Buying Based on ‘Investment Premise’

It’s hard to find a stock mutual fund with a better long-term record yet less visibility than First Eagle Fund of America.

This New York-based portfolio compiled a total return in excess of 320% over the decade ended June 30. Although it is classified as a mid-capitalization stock fund because middle-sized companies are the bulk of its holdings, the fund’s charter allows it to invest in any type of stock as well as in other financial instruments.

Co-managers Harold Levy, 43, and David Cohen, 41, use a venture capitalist approach, evaluating companies by asking themselves what a private investor would be willing to pay for the businesses.

Before joining the fund’s management firm, Arnhold & S. Bleichroeder Advisers, Levy cut his investment teeth as a venture capitalist, and Cohen worked as a bankruptcy specialist. They choose stocks first by identifying a compelling reason to own a company, then reviewing financial statements and meeting with management.

Russ Wiles, a mutual funds columnist for The Times, spoke to Levy and Cohen recently by phone.

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Times: Do you think of your fund as a medium-sized stock fund? That’s how fund-tracker Morningstar Inc. classifies it.

Levy: It just works out that most of the stocks we own are in the $1-billion to $10-billion [market value] range. But we also own bigger companies and smaller ones.

Times: You say you’re not traditional “value” managers. How do you choose stocks?

Cohen: Our style, as simply as we can put it, is to focus on corporate change. There’s often something going on at a company--such as a management change, major share repurchase, significant acquisition or divestiture, litigation controversy or a plan to enhance shareholder value--that creates what we call an investment premise.

Our presumption is that the market, at a point in time, might not be fully recognizing the implications of such a change. The key thing is that we don’t use traditional value screens to find attractive stocks. Our process starts with a reason for wanting to own a company, based on a change happening at the company that causes us to think we can make money. Then we do a valuation.

Times: Where do you learn about such changes?

Cohen: Probably 80% to 85% of our ideas come from reading about companies in the general press.

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Times: So after you have read a newspaper or magazine article on a company and it has piqued your interest, you start a more intense research effort, meeting with management and kicking the tires?

Cohen: Yes. When we do our valuations, we ask ourselves how much we’re paying to own this enterprise, as if we were businessmen buying a company.

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Times: What’s the trick to evaluating management? It seems as if they all exude confidence and optimism.

Levy: We think that’s our real skill--understanding what people are all about, whom to believe, whether a management’s actions conform with its deeds and strategies. It goes back to the venture-capital business, where you start out by spending weeks with a firm’s management team, getting to know them and how they will react. You do this because [venture capitalists] can’t easily change their mind and sell, as opposed to the stock market, where you can change your mind in a nanosecond.

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Times: Are you patient if a company’s stock doesn’t move after you buy?

Cohen: If we find something else more attractive, we’re not going to sit on a stock that’s not performing just because we think it is still cheap. In this sense, our portfolio-management style is fairly aggressive, because we’re trying to maximize returns for our investors.

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Times: How do you two interact as a team?

Cohen: We often interview managements together and conduct a detailed financial analysis together. Both of us do a fairly rigorous analysis for most of the positions in the portfolio, although one of us may have the primary research responsibility for a particular security.

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Times: Despite a strong record, the fund has a fairly small asset base. What’s the explanation?

Levy: We never spent much time or effort marketing the fund, because it wasn’t started with the goal of creating a huge mutual fund complex. To the contrary, it started out as a mechanism to invest money for the principals of the firm, their families and friends. But we’re not trying to keep the fund small, either. The idea is to invest money and build a good-enough record that people would find us, as is happening now.

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Times: The fund’s prospectus accords you quite a bit of flexibility. You can go into bonds, options, foreign stocks and can hold just a handful of securities. Is so much flexibility prudent?

Levy: Probably 90% to 95% of what we do is plain-vanilla stock investing, primarily in U.S. stocks. Bonds historically have been minimal for us. But if we spot an investment that interests us, we want the flexibility to do it.

Cohen: We invest within the confines of our discipline and have built a long-term record doing so. But sometimes we might prefer to invest in a company without buying its stock. For example, we could decide we can better leverage our capital by buying long-term options than the stock itself.

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Times: While your long-term record is quite good, you did suffer through two subpar years, in 1990 and 1991, when the fund finished in the bottom quartile of its peer group. What happened back then?

Levy: We tended to bunch a lot of investment mistakes into that period. We also had some bad luck. Dole Food, a big position of ours, was going to be sold, then management changed their minds, and the stock dropped a fair amount.

And it was a year when levered companies--those with a fair amount of debt--didn’t do well. At the time, high-yield companies were a concern. Viacom had a lot of junk debt and was a leveraged company. It also was a big position of ours and got hurt badly. I attribute those two examples to bad luck or temporarily bad timing, because both stocks came back later and were great investments.

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Times: Do you try to time the market at all?

Cohen: We generally remain fully invested. Frankly, we believe that our skills are in identifying corporate dynamics and value companies, not market timing.

Times: In light of the continuing bull market, are you still finding enough undervalued stocks to buy?

Levy: Given the environment today, it’s much more difficult to find incredibly cheap companies. But in the context of where interest rates are and the [low price-to-earnings] multiples of stocks that we own, it’s not so bad.

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Times: Overall, blue chips have beaten the rest of the market in recent years. Mid-cap stocks like the ones you buy have lagged blue chips. Will that change?

Levy: The great thing about capitalism is that things tend to arbitrage themselves, meaning that investor dollars over time will flow to where the returns are going to be made. If mid-cap companies as a whole trade at much lower [price-to-earnings] multiples than big companies and yet their earnings are growing faster, people eventually will figure out that they will make more money on the former.

Can General Electric go from selling at 28 times earnings to 31 times earnings? Sure. But at some point, there will be an earnings stumble or some other disappointment. If small and mid-size companies start doing better, capital will flow there and out of the GEs and Gillettes. There’s nothing wrong with those companies, but I find it difficult to make a compelling investment case for stocks trading at 30 times earnings while growing at 12% or 15% a year. The math just doesn’t work.

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Times: What market sectors do you like today?

Levy: We’ve really had two big sector weightings for several years: finance and defense. These positions reflect investments we made several years ago. We still own those, and I still think there are some good investment cases to be made.

But we’re closer to the end of our defense exposure than the beginning. We think . . . procurement will start increasing, and we’ve already had a huge consolidation.

Similar trends have been going on among finance companies, although we’re earlier in the game there--probably in the fifth inning rather than the eighth or ninth.

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Times: What do you like about your largest holdings?

Levy: BankBoston is going to earn about $6.30 a share next year, and it sells at 13 times earnings. The stock market [overall] is at a P/E of 20. Also, BankBoston is buying back its stock. But it’s hard to be as excited about the stock now above $80 a share as when it was in the $70s. I don’t want to give you the impression we’re not excited about BankBoston. But if you had asked me that a week or two ago, I would have given you a different answer.

Cohen: At 13 times earnings with the market at 20, you certainly can make a case that BankBoston is undervalued relative to its current dynamics and what it might offer amid the continued consolidation of the banking industry. It has a basic franchise in New England and Latin America, it’s generating free cash flow and buying back shares.

Levy: Lockheed Martin will report earnings next year of close to $7 a share, which is skewed by the fact the company has huge goodwill from past acquisitions. The economic earnings are above $9 a share. The company’s selling at 11 times earnings with great financial dynamics and has created value for shareholders for a long period. . . . [But] on a near-term basis today, we aren’t as enthusiastic as we were yesterday.

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Times: You have mentioned “special situations” as being a part of your strategy. Any examples of what you’re looking for?

Levy: One company we bought recently is Fortune Brands. It used to be known as American Brands, which spun off its tobacco business from its consumer-products business.

Fortune Brands owns some great brand names such as Footjoy, Titleist, Jim Beam and Moen faucets. It’s now trading on an economic basis, excluding goodwill, of less than 15 times next year’s earnings, in a market where companies of this ilk trade at 20-plus. It’s got good cash flow, good financial dynamics and good management.

Another example is Loral. It sold its defense business to Lockheed Martin and now is in the satellite business, which it bought from AT&T.; Loral is one of three significant U.S. producers of satellites, and that business is booming, with high free cash flow. And the company is setting up a global communications system called Globalstar, which has the potential to be an incredible home run.

Cohen: For Harold and me, this fund is our primary investment vehicle. We’re here to make money for our shareholders, including ourselves. Our motivation isn’t to go out and merely gather assets. Our motivation is to earn great returns, which hopefully will result in our becoming a great organization.

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First Eagle Fund of America

Strategy: Seeks capital appreciation through a flexible investment approach that primarily aims to identify undervalued domestic stocks, but with the ability to purchase various other types of investments.

Vital Statistics:

Year-to-date total return: +21.4%

YTD total return, avg. general stock fund: +21.1

5-year total return, through June 30: +174.2

5-year total return, avg. general stock fund: +123.5

10-year total return, through June 30 +322.6

10-year total ret., avg. general stock fund: +236.4

Five largest holdings: 1. BankBoston 2. Finova 3. St. Jude Medical 4. Lockheed Martin 5. General Dynamics

Sales charge: None Assets: $250 million

Min. investment: $5,000 Phone: (800) 451-3623

Morningstar risk-adjusted performance rating, 1-5: 5 stars

Source: Lipper Analytical Services; Morningstar