Value Investing Makes Sense by Jean-Marie Eveillard

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Jean-Marie Eveillard explains why value investing was the reason for his long-term success. From his introduction to Ben Graham to his transition to a Buffett-style approach, he shares the investing principles and experiences that led to a successful career.

The Notes

• Two main points: 1) value investing makes sense, and 2) it works over time.
• “Admittedly knowledge of value investing does not promise automatic success. The willingness to swim upstream, patience, hard work, good luck and skills — probably in that order — are also helpful, indeed necessary.”
• Skin in the Game: Eveillard still holds the investments he made in the funds he managed since the 1970s — grown to an eight-figure amount.
• Background
  • Born January 23, 1940 in Poitiers, France.
  • Found most courses in business school uninteresting except for security analysis — learned to read a balance sheet.
  • Was introduced to investing by his great-uncle Pierre who worked for and owned shares in Citreon.
  • Got interested in investing while interning at La Vie Francaise, a weekly business magazine.
  • Hired as a security analyst at Societe Generale in 1962.
  • Was mentored by Claude Echavidre at Societe Generale who created tables to compare companies by industry with metrics like revenues, cash flows, earnings, dividends, etc. over 5-year periods. “He insisted that numbers did matter and therefore should be carefully studied. I never forgot that.”
  • Took a position based in New York in 1968.
  • Heard about Ben Graham through two French students at Columbia Business School and read The Intelligent Investor and Security Analysis. Learned that the future was uncertain, the need for a margin of safety, and businesses had an intrinsic value.
  • Was offered to run a fund in 1974 but its investing committee had no interest in a value strategy. It wanted popular stocks.
  • “My first fifteen years at the bank were a waste, with the first five spent not knowing how to go about investing and the next ten being unable to use the value investing approach of Ben Graham.”
  • Heard about Warren Buffett in 1978, through a Lee Cooperman note. He read the Berkshire annual reports/letters and learned about owning “a comfortable business at a questionable price.”
  • Also read Jim Grant (Interest Rate Observer), Dylan Grice, James Montier, and William White (formerly at BIS).
• Fund Management
  • Sogen International Fund (Became First Eagle Global Fund)
    • Named manager in 1978 with $15 million in AUM. Worked alone until 1986. Stepped down after 2004. Returned in 2007 to 2009.
    • No advertising budget.
    • The early focus was on Graham-type net asset plays, mostly small stocks.
    • Outperformed his first 5 years by 188% vs. the MSCI World Index’s 78%.
    • Began a transition to Buffett-type stocks in 1993.
    • Had a time horizon of 5+ years, on average.
    • Had two objectives when he took over the fund: To do better than a money market fund over time. To do better than his benchmark.
    • Averaged 15.8% annual returns vs. 11.3% for the MSCI World index from 1979 to 2004. From 2007 to 2009, averaged -11.8% annual return vs. -25.5% for the MSCI World Index.
  • First Eagle Overseas Funds
    • The Class A shares averaged 14.4% annual return vs. 5.5% for the MSCI EAFE from 1993 to 2004. From 2007 to 2009, averaged -13.8% vs. -27.9% for the MSCI EAFE.
    • First Eagle Overseas Variable averaged 18.0% vs 5.4% for the MSCI EAFE from 1997 to 2004. From 2007 to 2009, averaged -12.5% vs. -27.9% for the MSCI EAFE.
  • The fund’s analysts had 3 jobs: track a number of existing holdings, look into Eveillard’s investment ideas (see if it was no good), and work on their own ideas and if Eveillard bought the stock based on their work, it was their responsibility as much as his.
  • Bottom-up but considered the risk of economic circumstances.
  • 1990s Bubble: “I for one always said that I would rather lose half of our shareholders (which we did, and change, in the late 1990s) rather than lose half of their money, which we did not, when the tide did turn, and the technology, media, telecom bubble burst.”
  • “Sell side research is of very little use to us. Which means that we have to do the work ourselves… Value investing among other things, requires hard work.”
  • “We did not want to speculate in currencies, so we hedged only (and then partially) in cases where we thought the currency was vastly overvalued in terms of purchasing power.”
  • Held cash temporarily. “Either we come up with enough investment opportunities and there is little cash or we don’t (maybe we are not looking in the right places) and cash builds up. So for us, cash is truly residual.”
  • Held mainly common stocks, but also special situations: preferred stock, holding companies, spin-offs, closed-end funds, high yield bonds.
  • Preferred not to own technology stocks since the industry changed quickly — too uncertain.
  • “The records of the First Eagle Global and First Eagle Overseas funds, while I was at the helm, (and with the help of our in-house analysts), over 28 years and 13 years respectively were due to a large extent to what I did not own: Japanese stock in the late 1980s, technology, media and telecom stocks in the late 1990s, and bank stocks in the years before the financial crisis in 2008.”
• Analysis:
  • “The size of the position is a function of the confidence (justified or not) in the quality of the business and also a function of the valuation of the stock.”
  • “I understand those who…acquire a position quickly. I personally have preferred to accumulate because it gives me time to keep thinking about the business of the company. Of course, I can (and did) get hurt if the stock moves sharply shortly after I have acquired only a few shares.”
  • “Unless you’re as smart as Warren Buffett, you expose yourself (and your clients) to major risk if the portfolio numbers only 20 or 25 shares.”
  • “Sometimes I’m told: ‘why don’t you just own your twenty best ideas?’ I answer that I do not know in advance what my twenty best ideas will be. If I did, yes, that’s all I would own.”
  • “We never take reported numbers at face value. For example, the value of the inventory of a clothing retailer may be overstated. Or the receivables from some clients may be suspect. Or the machinery is so old that it has been fully depreciated but it is in fact very costly because it is more or less obsolete.”
  • Hidden assets: assets on the books priced at their original costs but with a much higher current market value.
  • Stock Options: are costs that need to be accounted for in earnings per share.
  • Avoided high-growth businesses because stocks were too expensive and it’s hard for management to control high growth.
  • Looked for companies that were high ROE, moderate growth, free cash flow positive because they were more likely to trade at reasonable valuations and lacked extreme competition.
  • Buyback Rules: no borrowing to finance buybacks and undervalued stock.
  • “Everything starts with the quantitative, the numbers, public information, i.e. the annual report, the 10Ks, proxy statements, etc. And that includes the footnotes to the financial statements.”
  • “With the Buffett approach, the intrinsic value of a business is a function of the quality of the “moat.” So that one could argue that the margin of safety lies as much in the “perceived” quality of the moat as it does in the discount to intrinsic value. Therefore, one may continue to hold the stock as it reaches — current — intrinsic value, indeed one may — at least theoretically — even buy the stock at low — or at no — discount to intrinsic value but only if one has genuine confidence in the “moat” and if one believes that the expected increase — over time — in intrinsic value will be more than modest.”
  • Most businesses have no more than 4 or 5 qualitative strengths and weaknesses. The hard part is not missing a major strength/weakness. Everything else can be ignored.
  • Timberland: renewable resource, sustainable yield tied to forest growth, not capital intensive, great cash flow, and offers inflation protection.
  • Shipping Cos: the only way to be profitable is to sell ships at the top of the shipping cycle and buy ships at the bottom.
  • Double Discount: Buy companies whose stock sells at a discount and whose assets also trade at a discount. Ex: holdings like real estate or stocks that also trade at a discount.
  • “Balance sheet values are typically slower to evolve than earnings power (income statements).”
  • “An asset heavy business provides some protection to the investor particularly if many of the assets were acquired a long time ago so their value may be understated on the balance sheet.”
  • “If foreign markets, particularly emerging ones, the best opportunities often lie after a market and the local currency have both sharply declined. Then, as the market recovers, the currency also often does, and the combination can be as exhilarating as the previous double decline was terrifying.”
  • Preferred EV/EBIT because it introduced the balance sheet — debt. Was willing to pay 6-8 times EV/EBIT for good companies, 8-10 times for attractive companies, and 10-12 times for exceptional companies.
  • “If the EV/EBIT is very low and the net cash very high, and as the stock goes up moderately, the EV/EBIT will increase sharply. That’s how the arithmetic works.”
  • “Excessive leverage may be a problem not just because it works both ways (in other words, it helps in the good times and hurts in the bad times) but also because it reduces (or eliminates) the staying power of a business or of an investor… For an investor, staying power is all important, since the value investor is by definition a long-term investor.”
  • Selling Moats: Companies with true competitive advantages are too rare to sell even if it’s modestly overvalued (no guarantee you’ll be able to buy back in at a lower price). If it’s extremely overvalued, a portion of the holding may be sold.
  • Discount Cash Flow Models: works in theory but is “unusable in practice.” Too much focus on precise numbers looking 5+ years out. A small change in an input can have a major change in the output.
  • Holding Companies: “There are two ways to benefit: 1. To buy in a bear market when there is in effect a double discount: the components are cheap and the holding company discount is wide. 2. To find (but that’s hard) a holding company that has successfully reshuffled the stakes over time and seems likely to continue to do so.”
  • Closed-End Funds: never buy the IPO. Look for a double discount — the fund sells at a deep discount and its holdings also sell at a discount. Sector or country-type funds in particular.
  • High Yield Bonds:
    • looked for yields in the double digits.
    • “We only need the company to survive, not necessarily prosper.”
    • Best when it has the cash flow to cover the debt. If cash flows don’t, then make sure asset values are in excess of debt.
    • If the bond is worth buying, the stock may be worth buying too.
    • Sovereign Debt: may not be willing to pay but must be able to pay.
  • Emerging Markets: “We have had good investment returns from some Western listings of emerging market companies… In these cases the investment thesis was buying the stocks near the lows of the commodity price cycles and riding the subsequent boom in demand amidst tight supplies.”
  • Luxury Goods Cos: carries the risk of being a fad “famous today, infamous tomorrow.”
  • Avoids IPOs: most go public when things are good at the highest valuation possible.
  • “It’s very common to drown in the details or be attracted to complexity, but what’s most important to me is know what three, four, or five major characteristics of the business really matter. We have a great team of analysts who do the investigative work and I saw my job primarily as asking the right questions and focusing the analysis in order to make decisions.”
  • “The best opportunities tend to be when the company now facing a lousy short-term outlook was not long before considered a darling of growth investors, and when the problems are now perceived to be permanent. If you think those problems aren’t really permanent, you can make very attractive investment if you turn out to be right.”
• Specific Investments
  • Burlington Northern
    • Bought because of industry deregulation in 1970s, land grants (raw land, timber, oil/gas fields) offered asset protection, and stock was cheap.
    • Owned it for 2 decades.
    • Mistake: sold it before Berkshire bought it.
  • Bank for International Settlements (BIS)
    • Bank for central banks – created in 1930 after WWI to handle German reparations.
    • It was founded by several central banks of developed countries and 3 U.S. commercial banks. Each central/commercial bank got 16,000 shares. The U.S. tranche was sold to the public.
    • Started buying in 1982 and became the largest non-central bank shareholder.
    • Viewed as a combo money market and gold investment. Had an attractive yield, 90% of assets matured within 1 year, and it held gold bullion used to originally capitalize it.
    • Estimated (conservative) it sold at a 50% discount to NAV.
    • BIS decided to buy out the non-central bank shareholders around 1999/2000. Offered double the market price. Eveillard believed it was worth 4x the market price (twice the offer price), sued, and the Arbitral Tribunal (The Hague) ruled a 3x the market price (50% more than the BIS offer).
  • Lindt
    • Chocolate brands – typically have steady revenue growth, high operating margins, and strong free cash flow. Growth in chocolate consumption tends to follow economic growth. Prices increase regularly from 2% to 4% every two or so years. Limited competition.
    • “Even moderate care of long established food brands can lead to good and steady operating income growth for a long time.”
    • Started buying at 2500 CHF (9x EPS) in 1992 after troubles arose from reports that emerged about the then chairman Rudolph Spurngli.
    • Eveillard estimated competent management could produce 4-5% revenue growth per year long term, with 6-8% operating profit growth per year.
    • Newly hired CEO successfully focused on product quality, improving production/logistics, and expanding into the U.S.
    • Shares rose from 25000 CHF in 1992 to 74,000 CHF with a 725 CHF dividend by  2015.
    • “Working on both the qualitative and quantitative aspects of analysis, the big worry is assuming you found a Buffett type long-term earnings growth stock which turns out to be a Graham-type cigar butt or worse.”
    • Lindt was bought as a Graham stock that became a Buffett stock.
    • Held onto the stock even though it got very expensive, selling at 40x earnings in 2007.
  • Swissair (Mistake)
    • Started buying stock in the early 1990s at about 200 Swiss Francs.
    • Sold at a discount to NAV after losses in 1990 to 1992. Believed the losses were one-offs due to the 1990 recession. Had a solid balance sheet, debt to equity near 1, and hidden liability reserve.
    • Debt rose through 1998: “I ignored this increase in the company’s debt load, expecting the undervalued assets to provide protection to shareholders in the case of a decline in profits.”
    • 1998-9: the company followed a McKinsey strategy for expansion that bought minor stakes in national carriers in Europe, regional carriers, freight operators, and unrelated businesses (260 companies in total) and failed horribly.
    • The stock fell to 300 Swiss Francs by 2000, and 100 by 2001 after it was discovered the management hid 2.9 billion in losses in 2000.
    • Filed for bankruptcy in Oct. 2001.
    • Took an 80% loss on the position.
    • “In general, I have tended to avoid investing in businesses run — directly or indirectly — by former or current consultants.”
    • “The lesson I learnt was that you better be right about the asset values when making investments on the basis of estimating net asset value using market prices. This is especially important when the company has a lot of debt. If the debt to equity ratio is 10:1 then even a 10% decline in the value of the assets will wipe out the equity. So debt is a weapon that works both ways in enhancing as well as destroying returns from an investment. And it’s best to stay away from investing in a company with too much debt and that too in a cyclical business.”
    • “Airlines overall are usually bad long term investments. They sell a perishable item and are both capital and labor intensive, with older airlines having strong unions and high pension and other retirement costs. Also, most countries own or subsidize national airlines, which often add capacity for prestige and other reasons, ignoring profitability.”
  • Gold
    • “What matters is the investment demand for gold.”
    • Views gold as a substitute for money.
    • Protection against extreme outcomes.
    • Position size: 10% is good. Less than 10% is irrelevant, more than 10% becomes speculation.
    • Prefers bullion. Mining stocks bring the risk that the ore can’t be mined. “Gold mining stocks are call options on future ounces.”
• “I read a lot because I found out in the late 1970s that the successful investor Warren Buffett was a voracious reader. I thought: I’m not as smart as Mr. Buffett but if reading helped him, it might do the same for me, which it did.”
• “To value investors, investing begins (and sometimes ends) with analysis of public information. If the analysis is not satisfactory, then the documents go into the waste basket and value investors move on.”
• “What particularly appealed to me was the idea of “order,” that long-term, as Graham put it, the stock market is a “weighing” machine, that weighed the realities — good or bad — of a business and that those realities would — eventually — be reflected in the price of the stock, while short term, the market is a “voting” machine where traders “vote” through their purchases and sale of securities, based on market psychology. And the value investor wants to be on the side of the “weighing” machine.”
• “In money management shops that are not value shops (however one should call them) the risk for the in-house analysts is that the portfolio manager may be more likely to listen to the Goldman Sachs or Morgan Stanley analyst than to them.”
• “A saying on Wall Street is “timing is everything.” Well, not to this value investor. Indeed, often enough, I bought a stock that had already declined and continued to do so. After a while, if I had done my work right (a big if) it would bottom and then move back up. By that time, I would have a full position at an average cost not much above the bottom. I almost never bought a full position at the bottom or sold it at the peak. When I did, it was sheer luck.”
• “It takes quite a while for investors in a big bubble to get thoroughly discouraged and give up.”
• Walter Schloss found Buffett’s take on cigar butt stocks amusing. He said he usually got several good puffs out of his “cigar butts,” not just one.
• Capital Cycle: “In a reasonably fluid system like the U.S., capital moves into highly profitable fields and, as a result, over time returns decline. Conversely, if a field is no longer profitable, then capital leaves and over time, returns improve.”
• “If I buy a stock at $50 and after four years it’s still at $50 but it moves to $100 in the fifth year, I don’t complain about “sterile” money for four years, I say I doubled my money in five years and that’s good enough for me.”
• “Investing is not easy. Particularly the Buffett approach, which requires the exercise of judgment.”
• Permanent losses are more important than unrealized losses.
• “The late Bill Ruane, who ran successfully the Sequoia find for decades, estimated a couple of decades ago that about 5% of professional investors were genuine value investors, broadly speaking, from Graham to Buffett and everyone in between.”
• Most fund managers are too focused on the short-term (career risk) to be long-term (value) investors. A true value investor excepts they will lag the market at times.
• “When you have a theory to work from, you avoid the problem that comes with stumbling around in the dark over chairs and nightstands. At least you can begin to visualize in the dark, which is where we all work. The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in awhile.” — Jim Grant
• “Like the life of the art collector, the life of the investor is a life of regret.”
• “Value investors are (or should be) uncomfortable with the risks associated with short selling and leverage. Short selling because the potential downside risk cannot be measured… As for leverage, it reduces (or eliminates) the staying power of the investor. I can be patient (for years, if necessary) if I use no leverage, as long as, admittedly, I do not suffer major redemptions. I cannot be patient if I face a margin call and do not have the cash.”
• “Most people aren’t cut out for value investing, because human nature shrinks from pain.”

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