real difference was my honours year where you have to switch your modus operandi from regurgitating facts to constructively creating your own thought processes, which was very important to me. At the end of the year I was lucky enough to win the university medal.

I was also fortunate to be at UQ at a time when there were professors doing interesting research into market anomalies in asset prices and corporate capital structures that confounded the “efficient market hypothesis”, which implied these anomalies might not exist. The EMH was much more popular at UQ back in the late 1970s and 1980s.

I ended up writing my honours thesis on the impact of dividend imputation on Australian equity market pricing. I found that what matters for optimal portfolio construction is the relativities between your marginal tax and the tax rate that was being priced into the market.

Q: The CEO of Challenger Life, Richard Howes, was the first guy to ever mention you to me. How do you know Richard?

Richard Howes and I studied together at the University of Queensland. We really got to know each other well in the honours program, where we were probably two of the hardest-working kids, and co-critiqued an external academic paper together.

There was a visiting professor from Canada, and Richard and I found a flaw in his paper. It was with great trepidation that we went back into class the next day to report our findings and with equally great relief that we discovered the professor was delighted we had identified the problem. It was a wonderful educational experience. We so enjoyed that time that we are putting in place a fellowship at UQ for collaborative research.

Richard is a person I respect intellectually a lot – and when we catch up we are always trying to crack the code on some arcane issue related to markets or the state of the world.

Q: What are your thoughts on Newcrest as an investment? And how will you vote at the AGM?

We don’t typically discuss how we plan to vote in advance of an AGM. Clearly Newcrest is a security that is very out of favour for a handful of reasons that have been very well discussed.

It has obviously been a disappointing investment over the last couple of years – but I think it is a lot cheaper to buy gold reserves via a listed company like Newcrest than to go out and build a new gold mine today.

I would draw attention to the fact that they do have very high quality assets in the sense of gold mines with a reserve life north of 20 years. If we go into a world where some of the taxes get unwound in the Australian mining industry, and perhaps there is a little less ebullience around the whole metals complex, and if it is a softer environment for Australia as a whole – this is a company that has long dated assets that could benefit from a potentially weaker dollar and less labour cost inflation.

I think Newcrest have dramatically adjusted their capex plans now towards more maintenance levels – and so there is a renewed focus on free cash flow generation.

Q: Are you a long holder of Newcrest or are you revisiting your investment?

We have a long term hold in there at these prices. If you are looking for one area of distress in the world equity markets it has been the gold miners – the gold price has retraced two to three years – gold miners have retraced a decade.

So not only is there a potential inflationary hedge angle for investing, there is also a value element as well.

Q: How much do you own?

Around 8.5%

Q: what does Newcrest management need to do better?

We are great believers that companies that have good long duration assets like this in extractive industries should run themselves with more consistent capex plans and run themselves to generate free cash flow in a range of scenarios and look to distribute that free cash flow to shareholders.

Unlike many mining companies that have short duration assets Newcrest’s long duration assets give them a platform from which they can manage their business with much more stability in capital plans, rather than more cyclical ebbs and flows in capex.

The Australian Financial Review

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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