More Reflection on Value

I got some good feedback from a reader about my comments on Microsoft and Google as value stocks. I had referred back to the original Graham & Dodd concepts, including the margin of safety. Today, I read an interview with Matthew McLennan, the portfolio manager of First Eagle U.S. Value Fund (Class A: FEVAX), which invests $1.8 billion in assets. The firm evolved in a long path from Arnhold and Bleichroeder, the distinguished German firm that once advised Chancellor Bismarck before opening offices in London. Eventually, the firm was bought and sold by Societe Generale, before Jean-Marie Eveillard launched First Eagle. Mr. Eveillard is a classic Graham & Dodd investor, with a long term, successful track record of attracting and investing assets using a disciplined process.

Matt McLennan describes the margin of safety in First Eagle's approach as paying no more than a single digit multiple of EBIT for quality businesses. He then distinguishes between commodity businesses and other businesses, and he understands the reasons for adjusting this upward to pay a bit more for franchise value, or the ability to command prices increases. Basically, he says that to avoid making arbitrary decisions about franchise values, he prefers to stick to the single digit EBIT discipline.

Looking at their portfolio, the large cash position mirrors the position of Sequoia Fund (SEQUX), another large traditional value fund using a Graham & Dodd philosophy. They have a significant exposure to gold, and some of the names, like Comcast, reflect strong cash flows and quasi-monopoly pricing power. Interestingly, the largest sector in the fund is technology, which includes Microsoft and Intel in the top 25. Intel is really a growth cyclical, and can be bought cheaply at low points in the tech cycle. First Eagle also owns Cisco Systems.

In response to my reader, a value investor can apply the margin of safety concept to technology stocks, in this case by using the proxy of a single digit EBIT multiple as a basic screen.