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What Lies Beneath

In 1992, with Europe buried in a deep recession, Charles de Vaulx was digging through the rubble, looking, as always, for value. One day, while poring over a list of companies published by the Swiss foreign exchange, he struck gold in the form of the BVZ Zermatt-Bahn railway, whose business revolved around transporting tourists to a swank ski resort. This little, boring train [with earnings growth

In 1992, with Europe buried in a deep recession, Charles de Vaulx was digging through the rubble, looking, as always, for value. One day, while poring over a list of companies published by the Swiss foreign exchange, he struck gold in the form of the BVZ Zermatt-Bahn railway, whose business revolved around transporting tourists to a swank ski resort. “This little, boring train [with earnings growth of maybe 2 percent per year], it was cheap,” says de Vaulx. The year before, there had been an accident, which had no significant impact on ridership but did require some capital expenditures for repairs. The company depreciated the outlays abnormally quickly, depressing earnings. Confident the negative state was a temporary one, de Vaulx bought the stock — and watched it triple in two years.

It is with calls like this that de Vaulx has built his reputation as one of the world's best value players. The senior vice president of Arnhold and S. Bleichroeder Advisers co-manages the First Eagle funds, a family with decidedly un-value-like returns. First Eagle Global, for instance, boasts a 12.35 percent return over the last decade, which bests both the S&P 500 (11 percent) and virtually all its peers over that time span. (Three of the five First Eagle funds get five-star ratings from Morningstar; one gets four and another is unrated.)

Thanks in no small part to an obsessive stance towards principal protection, First Eagle weathered the bear market years in a way that caught the eye of investors and advisors alike. (First Eagle Global, for instance, returned 9.7 percent in 2000 and 10.2 percent in 2001.)

But the funds are now entering a brave new world. They're bigger and more popular than ever, and at year's end they'll be without the services of the man who is no small part of their current success: longtime co-manager Jean-Marie Eveillard, who will retire in a few months.

De Vaulx spoke with Registered Rep. about the challenges facing him and his funds in the coming years.

Registered Rep.: Can you talk a little bit about your firm's approach to value investing and how it differs from others'?

Charles de Vaulx: Most of our competitors tend to begin the process with a price they identify using screens and quantitative devices. Once they've compiled a list of cheap-looking stocks, they'll do some homework on them, hoping to find companies with decent businesses.

Our approach truly begins with the quality of the business. Perhaps I'll read something about a company that seems to have a good business, and that will prompt us to investigate the stock, and we hope, we pray, that the stock is cheap. Of course, this approach makes things tougher in a way, because good businesses typically do not come cheap. Oftentimes we need something to be hidden — maybe the company itself is small and obscure, maybe it's got some good news obscured by conservative accounting or it's got hidden assets, such as excess real estate, excess cash or a portfolio of multiple securities that were put on the books 80 years ago with prices much lower than market value.

We've done quite well over the years, investing in good businesses that are cyclical — newspaper publishing, radio, billboard advertising, temporary staffing — because those businesses do well over a poor economic cycle.

We invest with a three-to-five-year horizon; most institutional investors invest with a 10-month horizon — that's on average.

RR: Your firm's grown to a size and level of renown that probably makes it hard to take positions in small- and mid-cap companies without affecting their market fortunes in some way. To what extent are your funds victims of their own success?

de Vaulx: If by success you mean that we've grown in size and clout, that's true. We now manage $16 billion. As recently as three years ago we were only managing $3 billion, though, admittedly, that was down from $6 billion in late 1997. But clearly, we're much bigger than we've ever been.

In general, being larger is not much of a problem, because the U.S. market is so big and diverse. Temporarily, though, that translates into issues for us, because the U.S. market as a whole is too expensive right now, and we're not as heavily invested in it as we have been historically.

Because of our bias towards smaller and midsize companies, we often end up owning between 3 percent and 15 percent of companies. Is that a handicap? Perhaps. For us to be willing to own up to 10 percent of a company means that we have to be pretty confident about our analysis, because if at some point it becomes clear that we were wrong, it might be very difficult for us to exit our position at a decent price.

The fact that we have a team of seven analysts, compared to just one or two back eight or nine years ago, makes us sure that our analysis is keeping pace with our growth.

On the upside, our being big and owning a big stake in a company means that we have more leverage, and also it means we can justify the expense of taking some activist actions when we deem them necessary.

RR: You noted that the U.S. is a tough market right now, in terms of value opportunities. Where are the hot spots?

de Vaulx: Asian and European markets are reasonably valued — not cheap, but reasonable. Europe, for instance, trades at 8.4 times after-tax cash flow. This is a far cry from the early 90s when Europe was running between 4 and 5 times after-tax cash flow, but it's a world better than the U.S.'s 13.5.

Another positive about Europe is the fact that the valuation gap between small companies and big companies is still there. It's narrowed a bit, but there's still a gap that can be exploited. The same can no longer be said for the U.S. market, where the valuation gap has totally disappeared over the last four years.

Also, what we've seen in the U.S. is that companies are paying less and less in the form of dividends, but they don't necessarily do smart things with the extra cash flow. They oftentimes overpay for positions or, more recently, overpay to buy back their own stock. With European companies paying out more in dividends, they're forced to have better discipline in terms of capital allocation. Less money to squander is always a good thing.

In Asia, Japan trades at 9.3 times after-tax cash flow. What's intriguing are the depressed earnings — the average return on equity is only 4.8 percent. Will the companies wake up and do the cost-cutting that's needed, the outsourcing? Who knows? But statistically, there are quite a few cheap stocks in Japan, especially if you're able to notice that many of them do have hidden assets in the form of excess cash.

RR: Are there any domestic plays that you like?

de Vaulx: We're still very keen on Liberty Media. Another stock we've done well with, but we're content to hold onto, is Costco. We also like forest products — timber and the like — in part because these firms don't require any capex to perpetuate themselves: trees grow on their own. Also, it's a commodity which is global, and therefore, benefits if and when the dollar weakens.

RR: What advice do you have for retail investors and the financial advisors who serve them?

de Vaulx: Advisors should realize that the next five years' returns might only be 3 percent to 6 percent, and it's important for them to try and convey that to their clients.

In addition, advisors who lean heavily on asset allocation models should give some thought to the fact that now might be a very unusual situation where pretty much every asset class out there is pricey. Asset allocation, of course, assumes that at any given time some asset classes are pricey, but that is balanced by others that are cheap. In the absence of such a dichotomy, maybe it's time to introduce a new asset class into those allocation models: cash.

If you need some help feeling good about cash, try this: Instead of thinking of it as an investment that moves at 1 percent (which is less than zero in real terms, adjusted for inflation), think of it as an improvement over a stock that's likely to lose 3 percent or more. In addition, think of cash as being the raw material, the tool, that will enable you, maybe, three months from now, nine months from now, to buy tomorrow's bargain.

RR: What will it be like running the funds without Jean-Marie Eveillard?

de Vaulx: I'll be sad to see Jean-Marie leave, because he is both a friend and mentor. We're truly on the same psychological wavelength. We share a hatred towards losing money, and like Jean-Marie, I own the funds we manage; we eat our own cooking.

With all due respect for him, I do face a large challenge as he leaves. The firm is getting bigger, and our field has become more competitive.

In general, though, I'd say that the co-captain may be retiring, but the ship will stay its course.

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