From the June 2003 issue of Investment Advisor • Subscribe!

June 1, 2003

Still Glittering

International tensions may have cooled, but First

First Eagle's funds, run by Jean-Marie Eveillard, 62, who is set to retire in 2005, and Charles de Vaulx, 41, who will take sole management control then, have demonstrated that a disciplined approach to value investing can succeed in any economic environment. The managers' five-star First Eagle Gold Fund (SGGDX) is no exception. The fund's assets have increased nearly twentyfold in the last three years, from $10 million in 2000 to $190 million in April 2003.

Investing in a diverse menu of gold plays including mining stocks, gold-linked notes, and bullion, de Vaulx and Eveillard have lowered their fund's volatility (although de Vaulx admits it is still high) and have maintained a disciplined approach to investing. As bullion boomed amid international tensions last year, the fund's net asset value more than doubled, from $6.27 in 2001 to $12.89 in 2002.

In the first five months of 2002, gold was trading at more than $325 per ounce, compared with its mid-1999 price of $250, de Vaulx explains. "We decided to switch out of some gold mining stocks and started to buy gold-linked notes, and then later bullion itself." Gold-linked notes account for 13% of the First Eagle Gold Fund portfolio, and 16% of the fund is in bullion. "Those gold-linked notes were tailor-made for us. They have a one-year maturity and are leveraged one-and-a-half to one to the price of gold. So at the maturity of these notes, if the price of gold has gone up 20%, the redemption price would be 130% of par," he says. Later in 2002, as gold stocks began to increase in price, the fund began investing in the metal itself. Bullion is leveraged at one to one, "so this is how we control volatility," he says.

As of April 30, the fund had about 42% of its assets in foreign-based companies, and had a five-year annualized return of 10.7%. That compares with 0.1% for all equity sector funds and -2.4% for the S&P 500, according Standard & Poor's. The fund also ranked fifth within the universe of 533 equity sector funds for the five years ended April 30.

De Vaulx likes to have maximum exposure to the gold market. To that end, he does not invest in gold mining companies that "engage in too much forward selling and hedging," he says.

Though the fund's year-to-date return was -9.46% through April 30, de Vaulx says he is not surprised. "We are down because the price of gold was strong in January, but as the idea of war with Iraq spread, the price of gold fell sharply in February and March," de Vaulx says. "So the price of gold is now lower than it was at the end of last year as you would expect. And as the price of gold fell, bullion and gold stocks fell. If anything, our fund is down, but has held up better than most others for the simple reason that the gold-linked notes [we invested in] are leveraged and have not come down as much as the mining stocks."

We spoke to co-manager de Vaulx about his fund's performance, how gold behaves differently than other metals, and why he's invested much of his own money in the gold sector.

Does your fund invest mainly in gold stocks? Our fund, which was created in 1993, invests mostly in gold stocks. Over the years we have had a little in silver-related securities, at most 5% to 6% of the portfolio. Once in a while we've had 2% to 3% in platinum or palladium securities. But it is first and foremost a gold fund, as opposed to a precious metals fund or a natural resources fund, which would include base metal and forest products.

Do you feel that precious metal funds, which have performed better in a low-return environment than most other sectors, are on their way down? Has gold's run finally ended? I don't think so. Starting in November and December of last year, the price of gold went through the roof, and as the crisis with Iraq started, many speculators--including commodity funds and hedge fund speculators--bought gold, thinking that a war could be favorable to the price. The war brought out a lot of speculators, whom we think bought gold for the wrong reasons. And as the war unfolded, all the speculators sold their gold positions. As a result, the long-term fundamentals for gold are encouraging. I have found that as the dollar has resumed its slide, the price of gold has started to act better. Historically there is a pretty good inverse relationship between stocks and gold. We have been in a major bear market for stocks for three years in the United States, and we don't think U.S. stocks are going to rebound sharply. We think there is a potential for more investment demand for gold.

Please talk about how the different precious metals behave. To generalize, platinum and palladium behave mostly like industrial metals. They are linked to the economic cycle, whether it is in the form of jewelry demand, which impacts platinum, or automobile manufacturing, which impacts both platinum and palladium. Gold itself is hybrid in a sense that the bulk of demand has been in jewelry, as opposed to investment. In the mid '70s, however, the price of gold went up sharply due to investment demand. Historically, silver was used as money, and as in the case with gold, there is a fair amount of silver used as jewelry. Fifty-one percent of the demand for silver is linked to the photographic industry, as it is used for film. And photographic and photo usages are somewhat linked to the world economic cycle. So silver is somewhere between gold and platinum and palladium. Silver and gold have both jewelry demand and investment demand.

And jewelry demand in itself is somewhat ambiguous. In places like India or the Middle East, people buy gold as jewelry, but unlike the United States, the retail price of a gold necklace is at most worth 10% or 15% more than the gold content. Many people who buy gold jewelry in Asia or the Middle East have in the back of their minds that this is also an investment.

How do you handle risk in a sector where individual stocks can be very volatile? The way we handle risk for all our funds is by having a value approach to investing. We are very price-sensitive. Whenever we buy a stock, we try to assess what a company's intrinsic value is, and then we try to find securities that trade below that intrinsic value. When you do this, you create what Benjamin Graham, the father of value investing, called, "the margin of safety." It gets trickier to do this with gold mining stocks because they typically trade at a premium to the present value of their gold mines. Another way of reducing risk is diversification. When you run a specialized fund like our gold fund, it is harder to have hundreds of securities like we do in our global and our overseas funds. Nonetheless, our gold fund has around 66 positions, and, in fact, the real diversification is higher than that because in addition to diversifying our securities, we own bullion outright. Bullion makes up about 16% of the portfolio.

Currently, First Eagle Gold Fund has 57.76% in U.S holdings and 42.24% abroad. How do you determine the mix of the fund? Is it simply a reflection of where mining companies are domiciled? Yes, especially since a company might be domiciled in the United States but the bulk of that company's gold mines might be located outside of the U.S. As an example, we own Freeport-McMoRan Copper & Gold Inc., a New Orleans-based company that has a giant copper and gold deposit in Indonesia. Even though it is a U.S. company, the reality from a risk standpoint is that it is Indonesian. Likewise, we own another U.S.-based company with mines in Nevada, but they also have many mines in Mexico, Peru, and Australia. So where a company is headquartered is largely irrelevant. Conversely, when we look at each company, we do pay attention to where the assets are located. Some gold mines are in South Africa, which entails some political and health risks. To minimize risk, we pay attention to where the mines are located, and we would obviously be reluctant to have too much of our portfolio invested in companies in one single area.

Do you have any holdings requirements? No, and that is what makes us different from other gold funds. We tend to shy away from so-called junior mining companies. That covers two kinds of companies: the ones that don't have any current gold production [meaning they are exploration firms only], and the companies that have less than 100,000 ounces of gold per year of production. We tend to shy away from them because there is a lot of fraud, a lot of promoters in the gold mining industry. The deeper reason is that when you get involved with exploration type companies as an investor, your play is less on what is happening to the price of gold, but more on the odds of how lucky that company will be in finding more gold. If they are successful, those companies can do very well even if the price of gold goes down. But the reason why my partner and I launched a gold fund was based on the premise that the price of gold would go up, so it would not have made sense for us to spend too much time or devoted too much of the portfolio in exploration-related companies that have nothing to do with the price of gold.

How important is a company's management team in your screening process? In this business, the quality of management in gold mining is not very high. And we have respect for just a handful of people. Many [people in management] have decades of experience in the business, and we try to see what their background is, which companies they worked for, and if they did well. So we do check quite a bit on their backgrounds.

How large are the companies you usually invest in? Do you always stick to one cap size? We invest in some small companies and some of the junior companies that already have existing mines, but only a very small amount. Unfortunately, in the last few years there has been a fair amount of consolidation in the industry, and the number of legitimate big companies has shrunk tremendously.

For our other funds, we have a bias toward small- and mid-sized companies, as opposed to bigger companies, because as value investors, our experience has been that the art of finding an inefficiently priced stock tends to be higher the smaller and more obscure the company. There are just a handful of mid-sized and big companies in the gold mining business, and of the many smallish companies, many are of poor quality. This is one of the reasons why we have invested in bullion and gold-linked notes.

The dividend yield for this fund is about 0.62%. Is that something you focus on heavily? We wouldn't buy a stock just for the yield, but we do like companies that pay dividends.

For instance, many years ago, South African gold mining stocks were cheap, and in addition to being cheap, they had great yields. So we ended up buying a great deal of them.

Unfortunately, I don't have many very kind words to say about the management of gold mining companies now. The problem is that each company is a collection of mines and every mine has a finite life. Gold mining companies always feel the need to reinvest whatever cash flow is generated by the mine into exploration, to finding new mines, and making acquisitions and often overpaying.

One thing that shows how mismanaged this industry is is how low the dividend payout ratios are. So it is very hard to find companies with a decent yield.

Currently this fund's front-end sales load is 5%. Is that waived for advisors? Advisors that use Schwab and Bear Stearns and others, the fee-based planners, will have the load waived. Also, we plan to open I shares and C shares, which will be no-load but have higher expense ratios, in May. We have had those shares in our other funds for quite a few years. We forgot to put it on the gold fund, so this addition is more to normalize the funds than anything. Two years ago, the fund only had $12 or $13 million in assets. Now that there is more interest, we have normalized things and added these share classes.

Is there a limit to how large you want this fund to be? With some of our other funds we have issues with capacity and too much money coming our way, and in fact we've acted upon it. In early 1994 we closed our global fund to new investors and only a year and a half later, when enough stocks had come down in price around the world, were we able to reopen the fund. We have been sensitive to capacity and inflows. For the gold fund, because of all the mergers that took place, there are quite a few mid-cap and big-cap companies, so it is easy for the fund to reach $1 billion. We would be fine with that. Some of the larger gold companies have very liquid stocks, and because we also invest in the bullion and gold-linked notes, it is not a problem. So for all practical purposes we don't see any constraints.

Who is your ideal investor? First, we want someone who is interested in gold, not so much to try to make money, but someone who looks at gold defensively. Historically, people have associated gold funds with volatility. They think of gold as moving up and down very quickly. So our sector can attract hot-money and momentum investors. We want the opposite of this. We want people to buy gold defensively because there are too many things in the world that are shaky, like a murky outlook for stocks and bonds for the next five to ten years. Therefore, we want people to buy gold as a hedge. Second, we want investors in our fund who do not put all of their eggs into the same basket. We don't want someone to put all of his or her financial savings into gold and in our gold fund. We are bullish and we invest in many parts of the world, so we think having between 5% and 10% of one's financial assets in gold makes sense.

Do you have much of your own money in this fund? Most of [my] money is in our larger global and overseas funds. Both of those funds have roughly 5% of their investments in gold-related securities, so in my ownership I'm quite heavily exposed to gold. In addition, I do own some of the gold fund.

Historically, gold has had a great track record as a diversifier, and we have already talked about the great inverse relationship between the dollar and gold. When the dollar fell sharply, gold moved up sharply. Gold can be so volatile that even 5% to 10% in gold can double for the year, and if that happens that would help mitigate some losses that one would incur in bonds and stocks.

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