Jean-Marie Eveillard on the Art of Global Value Investing

The MOI Global community is grateful for the opportunity to learn from legendary value investor Jean-Marie Eveillard first-hand on numerous occasions over the years.

Jean-Marie has assembled one of the best long-term track records in the business and most recently served as senior adviser to the First Eagle Funds.

He has been incredibly generous with our members, devoting significant time to discussing timely and timeless investment topics. Below, we are pleased to bring you one of our earliest conversations with Jean-Marie, a tour de force on the art of global value investing.

The conversation was recorded in New York City in 2012. Enjoy!

The following transcript has been edited for space and clarity.

The Manual of Ideas: You’ve been in the business for decades, have amassed one of the best records. A lot of value investors these days struggle with how to make sense of what’s going on in the world. How has in your view, value investing changed over the decades and what has stayed the same?

Jean-Marie Eveillard: For several decades, value investors decided that they saw themselves as entirely bottom-up, that what they wanted to do was to look at particular businesses, try to figure out whether they could understand the business and if they thought they understood the business and liked the business, when all the stock was available at a reasonable price, in which case they would buy it and patiently wait for the stock to go up.

And it served them well for decades until in 2008, in the midst of the world financial crisis since the great depression, many value investors went down 30%-35%, 40%-45% in one year and, admittedly, it’s only one year, and many of them recovered very nicely in 2009. But I think a key question today is whether we are still in the post-World War II economic and financial landscape, in which case it would be appropriate to continue to be entirely bottom-up as a value investor, or whether we are in a new so far undefined, possibly threatening landscape, in which case one should continue to spend most of one’s time doing bottom-up work but meanwhile one should keep an eye on the top-down.

MOI: When it comes to the top-down, what worries you the most? What has become the biggest challenge to preserving purchasing power over time?

Eveillard: From the top-down, it seems to me that the best analysis of the recent and continuing financial crisis is provided by the so-called Austrian School, which among other things pointed out in the 1920s that it’s not enough to have overall prosperity and apparently low inflation, that you had to be very careful not to let the credit boom go on too long and be too strong, because a credit burst would eventually follow a credit boom, just like night follows day. And indeed that’s what happened in the late 1920s and again that’s what happened between say the early 1980s and 2006, 2007.

Recently, we had a 25-year credit boom, interrupted in the early 1990s already from a real estate point of view, and then on to 2006, 2007, the credit boom turned into a credit bust. The Austrians say, if you’ve been stupid enough to have a credit boom and then a bust, you have to be very careful not to try and patch things up in the short term because you may stabilize matters in the short term but you make the process compromised in the medium and long term.

Today, everybody seems to be a Neo-Keynesian, but it doesn’t seem to work. And if you look only at this country, an enormous amount of both fiscal and monetary stimulus has been in place since 2008, and yes, it stabilized matters, but the recovery has been weak by historical standards. The truth is, Keynes was a brilliant writer, he was the king of the seductive paradox but in the end he was a quack. And whenever I say that in public, I sense that there is a gasp in the audience but I think already in the 1970s, Neo-Keynesian remedies have been discredited and I think they’re going to be discredited again.

MOI: Isn’t it interesting, how even in the U.S. then people seem so willing to rush to the government for solutions and rely on the government given the experiences with socialism and communism around the world? Do you think even this society is much more fragile than is perhaps widely accepted?

Eveillard: Yes, to a lesser extent admittedly than in Europe. This is a country where politicians have made too many promises, which they can no longer keep really. But it’s hard on the politicians because they made all of these promises. They find out that they cannot really keep them, that either taxes have to be increased in a major way or government spending has to be reduced also in a major way or both. And so that’s where the tensions are appearing in society.

MOI: What do you make of the record low interest rate environment in all the major economies in the world? What distortions does that lead to?

Eveillard: It’s going to create tremendous distortions for a very simple reason. Money is not supposed to be free. And money for all practical purposes is free. People say, yes but there is no inflation. Going back to the Austrians, inflation to the Austrians—and they are right again—is not the increase in the consumer price index or the increase in the prices of various assets. Those are only symptoms. Inflation is the creation of too much money and too much credit.

Indeed, in 1980, the consumer price index was changed. Major changes were made to the consumer price index. And there are some people who continue to compute the consumer price index as if no changes had been made in 1980. And they come up with a number which is not 2%, which is the current CPI index number. It’s more like 6% or 7%. Now, I suppose that some of the changes made in 1980 were legitimate but some probably were not, particularly the idea of substitution. The idea that if the price of beef goes up, we will not include it in the consumer price index because we will assume that the consumer would substitute chicken for beef. Well, if you don’t like chicken…

MOI: What is an investor to do then in this environment? Even in the investment industry people are reporting nominal numbers. Customers generally don’t even ask the question about real returns, they only find out in hindsight…

Eveillard: Yes. In the future, nominal returns may appear to be half-decent but real returns may be less than decent. Because in a way what we have is equities by default. In other words, the authorities and Mr. Bernanke has been quite clear about it. He’s trying to push investors towards equities with the idea that, which is probably right, that if the equity market goes up then the confidence of investors, the confidence of businessmen would be greater than otherwise.

The investor has to continue to do the work from the bottom up and again keep an eye on the top down in the sense that accepting that in the U.S. and in Europe and in Japan, and possibly as well in China and in India, there’s very little doubt in my mind that from a long term point of view the East is rising and the West is declining. But meanwhile, I think China and India, of course there would be bumps along the road and maybe that’s what we’re about to see.

Whenever Benjamin Graham, the founder of the value school, was asked what do you think will happen to Company X or Y? What do you think will happen to the economy? He used to deadpan that the future is uncertain. And so the future is uncertain. On Wall Street, you have all sorts of people who tell you on October 8, 2013, the Dow Jones will be at 18,225. You’re lucky if they don’t give you the decimals. Of course this is nonsense, nobody knows. Only God knows and he ain’t telling.

But I think one has to accept today that some of these are even greater than usual, that where we will be five or ten years down the road nobody knows. And nobody knows in any case, but today I think nobody knows because there seems to be a risk greater than usual. There are things that will turn out sour, not forever, but may turn out totally sour for a period of time so one should be very careful about not overpaying for securities, for equities.

MOI: Are the uncertainties greater because of the amount of debt that has been accumulated over time or are there other just as important factors?

Eveillard: The debt in the developed world, because in India and China and Asia in general there is much less debt than there is in the U.S., in Europe and in Japan. The excessive amount of debt is the major problem. Of course, the paradox is that if you take the U.S., the tremendous increase in public, in federal government debt is associated with the deleveraging of the private sector and precisely because the private sector is reducing or attempting to reduce, that the state has to increase that in order to prevent the deleveraging of the private sector from resulting in a major recession or worse.

Although, of course the paradox says, if too much debt is the problem to begin with, how can more debt be the solution, or more public debt be the solution? So yes, I think the excessive amount of debt is the major problem.

MOI: Warren Buffett has embraced buying great businesses as the best of all the poor alternatives in an era of inflation. Why do you favor holding a large portion of your portfolios at First Eagle in gold and cash?

Eveillard: Right. Now incidentally, I’m now in the position of adviser and I have been in the position of adviser for several years now. So I try to advise the best I can and I get along famously with my successor. But as you can imagine, there is a big difference between advising and doing. So I’m the one who introduced gold into the portfolio. So far, Matt McLennan has continued to own gold, although admittedly, below 5% of total assets, gold is irrelevant. Above 10% or 12% of total assets, gold becomes more than, I think it’s the late Peter Bernstein who said, gold is protection against extreme outcomes.

Whenever it looks like gold, which is a combination of gold bullion and mining stocks, was in excess of 10% or 12%, Matt McLennan, my successor, has sold a bit which is absolutely fine with me because again above 10% or 12% it becomes something other than seeking protection. When Buffett and others who are negative towards gold say, there is no intrinsic value to gold, what they don’t seem to accept is the fact that we look at gold as a substitute currency.

There is no intrinsic value to a dollar bill. A dollar bill is worth what the government says it’s worth. There is no intrinsic value to gold either, but gold has a history of being a currency—up until 1914. After 1914, the gold standard was softened. It was softened again after World War II. Then in 1971, Nixon, a Republican president, closed the so-called gold window. Individuals couldn’t exchange dollars for gold at the Federal Reserve or Treasury, but a country that was holding dollars as foreign exchange reserves could present those dollars at the so-called gold window in the U.S. and get gold in exchange.

And then Nixon saw that the gold was flowing out, he wanted to put an end to it. Even Greenspan, who I thought and I said so at a time when he was looked at as God or God equivalent, I said he’s going to end up as the worst Chairman of the Fed since the Fed was created in 1913, even Greenspan whenever a congressman said, hey why don’t we sell the gold at Fort Knox and build a few hospitals with the proceeds, even Greenspan said, hey it’s a currency of last resort. And that’s the way we look at it, as a substitute currency, because I believe that neither the dollar, nor the yen, nor the euro, nor the Swiss franc for that matter are currencies that are trustworthy. Gold is the only currency that cannot be printed, so that’s why we look at it really as cash, as cash in a currency that cannot be printed.

MOI: And in terms of the cash position, I know you’re not actively running the portfolios, how do you see the cash portion of the portfolio? Does that indicate perhaps that you’re waiting for better opportunities?

Eveillard: I think Matt sees it the way I did; cash is a residual. We don’t decide from the top down we’re going to be 7% in cash, 18%, 25%, it’s a residual. If we see plenty of investment opportunities, then the cash will not disappear because we want to have some cash to handle redemptions, if necessary.

But if we don’t see too many investment opportunities and maybe if we don’t see too many investment opportunities it’s because we pay a great deal of attention to valuations as I’ve said before, maybe in these circumstances one should be very careful not to overpay for securities. So then, if we don’t see enough investment opportunities and maybe we’re not looking in the right places for all I know, if we don’t see enough investment opportunities then the cash builds up, and again it goes down if we see investment opportunities.

MOI: Can you give us some sense around “one should not overpay”? That holds true always, doesn’t it, and so what does it really mean? Would you give us an example where that dilemma becomes apparent in today’s environment?

Eveillard: For valuation, we tend to use not price to earnings but EV/EBIT. I’m the first to acknowledge that there is no perfect way to place a value on a business, but we like EV/EBIT because it introduces the balance sheet into the picture, to which we as value investors pay a great deal of attention. As Martin Whitman at Third Avenue says, we want the stocks to be safe and cheap, and by safe he is alluding to the balance sheet.

There are dangers lurking which did not exist prior to the 1980s and 1990s, prior to the credit boom, and so valuations become even more important than usual. Now admittedly, I think with the Buffett approach, the so-called margin of safety, with the Graham approach the margin of safety is in the discount to the intrinsic value. The larger the discount, the better. And the intrinsic value is often by Ben Graham, looked at as in a somewhat static matter often balance sheet derived, not always, but often balance sheet derived.

With Buffett, the true margin of safety may be more associated with the perception of the quality of the business, the perception of the quality of the moat than it is with the discount. I will argue that from a theoretical standpoint with the Buffett approach, one could buy an equity that even though it may be selling at what we think is the current intrinsic value, with the idea that because the true margin of safety isn’t the perceived quality of the business, with the idea that the business will continue to create value in the future because it has a moat.

And indeed for value investors, one of the great questions is I believe, if we believe that a business has indeed a moat, and if the stock is bought with a discount to the intrinsic value but moves to intrinsic value, should the stock be sold because it’s selling at intrinsic value currently? Or should one, depending upon how confident, rightly or wrongly so, one is about the quality of the moat, should one accept that the stock might be temporarily, modestly or moderately overvalued and continue to hold on to it or at least to most of it?

Even Buffett said that he made a mistake when he didn’t sell any Coca-Cola [KO] in the late 1990s when it became vastly overvalued. Admittedly, Buffett, in order to make a point, tends sometimes to exaggerate, but he was once asked, when do you sell? And he said almost never. If it’s indeed almost never, then it means he accepts the fact that even if the stock gets to what he thinks is the intrinsic value of a business, if he has enough confidence in the business, the quality of it, then he’s willing to hold onto it and accept that maybe temporarily it is what people would call “sterile” money.

MOI: Howard Marks talks about the importance of having reasonable expectations when it comes to investing. With the portfolio positioning at First Eagle, what return expectations do you have, nominal or even more interestingly in real terms? And how would that compare to five or ten years ago?

Eveillard: We were never willing to put a number on expectations. When I took over in early 1979 what was then a $15 million fund and today we’re on $50 billion, I thought I would try to achieve two objectives. One, which is an objective in terms of absolute return, to do better over time and the key was over time, to do better over time than a money market fund because we’re subjecting shareholders in our funds to the risks of equities.

When I was mentioning that objective in the late 1990s, when it was so easy for people, who are aggressive investors, to do much better than a money market fund, people thought that’s not a particular interesting objective. And then of course after the turn of the century, it became difficult to achieve that kind of a return. And maybe I should have added, do better over time than a money market fund, in real terms, in other words, after inflation.

The second objective, which is a relative objective, that I have to do better over time than whatever benchmark is appropriate, or my peers—but again, over time, because otherwise investors in our funds could say, we don’t need you, might as well invest in an index fund. Those were the two objectives, but again we never mentioned any number.

MOI: With the trend toward compression of time horizons and focus on short term performance, we’re seeing many investors even those who perceive of themselves as value investors, emphasizing near-term stock price catalysts.

Eveillard: They’re wrong, they’re wrong. Number one, real value investing, it makes sense. I remember when I first came to this country, which was in 1968… I was bicycling in Central Park in the summer of 1968 with two French students at Columbia Business School. Benjamin Graham was no longer teaching there, he had already retired to California, but he was well known still at Columbia Business School. My two friends—their interest was marketing—it was not investing, but they knew I was a professional investor so they mentioned the name of Benjamin Graham to me. I went to a bookstore and bought Security Analysis and, more importantly, The Intelligent Investor, which Buffett says is the best book ever written about investing. And I was truly illuminated.

And then I discovered Buffett through his letters to shareholders in the annual reports of Berkshire Hathaway [BRK.A/B] ten years later, in 1978. And I was illuminated twice, first by The Intelligent Investor and then by Buffett’s approach. So number one, value investing makes sense, at least to me. As I’ve said, I was truly illuminated twice. And number two, it works over time. There was in 1984, the article in the magazine of Columbia Business School, and then twenty years later, the late Louis Lowenstein updated the Buffett piece of twenty years before, took ten value investors including, in the interest of full disclosure, our First Eagle Global Fund, and again showed that it was not two out of ten or six out of ten, it was ten out of ten who had done much better than other investors over a period of time long enough to be significant.

Number one, it makes sense, and number two, it works over time. So how come there are so few genuine value investors? There are several answers, but the major answer is psychological. If you’re a value investor, you’re a long-term investor. It goes back to what Ben Graham said about the fact that, short term, the stock market is a voting machine and, long term, it’s a weighing machine.

If you’re a long-term investor, you accept in advance that every now and then you will lag because you’re not trying to keep up with your peers, and you’re not trying to keep up with the benchmark in the short term. To lag is to suffer. Suffer psychologically. In the 1980s and the early to mid-1990s, we had lagged maybe for six or nine months moderately every now and then. In the late 1990s, I lagged in a major way for three years in a row, 1997, 1998, 1999.

What happened was that after one year, investors in our funds were upset, after two years they were mad, after three years they were gone. I lost, in a fund that was around since 1979, so it had a long term record, between the fall of 1997 and the spring of 2000, seven out of ten shareholders abandoned us. So you suffer psychologically, you go home you think, I’m an idiot, what is it that everybody else seems to be seeing which I don’t seem to be seeing? You suffer financially in terms of bonus or even worse losing one’s job.

And that’s what Jeremy Grantham alluded to in a recent piece where he talked about career risk, which is not something that people should be ashamed of. If you’re in your late twenties, early thirties, you have a wife, and two kids, the idea of losing a job to career risk is a legitimate worry. But that’s what it is, it’s career risk. So I think the value investors who try to see catalysts and who pay plenty of attention to the short term they’re wrong.

I was at a wedding last year where Seth Klarman of the Baupost Group was at the wedding too. And I was sitting at his table, and Seth told me that he had two advantages, he felt, over other professional investors. One, which is an advantage I think I also have, and genuine value investors also have, it has to do with the fact that as I’ve said before, value investing works over time.

Seth said two advantages, one, I’m a genuine value investor and two, he has an advantage which very few investors including value investors have, which is because he’s not in the mutual fund business, he’s in the hedge fund business and because he’s been so successful over such a long period of time that his fund, now that he runs $25 billion, is closed most of the time but every now and then he reopens it when he thinks he sees investment opportunities. And when he reopens it, he said he decides who comes in and who doesn’t.

In other words, he achieves what I think other investors very seldom achieve, which is a coincidence between how he sees investing and how the shareholders in his fund see investing. The odds that shareholders in his fund will abandon the fund because he’s lagging for a year or two are very modest.

MOI: But that is good news for genuine value investors who manage just their own money because they have that same advantage.

Eveillard: That’s right, that’s right. When I was working full-time, I didn’t really have a personal account because I didn’t want to spend my weekend working on my personal account. But now that I’ve been in the position of adviser for three years, I’ve had a personal account because I already have substantial investments in the First Eagle Fund, and I’m finding it much less difficult to invest for my own account than I did to invest for other people.

Even though with a mutual fund, I don’t know, we have I think more than one million investors in our funds, I know maybe four or five of them. I’ve met four or five of them. And it’s less difficult to run abstract money than it is to run the money of people. I’ve always refused, I have four brothers who live in France, I’ve always refused to give them advice because it’s too difficult to advise family and friends.

MOI: Well then, talking not about First Eagle where you don’t actually manage money anymore, but your personal account, I’m curious, could you share with our audience where do you see then the biggest inefficiencies today? What about Europe? It’s in the news, there’s so much noise. How do you make sense of what’s going on there? Where do you see the best opportunities?

Eveillard: It’s true that the American market over the past twelve months or more has done much better, particularly in view of the fact that the Euro has been weak; in dollar terms the American market has done much better than the European market.

At the same time there is a real problem in Europe. It’s a problem which goes back twelve years. There was a knowledgeable flaw. And indeed, the Euro was created for political reasons more than for economic reasons. The idea that a full integration of Germany into Europe required the Euro. And the flaw was of course associated with the idea that there was a single currency, but at the same time it was still the national governments and parliaments that had direct responsibility for the power of the purse, for government spending and taxes.

The flaw was not apparent for almost ten years and then to a large extent because of the financial crisis, the flaw became obvious. And in essence, the only ultimate solution would be to correct the mistake that was made twelve years ago and have a European government, the idea that you can have a single currency like in the United States, if you have a federal government, that you will have a European federal government, that France would be like Massachusetts and that Italy would be like Florida.

But there is no appetite today, particularly in view of the fact that times are difficult in Europe, there is no appetite on the part of the French or the Italians, or even maybe the Germans, for a European government. The idea of giving up some of the sovereignty is unpalatable. So there is a major problem. And yes, the Italians and the French, and the Spaniards can push around the Germans somewhat successfully, but they seem to be simply buying some time. They buy a few months and then they’re in the soup again. So there is a major problem.

It’s true that equities have declined and now have equities in Europe declined to the point where they have become attractive in spite of the fact that the European problem seems to be far from resolution. One has to take into account that because most European countries are very small, many of them have interests that go far beyond Europe. There are many European companies that do a lot of business not only in the U.S. but also in Asia including China, India and South America. I think some investors are saying I don’t want to look at European equities, period. I think one has to insist on modest valuation but I think some European equities are worth looking at.

MOI: Some investors then tend to gravitate to great businesses, seeking safety, avoiding the eye of the storm in Greece, Spain. Do you see more opportunity in the core European markets or actually where the eye of the storm is?

Eveillard: One reason why Buffett waited a long time before he invested in foreign equities, and I remember Walter Schloss, I was at a dinner with Walter before he died a couple of years ago—he was already in his nineties—and Walter told me, I’ve never bought foreign equity. And I said, why Walter? He said well, I don’t trust foreign accounting. I need my 10-Qs, my 10-Ks, I need the SEC, etc. I don’t trust the accounts of foreign companies. And the dinner took place where I was and he was before Enron. And when Enron happened I said, Walter, funny things also happen here.

Still, genuine value investors, they are more comfortable analyzing a business than trying to figure out the political, overall economic risks and that’s why value investors were for a long time very reluctant to the so-called emerging market securities. Worries about the accounting. Today, in China for instance, I think most genuine value investors hesitate before investing in China because there had been so many scandals about the accounting.

Genuine value investors are more interested where the top-down does not intrude in a major way. Although I suppose there are exceptions, there may be Spanish or even Greek securities for that matter that have declined so much that the risks associated with those businesses seem to have been taken into account.

MOI: Could you share with our audience one or two names in Europe where you feel most comfortable?

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