Is the World on Sale?
Franklin Templeton Investments
By Peter Langerman, Christian Correa
June 15, 2012
Like a swift kick to the gut, the eurozone crisis knocked the wind out of the stock market in May. While most investors duck and run, others see market stumbles as opportunities to pick up potential long-term values. For these contrarians, they see the world on sale. Peter Langerman, Chairman, President and CEO of Mutual Series and co-manager of Mutual Shares and Mutual Global Discovery funds, and Christian Correa, Director of Research for Mutual Series and co-manager of Mutual Beacon and Mutual Recovery funds, are in the latter group. They’re looking for bargains—but not without a thorough examination of the goods and a solid understanding of the risks, because like all those black suitcases on the luggage turnstile, a designer bag and a convincing imposter can often look alike.
Investors hate uncertainty, and we’ve got plenty of it right now. As European leaders continue to muddle through their debt problems, no clear solution has yet emerged. As no one really knows what the future holds for the eurozone, or what the potential global economic impact will be, even those investors lured by the potential for greater yield to take on risk now seem to be backpedaling from risk. A quick tour of the headlines paints a picture in which consumers are losing confidence and companies are holding back on hiring plans. While Langerman and Correa are bottom-up investors, it’s hard to ignore macroeconomic events as powerful as this one. And they don’t! While these two affirm that they pay attention to short-term market movements, they don’t react to every twist and turn. They do consider various “what if” scenarios and how they might impact individual holdings in the portfolios. They carefully examine each potential investment on a company-by-company basis.
Peter Langerman on the Eurozone
“The eurozone issues have once again thrown us and the investment world into a degree of chaos that really feels, to a great extent, like we’re back where we were several years ago. And I think it’s fair to say no one knows with a high degree of assurance where this all will end up. Generally speaking, one might say that the world is on sale. Europe certainly has gotten hit—disproportionately in our view—but the U.S. has not been immune from what we’ve seen in this past month’s market downturn. Most people are suggesting (and we would tend to agree) that the issues out of Europe are having both real and psychological impacts on investors and companies in the U.S., so there’s a link.
We have been concerned about the lack of complete progress in fixing Europe’s financial problems. Having said that, when you look at the valuations, some areas appear particularly cheap to us. We do have exposure to Europe today,1 and I would say there are some opportunities there. We are certainly looking, but there’s always a weighing of the risk and reward.
For example, we are looking at a large European conglomerate, but most of its business is not European-based; just because a company is located in Europe doesn’t necessarily mean it has a 100% European exposure. The company may be viewed as a proxy for Europe, and may be getting disproportionally hit in the marketplace as a result. We have to look at where the businesses are, where the revenues are, where the profitability is.”
It’s an interesting way to look at it, and it makes sense. You don’t stop buying groceries when a particular food is recalled and taken off the shelves; you just adjust your buying pattern to avoid the known peril.
Christian Correa on Uncertainty
“Uncertainty means that a lot of companies, investors and consumers don’t spend money or don’t take risks that they might take otherwise. That can have a self-fulfilling effect of slowing down the economy, which is basically what we are seeing.
As bottom-up investors, security-level analysis is the heart of what we do. In every environment; we spend a lot of time thinking about different scenarios. We think about what can go wrong, what can go right, and we try to lay out valuations attached to different scenarios. In an environment like this, we have to acknowledge that there is a certain level of uncertainty that we have high difficulty forecasting, so I think we tend to stress our downside scenarios a little more severely than we might otherwise.
We also think a lot about the specific business a company is in, and how much it will be affected by the macro economy. Different companies have more or less direct impact from economic growth. We also think a lot about credit. We are more cautious about companies that have leverage.
Then we take a step up above the security and look at the portfolio level. When there’s an attractive opportunity but the scenarios are fairly extreme both up and down, we might manage position size to make sure we are not taking on more portfolio-level risk than we’re comfortable with. We also look at our portfolio-level concentrations in geographies and across industries to make sure we aren’t making some kind of macroeconomic bet that we don’t want to be making.”
This all begs an important question: How does an investor determine whether a stock that’s been knocked down looks healthy enough to bounce back (representing a value), or whether it’s down for the count (a value trap)?
Christian Correa on Value Traps
“I differentiate between two kinds of value traps. The first kind of value trap is a company that has very valuable assets or very strong cash flows but fails to realize that value. It generally takes the cash and reinvests it poorly, or otherwise transforms that value into something worth less. That’s a classic value-destroying company. The key there in differentiating between the value destroyers and the value creators is really about assessing management quality and their capital allocation plans. Often times, companies will tell us that they tend to reinvest cash flow in X, and it’s our job as investors to understand what X is and what we think the value of X is. It’s really about doing thorough analysis of the management, the capital plan and the strength of the business. If we prove to be right about those things and the market has misjudged them, then it can be an incredible value.
The other kind of value trap is what I call the stock value trap. It’s a situation where a company is valuable and performs reasonably well, but the stock does nothing for an incredibly long period of time. We start scratching our heads trying to figure out what’s going on. Generally in those situations, we’ve found it’s an issue of market perception. From time A to time B, the market’s view of the strength of the company has changed. The key to our analysis in this case is two-fold. One is making sure that we are firm in our view of the strength of the business and cash flow and that we believe the market’s reaction is unwarranted.
Then we look for some kind of catalyst that might trigger the market’s view to change. Often it can be something like a change in the capital policies (like an increased dividend), a share buyback or something along those lines that helps to unlock value. In any case, what we are looking for in our analysis is really the same: good management, good capital allocation policies, value-creating policies, and having strong convictions about the strengths of the business and the value of the assets.”
What Are the Risks?
All investments involve risks, including possible loss of principal. Value securities may not increase in price as anticipated or may decline further in value. Special risks are involved with smaller-company stocks, which typically have exhibited greater price volatility than larger-company stocks, particularly over the short term, and foreign securities, which can experience economic and political uncertainty and currency fluctuations.. Investing in companies involved in mergers or other restructurings carry special risks as pending deals may not be completed on time or on favorable terms.
Mutual Recovery is structured as a continuously offered, closed-end investment company due to the relatively illiquid nature of many of the fund’s investments. Investors can purchase shares on any day the markets are open, but shares aren’t redeemed daily. Instead, Mutual Recovery Fund offers to buy back 5%-25% of the outstanding shares each quarter during the tender offer period. The fund may suspend or postpone a tender offer subject to approval by the fund’s board.
1 As of 5/31/12, the Mutual Global Discovery Fund held the following as a percentage of total net assets: United Kingdom (16.41%); France (7.40%); Germany (4.26%); Switzerland (4.80%); Netherlands (2.80%); Denmark (1.36%); Ireland (0.84%); Norway (0.07%); Belgium (0.0%); Portugal (0.0%). Holdings are subject to change. As of 5/31/12, the Mutual Shares Fund held the following as a percentage of total net assets: United Kingdom (10.75%); Germany (2.35%); France (1.83%); Switzerland (1.06%); Denmark (0.96%); Netherlands (0.46%); Belgium (0.00%); Ireland (0.00%); Norway (0.0%); Portugal (0.0%). Holdings are subject to change. As of 5/31/12, the five other Mutual Series funds had the following percentage of European holdings as a percentage of total net assets: Mutual Beacon Fund: 23.55%; Mutual Quest Fund: 26.90%; Mutual European Fund: 82.95%; Mutual Financial Services Fund: 28.35%; Mutual International Fund: 44.61%. Holdings are subject to change.
(c) Franklin Templeton Investments