INCOME & growth

When a client’s primary goal is income from their portfolio, there are a number of options to choose from: dividends are popular because of the favorable tax treatment that many now enjoy, but with interest rates creeping up from what were historically low levels there may be opportunities there, too. And what of capital growth? Does an income-producing portfolio have to rule out capital growth? Not necessarily, says Edward Perks, senior vice president of San Mateo, California-based Franklin Advisors, and co-lead portfolio manager of the $25.2 billion Franklin Income Fund (FKINX): “I jokingly say they should think about it as ‘INCOME’ in capital letters, and ‘growth’ in lower case letters. I think it’s one of the things that really differentiates our style and our approach.”

Under the leadership of Perks and Charles B. Johnson, chairman of Franklin Resources and manager of this fund since 1957, the fund has achieved a consistent and impressive record, receiving Standard & Poor’s highest ranking of five stars overall and in the one-, three-, five- and 10-year periods. As of July 31, the fund had 10-year annualized total returns of 9.54% versus 5.45% for its Hybrid U.S. Income peer group; and five-year annualized total returns of 10.07% versus 3.67% for its peer group. If one had invested $10,000 in this fund on its August 31, 1948 inception date, and had reinvested all capital gain and dividend distributions, as of June 30 that holding would hypothetically be worth $4,011,723.

I saw that you have a new Balanced Fund as well as the Income Fund?

Yes, we very recently launched, on July 3rd.

Congratulations… how is the new Balanced Fund different from the Income Fund?

I think there are obvious differences between the Income Fund and our new Balanced Fund, and in many ways our clients have viewed the Income Fund as a very balanced type fund, because it’s had a very consistent commitment to using a wide range of asset classes. I think the opportunity that the new Balanced Fund offers is that it’s more traditional, a defined mix of equities and fixed income. In most market conditions we’ll maintain a 60/40 split, equity/fixed income. Clearly, the Income Fund is very income-oriented in that it pays a high current monthly distribution, and is very much managed to maintain that attractive distribution for shareholders and a very consistent distribution over time. That’s certainly one of the hallmarks of the Franklin Income Fund, that it’s paid uninterrupted dividends for its entire history, and in fact, when you look at it relative to its peers, it maintains a very high level of income.

Which is very important today, of course…

Yes, [over] the last five years, once we went through the boom and bust of technology and growth, investors did turn a lot of their attention toward this type of product, for the benefits of the diversification, as well as for the capture of near-term total returns. I think there are a lot of ways you can look at how investor preferences have changed and certainly overlaying it from a much longer-term standpoint, demographics, as baby boomers in particular are getting more focused on stability of their principal and yet still wanting some kind of play on growth. When I tell people about the Franklin Income Fund, when you look at our objective it is certainly income-oriented, but all of our investment selection and the active management of the fund is geared to also maintain prospects for capital appreciation. Certainly if you look at the prospectus it is defined as part of the objectives so, whether it’s bond investments, or convertible securities, or common stocks, that combination of delivering an attractive, reliable income stream, yet also having a view, over time, for possible appreciation is something that we very much use in our portfolio management process.

And of course that fits right in with the goal of many baby boomers-to fund a (potentially) much longer retirement situation?

Yes, it’s certainly good that a lot of investors are thinking more along those lines, and hopefully those lessons learned, albeit very painful for some, I think it’s important for people to have a longer-term view of how to manage their investments, and we think that’s where the advisor plays a really critical role. When you think about the cycle we went through, you’ve heard the anecdotes investment managers talk about: being at cocktail parties [where] the conversation was, everybody was a do-it-yourself [investor]; that was a very dangerous thing as well. The value-add of the investment advisor is something that we certainly believe in.

How much money do you manage in the Income Fund portfolio overall?

The Franklin Income Fund is up to about $44 billion. We have a total of five income-related funds that I lead-manage, and the total is about $49 billion; there are three Franklin portfolios, and two sub-advised portfolios. My lead management roles are limited to the Franklin Income Fund strategies as well as the new Franklin Balanced Fund. I also oversee they hybrid group within the Franklin Equity Group, given the hybrid nature of these products, which also includes our Convertible Securities Fund, which is a little over $900 million. We’ve had a very longstanding commitment to investing in convertibles-we think our system here, where we have in-house equity and credit research, is very well suited to the convertible market, given that those securities do combine components of both equity and fixed-income. If you look at our track record on a long-term basis, three-, five-, and 10-years, we think we’ve done a very good job managing convertibles. Also the Equity Income Funds, which are certainly similar to the Income Fund strategy but really more focused on equity-only investments. Both of those portfolios, the Convertible Securities Fund and the Equity Income Fund, are lead-managed By Alan Muschott, who I work very closely with as well as the manager of our Utilities Fund, who is John Kohli, and I think we also have a very long term track record managing a utility-only portfolio. That’s our core group of investment professionals; [we] work very closely together, and I think there are a lot of synergies that we can get from understanding what one another is thinking, and bouncing ideas off of one another for different portfolios, but my lead managed role is really the Income Fund and the new Balanced Fund.

What makes the Income Fund different from its peers?

The primary difference is the commitment that we’ve had to maintaining stable, attractive income. If you look at the Income Fund’s distribution, it’s monthly; it’s consistently in the top decile of its peer group from a distribution standpoint. We also really seek to maintain stable distribution and that’s reflected in a lot of ways. Despite a significant amount of interest rate volatility over the last 10 years, the Income Fund’s distribution has changed only three times. Granted, we’ve been in a kind of declining interest rate environment until recently, so the pressure has been downward on our distributions, but throughout all those market conditions we did make an effort to really maintain consistency in our distribution, which we think a lot of our investors have really come to appreciate from the Franklin Income Fund. I think that’s really a very significant differentiator.

When you look at the portfolio, the fact that we’ve grown up, if you will, in San Mateo, out here at the company’s headquarters, having a really strong core group of equity research analysts and a strong core group of credit analysts that in many ways can leverage off one another-I think that’s a real competitive strength that we have in managing a fund like this. In many instances other organizations approach this type of product somewhat independently, meaning the fixed income portion would be managed here, and the equity portion would be managed somewhere else. Our analysts are really intermixed, I mean you walk around our building here, and one office or cubicle might be an equity analyst, and right next to it is a fixed-income analyst. When we’re meeting with companies, when we’re doing in-depth research on either an industry level or an individual company level there will be cross-participation. It adds a lot of value-certainly to the Income Funds-but I think more broadly to the effort out here not only for the Franklin Equity Group, but also the Franklin-Templeton Fixed Income Group which we’re pretty integrated with.

Would you tell me about your investment process?

It’s highly flexible and that’s the real key to our historical success-that we have a significant amount of resources that we can deploy to look across a very wide range of asset classes: on the equity side, predominantly dividend-paying common stocks, but also the ability to actively participate and look at the convertible securities market, leveraging off of our expertise in that area; on the fixed-income side, everything from government, and agency, and mortgage-backed securities where we have a very strong, dedicated group, all the way into the credit universe from investment grade corporate credit down into non-investment grade corporate credit. The process is really to be very open-minded. We don’t manage from a top-down basis running screens looking for things; we really try to leverage the research, and leverage what the investment professionals in their unique areas are doing. Then it’s my job to evaluate the relative attractiveness of one opportunity to another in helping us meet the objectives. So [the process] is highly flexible and well-suited to leverage or take advantage of the organization here.

How do you select securities once you hear from the analysts who look at everything?

It depends on the product area we’re talking about. On the equity side, generally, how we get to the point of making an investment is doing our own independent research utilizing, certainly, information that we can get out of management at the company as well as other sources, [including] sell-side research. But our internal analysts do maintain models and are responsible for following companies within given industries, so we attempt to leverage that, and that will help us determine at what level we find a stock attractive and suitable for the portfolio, and similarly, at what point a certain company may have reached our price target and warrants reducing or eliminating the position. So it’s a very dynamic, kind of ongoing process, very based on fundamental analysis, on the equity side.

On the credit side it’s a very similar story, when you’re talking about corporate bonds, particularly non-investment grade corporate bonds where our credit research analysts are very actively maintaining a view on the company’s credit profile. We’ll use that as part of the information to evaluate how attractive that opportunity is in the overall fixed-income market. That’s something that we also do on a very active, very bottoms-up oriented nature. The other parts of the fixed-income market, certainly, your overall view on the economy and interest rates becomes a much greater factor in evaluating the investment opportunity. That’s something where we can, through our integration with the Franklin Templeton Fixed Income Group, participate in our bi-weekly global economic outlook meetings, and our bi-weekly fixed-income sector allocation meetings. It’s a very collaborative process, really, on all fronts, whether it’s management of the common stocks, the equity portion of the portfolio, interaction and collaboration with our research analysts, as well as on the fixed-income side in a lot of different ways.

In terms of fixed income, will the return of the 30-year Treasury have an effect on the portfolio?

It’s a little bit of a non-event; to the extent that they bring it back and it increases supply, and potentially moves interest rates up a little bit-certainly that kind of action can have an impact on a portfolio. In general, the way we’ve been positioned-the income fund portfolio’s changed over the last year; it’s changed fairly significantly and normally we don’t have these kind of changes, so it’s kind of a timely conversation, but in general I’ve been about the happiest guy in the building to see interest rates moving up.

I’ll bet you have!

It was just a very difficult environment a year ago-we were flirting with below 4% yields on the 10-year Treasury; we had generally had a very strong period in corporate credit, meaning credit spreads in the corporate universe had tightened significantly, and we were somewhat idea-constrained. Actually, if you look at June 30, 2005, we had about 8% cash, which is a pretty high cash balance for us. Fast forward to today, we’re down, generally, in the 1.5% range on cash, we’ve had much better opportunities with the back-up in Treasurys, and a little bit of volatility in corporate credit spreads. We think fixed income has become, overall, much more attractive. To the extent that you have dynamics like that playing out in the Treasury market, we then can take advantage of that, in one way or another. We’ll certainly talk to all of the investment professionals, like we’re doing on an ongoing basis, and evaluate whether or not mortgage-backed securities are now more attractive given the profile of what’s happening in the Treasury market. There’s a lot of interaction there to help us evaluate what the best longer-term opportunities are.

Then the new 30-year acts with everything else that’s been going on in the past year to shake loose a bit more opportunity for you?

Yes, I think so. Earlier this year we were-everybody was-somewhat surprised at how well that initial auction of the 30-year went [the initial Treasury 4.5% of 2/15/2036]. There was a lot of demand, obviously, when we initially saw the 30-year come back. That bond-it’s interesting to note when it was issued, February, I believe, it’s is now trading at about a $92 _, because of the backup in rates. It shows you the power of interest-rate moves on long-duration fixed income (chuckling).

So you’ve had more opportunity to pick and choose?

Yes, I mentioned the cash position but if you look at how the portfolio’s changed, a year ago, so June 30, 2005, we were very equity-tilted, and when I talk about equity or stocks in the portfolio I’m really talking about common stocks, convertible preferred stocks, and any straight preferreds that we may own-we were up at close to 53% of the portfolio. The flip side of that-the bond side-we were very idea-constrained, and having a difficult time justifying the exposure, certainly our view was somewhat negative on interest rates particularly when we were down below 4% on the 10-year. We felt like we had pretty much one way to go from there, and we don’t spend a lot of time trying to pick [or] point to when things will happen; rather, get the overall trend and direction correct over the longer term and have the portfolio positioned in the right way. We’d gotten down below 40%, [to] 39.2% in total fixed income, and within that virtually all of our exposure was geared towards corporate debt. We had about 4% in mortgage-backeds, so we were very credit-oriented, where we thought the primary driver of the investments’ performance over time would be the fundamental improvement in the business, and interest-rate moves would take somewhat of a backseat as opposed to Treasurys, or Agencies, or mortgages, where the Treasury move is really the primary factor. And cash, as I said, was close to 8%, so that was a pretty uniquely positioned fund, very dictated by and driven by the state of the overall market.

Fast-forward a year to June 30, 2006, we’re actually much more balanced, and in fact, we’ve actually flipped to the point where bonds actually exceed our stocks. Our [allocation to] stocks [has] declined about five percentage points down to just below 47%, bonds are just below 52%, and the cash is at 1.7%, so [that's] quite a swing. So, as interest rates [rose], particularly since we went from 4% earlier this year to around 5_% on the 10-year [Treasury]-also in that environment there was a decent amount of spread movement on the credit side-that definitely presented some interesting opportunities for us.

How has the volatility in oil stocks and oil prices affected the portfolio?

Not that significantly, certainly it will impact our unique holdings in that sector, but we’ve generally had a somewhat lighter allocation to the oil and gas sector. We’ve been roughly flat in our holdings in the last year and we’ve seen some appreciation above other parts of the portfolio, so it’s increased a little bit but we’re down near 6% of the portfolio as of June 30, 2006, in oil and gas names. Most of that is in the major integrateds where there is a more attractive dividend yield, and a little bit more muted play on the commodity price as opposed to a very small, purely focused producer of oil and gas, or an oil field service company where swings in the commodity price can have a more significant effect on the shares’ value. That said, earlier this year we did have an opportunity, particularly on the fixed income side of the portfolio, to add debt securities in the exploration and production universe: companies like Newfield Exploration [Company] (NFX), Chesapeake Energy [Corp] (CHK), Pogo Producing (PPP). It certainly was an opportunity where we thought with that back-up in interest rates and with that increase credit spreads, that there was an attractive opportunity to buy bonds in companies that we think have good long-term prospects at relatively attractive yields for the portfolio.

Can you talk about some of your largest holdings?

Yes. I mentioned Chesapeake Energy, it is one of our larger positions that we’ve added recently, meaning in the last year when I talk about recently-I generally have a little bit longer time period. [What] makes Chesapeake an interesting company for us to talk about is because it really is an opportunity to talk about how we can take advantage of having this flexible approach, meaning, looking across an entire capital structure for either the unique investment that makes sense or the combination of investments in a given company that make the most sense.

Many of the companies, particularly larger-capitalization companies, might have corporate debt; might have convertible securities, both preferred stocks and convertible corporate debt as well as the common stock, and if it pays a dividend that’s something that we can consider. We generally will not invest in securities that do not generate income for the portfolio. Chesapeake’s a good example: It’s a company that’s been very focused on building a very core, strategic, strong asset base in North America that’s focused on natural gas, and we think that that, over the long term, is a very good place to be positioned. We think the company has done a very good job leveraging the scale that they’ve been able to build across different regions of the country. Ultimately, we viewed the opportunity to buy not only some of their corporate debt securities, but also some convertible preferred positions, that that offered a really compelling and interesting blend for the portfolio, enabling us to lock in very attractive income stream; but also through the convertible nature of the preferred stocks, long term appreciation in the common stock is certainly something we think we can benefit from as well. So it’s a good example of the fund’s flexibility using our research approach that’s driven both by equity and credit research, and identifying what we think is an attractive opportunity well aligned with the fund’s investment objective.