Income Builder through Value Investing
First Eagle Global Income Builder Fund
Kimball Brooker, Sean Slein
Author: Ticker Magazine
Last Update: Apr 05, 10:34 AM EDT
|Valuation drives everything, according to Sean Slein and Kimball Brooker, portfolio managers of the First Eagle Global Income Builder Fund. Investing with a perceived ďmargin of safetyĒ in equities and fixed income, the fund aims to provide both current and future income. With a flexible, bottom-up approach, the team can go anywhere it concludes there is valueóincluding cashówhile keeping a steady focus on avoiding the risk of capital impairment.
ďThe fund seeks to provide income for today and tomorrow, and thereís a tradeoff between the two. If we over-rely on higher-yielding securities, we expose the fundís investors to the potential risk of capital impairment. We need to be extremely disciplined.Ē
One of the fundís equity holdings is Jardine Matheson Holdings Limited, a Hong Kong-based company established in the 19th century. The bulk of its business was in real estate, and the company owned a lot of commercial real estate in the central business district of Hong Kong. So, a substantial portion of the business was rental, which we feel has historically been reasonably stable and predictable as the tenants tended to be quite high-quality obligors. But Jardine had many other businesses, including retailer Dairy Farm, a convenience store company, an elevator maintenance business, a palm oil plantation, etc. It was, and still is, a very diverse collection of companies.
We liked Jardine because we believed it was the leader in each of the businesses that it operated in. In our view, the company had a clean balance sheet and very little net debt. The family of one of the founders still had a substantial investment in the company. Thatís important to us because the timeline that the family operates on is more akin to our timeline, not to the quarterly Wall Street cycle. They are able to think on a much longer-term basis.
Finally, we feel that the company had an attractive track record of paying and growing the dividend, which is important for the fundís strategy. We believe that the valuation was not very demanding, particularly given our view of the quality of the company.
Q: Could you tell us about an investment on the fixed-income side?
The fund purchased bonds issued by the American refiner Citgo Petroleum Corporation many years ago. This example is interesting from a structural, covenant, asset quality and a general indenture perspective. It is owned by Petrůleos de Venezuela, S.A. (PDVSA), the Venezuelan state-owned oil and natural gas company, but is domiciled in the US and governed by US laws. The refineries themselves are located within Illinois, Texas and Louisiana. They have 750,000 barrels per day of refining capacity.
The bonds are secured by those refineries, so we believe it would be very difficult for PDVSA to try to take value from the fund, because they are governed by US law. The fundís investment is also protected by covenants that limit PDVSAís ability to take money out of the structure. There needs to be post-dividend liquidity of $500 million either in cash, in the credit facility or in a combination of the two. Additionally, Citgo is required to maintain a ratio of total debt to total capital of 55% or less on a pro forma basis post dividend payment.
The assets themselves, the refineries, are fairly complex and can blend heavy high-sulfur crude along with the lighter crude thatís produced in the United States. Historically, thatís provided them a little bit more margin. The light-to-heavy spread has narrowed, but the refinery assets provide options from an input perspective.
The asset value of the refineries is covering the debt by probably a factor of two. Leverage is below three times, if we include pension liabilities. Citgo itself has generated, in our view, a significant amount of free cash flow that, if continued, could give it the potential to deleverage.
So, we feel that thereís a fair amount of asset coverage and an equity cushion that provided us with a ďmargin of safety,Ē in addition to the covenant structure that governs the indenture. Given the fact that cash flows can be volatile and credit spreads can ebb and flow, the asset coverage provides us with an additional comfort level.
Q: Do you view Citgo as an income generating security?
We are not necessarily looking for credit improvement. There is the potential that PDVSA at some point will want to monetize its stake in Citgo and sell it. That provides some upside potential if it is sold to another refiner. Thereís the potential for spread compression, but given the goals of the fund, we are looking to clip a coupon and have the fund paid without taking excessive risk. So Citgo, with sub-three times leverage, provides the fund with the potential for the relatively stable income stream that we desire.
Q: What is your portfolio construction process?
We donít make any top-down allocations; the process is entirely bottom-up. We are sensitive to aggregation risk and firmly believe in diversification. As long as the fundís portfolio is diverse by the number and sizing of positions, by geography and by industry, we donít have any constraints.
On the fixed-income side, we have a global, multi-asset approach and we have the flexibility to invest across different asset classes like sovereigns, agencies, investment grade, or high yield. The fund holds some European and other foreign corporates. Importantly, in terms of portfolio management, we want the fund to be adequately paid for the duration, credit or liquidity risk that is taken.
As we move through this credit cycle, weíve gradually moved towards higher credit quality to seek to minimize credit risk, and weíve shortened the duration in an attempt to avoid duration risk. We are not momentum players; we are absolute-value-oriented investors. As credit risk increases and duration risk remains elevated, cash and cash equivalents are useful risk management tools. As the markets become more attractive in time and prices fall, we expect the fund may benefit from the attractive optionality that cash and short term higher quality credit provides.
As manager of a First Eagle fund, we are patient and willing to wait. Credit markets go through cycles and investors often misprice risk. As we move through that cycle, many may be willing to tolerate greater and greater credit risk for narrower and narrower spreads. We want to be in a position to potentially take advantage of investor complacency as we move through the cycle. That is consistent with the philosophy of seeking loss avoidance and attempting to maximize risk-adjusted returns of the fund.
Although we are not top-down investors, we believe that equity and fixed-income markets around the world are quite fully valued. It isnít a particularly wise moment to take duration or credit risk or to chase equity performance. At the moment, we believe patience is warranted.
Q: How do you define and manage risk?
For us risk is separate from volatility. Risk is the impairment of capital and the simple definition of risk is loss. Risk is often considered and measured at the portfolio level, but the front line in any risk management process is security selection. Thatís why security selection is of paramount importance to us.
Everyone knows that there are geographic and macroeconomic risks, but you really donít know when trouble will come and in what form. In our view, the key factor in risk management is finding businesses that are well financed, well positioned in their ecosystem and capably managed by ethical people. Combined with diversification and a discount to intrinsic value, that approach can go a long way in risk management.
Of, course, we canít completely avoid risk. We need to seek to meet the fundís investment objectives, but if we can minimize the risks that the market is mispricing and take advantage of the re-pricing of that risk through deferred purchasing power, thatís truly bottom-up investing. In other words, risk management is not just about avoiding risk, but also about providing liquidity and potentially benefiting from that liquidity when the risk is re-priced or overpriced in subsequent periods.
So thereís a temporal arbitrage, where our patience and longer-term perspective provides us with the flexibility to wait until the markets become a little bit more attractive in our view and to avoid risks that we are not being properly compensated to take.
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