I’ve read about the investment firm First Eagle Investments and its legendary portfolio manager, Jean-Marie Eveillard, many years ago. But I was not familiar with Matthew McLennan, currently an important leader in First Eagle’s stock market investment team, until I came across his interview with William Green for the Richer, Happier, Wiser podcast series on The Investor’s Podcast Network.
During their nearly two-hour conversation, McLennan and Green covered plenty of high–quality ground and I had many takeaways that I wish to share. Here goes!
Using gardening as an analogy for the importance of having a long-term mindset in stock market investing
McLennan: I mentioned that my grandfather was a gardener and he passed that skill on to my mother and this little home that we built, she was an ardent gardener in this home. As a child, I always wondered why she went to the effort because there was always some issue. There were drought conditions or the bamboo root would spread to somewhere where it wasn’t meant to be or there was some weird fungus or virus. She was always having troubles.
Whereas, there’s a gentleman who lived next to us who mow his lawn every week and it just looked pristine and clean. We had another house behind us at the bottom of the rainforest where he just lived amidst the rainforest. I didn’t realized the wisdom of my mother’s long-term strategy when I came back to the house some 20 years later with children, my children. The garden had really grown into this resplendent beautiful space. It had been selectively curated over time. Whereas, the house next to me was still being mowed. The lawn was still being mowed every week. But there was nothing to show for all of this activity. He was like the active manager turning over the portfolio once a week.
The gentleman who’d had his house down the hill behind us had some fire damage I heard at some point. The passive strategy of just letting the forest go around you wasn’t necessarily the safe strategy my mother had worked in all of these fire buffers and things. Selectively curating something and letting time take its course is something that doesn’t seem like a very well-rewarded activity in the short term. When you step back and let time play out, it can be very rewarding.
The scientific principle of entropy is a useful framework for thinking about the longevity of companies
McLennan: Entropy is probably one of the few absolute truths. It’s a second law of the thermodynamics that any form of order is essentially transient. And perhaps it’s the fight against entropy that’s sort of gotten me interested in old master art or great wine that can survive for generations, from vineyards that have been planted for generations, or a business that has a slow fade rate relative to the typical business.
But if you think about the economy as an ecosystem, rather than as machine, productivity happens every year, productivity growth, and over the last century, we’ve grown productivity close to 2% a year. But the dark symmetry of productivity is that the existing pool of companies won’t control a future profit pool in perpetuity. New businesses get created that chip away at the margins at existing incumbency. And so entropy is a fundamental principle and investing. And when you go through business school and learn about asset pricing, you’re really only taught to think about beta risk or systemic risk. But idiosyncratic risk is interesting to think about as well.
And in fact, entropy is a form of systemic risk because change in the economy and the overall improvement in the economy imputes that existing companies will grab a smaller share of the future pie given enough time. And so I’ve focused a lot on this question. And the paradox of it is that buying businesses that have been around for a long period of time, that have demonstrated persistence, in some ways, can be a safer strategy than trying to buy a business that’s growing a lot today because many of the businesses that are growing a lot today are in industry verticals where market share positions move around a lot. And so by definition, your ability to capitalize their terminal earnings at any given period of time is low because easy come, easy go, as it would relate to market share shifts.
And so we do like to try and focus on businesses that have a stickiness to their market share over time, high customer retention rates, to try and slow the curve of entropy. And we approach it with a great deal of humility and respect, and we recognize that even our favorite ideas are going to get disrupted at some point or another.
Digital wealth could co-exist with financial assets
McLennan: Most wealth before the industrial revolution was stored in real assets, land, art, precious metals, livestock. And then we created all these financial assets which were essentially the crypto of the time. They were virtual claims. The original companies were beneficial claims of trusts on underlying assets. And so this was kind of arcane and abstract at the time, but financial assets came to coexist alongside real assets. They didn’t disrupt totally, they coexisted.
And if digital assets are another concentric circle around financial assets and real assets, it doesn’t mean that real assets will disappear and it doesn’t mean that all financial assets will disappear. I think what we’re going to see is the emergent coexistence.
Emerging economies often don’t “emerge”; the problems with China’s economy today
McLennan: Well, it’s not clear to me that China will become, and even if it does sustain its position as the world’s largest economy. And I think a lot of people are presuming that will happen, but it’s not clear to me that happens. I think one of the things that’s interesting is if you look at a list of emerging markets and of 50 years ago and look at a list today, very few emerging markets actually emerge.
And there’s a whole host of reasons for this and there’s, in fact, there was an interesting book on this called Why Nations Fail by Robinson and I think Acemoglu MIT economist. And one of the tells of a country that’s managed to sort of grow and benefit from capitalism and the spread of property rights and all those sorts of things. There’s an inherent pluralism and a political process that gives voice to multiple constituencies. And historically at least if you haven’t had that, it’s been difficult to sustain growth to develop market levels. And ultimately if you have some form of authoritarian regime, it’s impeding to the very notion of creative destruction because if there’s a rent seeking regime, it has to retard at some point in time, creative destruction to preserve its own existence.
And so I think if you were to ask if Hayek still lived and you were to ask him, will China become and sustain its position as the world’s largest economy? I think he’d be very weary of making that prediction. And so I think that China is set with quite a few problems right now despite the fact that there are opportunities, this self-inflicted wound with the COVID policy response and the lockdowns. There is dramatic adjustment going on in the real estate sector and that market is very overbuilt. And they had a clamp down on the entrepreneurial class and which has really led to sort a derating of that sector.
Through a study of history, there’s a risk of China and the USA coming into conflict
Green: And you seem pretty concerned as a fan of Thucydides and his views on history, you seem pretty concerned about some kind of mounting inevitability to a conflict between the US and China sort of echoing the Spartan Athenian kind of conflict that we saw thousands of years ago.
McLennan: Well I think if you read Thucydides what’s compelling about it is that it was written before 400 BC and a lot’s changed since then. Obviously technology is dramatically different today from what it was back then. On the other hand, human behavior and human wiring hasn’t changed that much. And I get the analyst on our team to read the book because it shows you the common mistakes that people make. Hubris, dogma, acting with haste. And I use that as a template to get people to think about doing the opposite with their temperament, having humility to accept uncertainty, being a patient investor, being flexible, not dogmatic about just investing in one particular part of the world or one particular industry.
And so I think there’s a lot we can learn from Thucydides and I think what he showed us is that the fear of war is often the cause of war, and especially when you have two competing regimes. And I certainly hope we don’t see that emerge, but Nancy Pelosi’s visit to Taiwan and the response is clearly flashing some warning signs here that I think we can’t ignore in totality.
How to improve your thinking
McLennan: So I think the first thing is you have to create time to reflect. And it’s easier said than done. We all have busy schedules. We could all spend all of our time doing a subset of our jobs. And so first you just have to, in the mental hierarchy of things, acknowledge that some time spent on reflection is important. And in fact, as I think about it, what, if I were a client? What would I want Matt or any of the team members to be spending their time on? And I’d want them to be spending some meaningful amount of their time on reflection so that they’re seeing the world through a different prism.
The second thing is that it doesn’t happen linearly. Even though I try to religiously schedule some time for reflection on certain days of the week or certain times of the day, reality intervenes frequently. And so you have to squeeze it in while you can but, and it’s not even linear in that context.
So I might go through some years where I’m reading voraciously, I read many books in a year. And then I go through other years where I get into four or five books but I don’t complete any. And I’m actually spending most of my time to your point before raking the zen garden, and trying to order my thoughts. And I do keep many notes that essential attempts to sort distill what I’ve learned from different works and tying it together in a philosophy that makes sense. And sometimes I’ll wake up at five o’clock in the morning and I’ll just spend two hours trying to refine one element of a mental model. And so part of it is creating time to absorb new ideas, many of which have come from great people that you never got the chance to meet, but you can at least read their books.
And the other part that’s equally important is to synthesize. And it’s the same notion if you’re going to visit a company that you, you’re going to Tokyo and visiting a bunch of companies, you have to spend the time preparing for it and the time to make sense of what you’ve learned after the fact. And so it’s not enough just to read a lot. You have to try and think about it and distill it and it’s both of those things.
And then sometimes you just get stuck. You feel like you’re not necessarily making a leap forward in your understanding. I don’t know if you’ve gone through the process of learning another language, often it feels like you get this window of stasis and then all of a sudden in a non-linear way you take a stair step function up and you’re seeing things in a new light.
And so I think often when you’re feeling stuck, it makes sense to do something different, to travel somewhere, to do something physical. I like to play backgammon against the computer from time to time and sometimes it takes doing something different. A friend of mine, Josh Waskin said sometimes the ember needs to withdraw before the flame comes back up. And so I think it’s a combination of all those things, prioritization of reflection, realizing that it’s not just about reading but equal measure must be spent to synthesis and making sense. And then the final thing, recognizing that it’s a kind of step function process where you need time to step outside.
And Lord Dening, one of the great English judges said, “Let not our vision be clouded by the dust of the arena”. Sometimes you’re just too much in the thick of something to make sense of it all and sometimes you’ve got to leave the snow globe, let it settle and then come back. And so those are the ways I try to do it and it feels rather imperfect. I’ve been at this for decades now and I feel like I’m just beginning and I feel like I’m so far behind in so many dimensions that it’s humbling.
How to deal with living in a world of complexity
McLennan: If we go back to Wolfram and complexity theory, something that was just a blinding revelation to me when I read that his book, A New Kind of Science was that he was studying deterministic systems. So what I mean by that, think of an Excel spreadsheet where a cell could be different colors based on the behavior of cells around it, but there’s an underlying formula. And he did thousands and thousands of simulations of what the patterns would be for different formulas.
And what he found was really interesting, which was that only a small fraction of the formulas produced linearity. And most of science is built on regression and looking for linear relationships, but this is the minority of reality. And then there was a bigger subset but still small where there was some sort of nested cyclicality to the patent but not a hundred percent neat.
So I think the business cycle, we know it, there’s an ebb and flow, but we can’t call it precisely. And then the vast majority of the patents of these cellular automata in these spreadsheets were effect, They looked like they were random but they were driven by a given formula. And what’s interesting is if something as linear, you can predict it in the future with a small number of observations. If something has a nested cyclicality with more observations, you can kind of predict the skew in it, but not necessarily exactly where it will be.
But if something’s truly complex, it would take you more observations than actually exist in reality playing out to backwards induce the formula. And he came up with this notion of the computational irreducibility that basically, even though there’s a formula behind the patent, it’s effectively random unless the formula because it would take you more steps to observe it than to figure it out. And so the reason I mentioned this upfront is that number one, there’s a realization that there’s a lot that we can’t know unless you actually know.
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