First Among Equals

Would you talk about some of the larger holdings or something that surprised you with how well it’s done?

We’ve had good success with two companies in Europe, which are leading wind turbine manufacturers. One is called Vestas [Wind Systems], that’s in Denmark, and the other one is Gamesa, and that’s in Spain. We bought both of these stocks three- to four-years ago, when they were pretty badly beaten-up, and the thesis on both was that wind was a secular growth business, and that the economics were now at such a level that they were competitive with fossil fuel energy production, and that the politics were lining up behind wind as a very strong secular theme. Neither company was particularly profitable at the time but when we did our normalization analysis and wanted to figure out how much growth we thought we should pay for, we thought they were exceptionally cheap. That has, indeed, come to pass; those stocks–Vestas is up about 10 times from its lows, and Gamesa up not quite that much but, again, a very significant gain. Those are an instance where those stocks fell out of favor, the long-term fund fundamentals were there; the short-term fundamentals were not; but an instance where we’ve made a lot of money for our clients in those two stocks–which we still hold in the portfolio, although they’re no longer cheap, I would argue.

But maybe not fully valued?

Exactly. Getting close–we’ve reduced our positions but we’re not out completely.

Is there something that didn’t work out they way your thesis expected?

One of the stocks which has been a disappointment has been Rentokil in the U.K., in which we have a small position in the portfolio but it has not been a success. They’re a diversified services company; they wash uniforms, clean bathrooms, spray for rats–they do all kinds of stuff like that. The core issue there was, it was in retrospect what they term a value trap, where the stock got cheap, it looked cheap on P/E, on dividend yield, on a number of different metrics, but what the market had correct and what we had incorrect was that the profit was unsustainably high at that point, and indeed operating margins have gone from 19% down to 12% in the span of three years. We have not been able to get out in front of that and accurately predict that that trend was going to continue and be as extreme as it has been, and the stock has done nothing while the markets have gone up 50%. Poor forecasting.

Do you have a sell discipline?

Both the buy and the sell recommendations from the analysts and also from the portfolio managers’ actual executing the orders, it’s really fundamentally-based on our estimates for fair value for these companies. We’re looking to buy things 40% cheaper than what we think they’re worth, and we’re selling them for what they’re worth or hopefully even more than what they’re worth. If you think for a moment that the market is fairly valued but there are certain securities that are undervalued or overvalued, which I think is probably true, we’re buying the ones that are extremely cheap, and selling them when they kind of get back to average, so we’re trying not to hold the securities–which almost by definition is half the market–where they are overvalued. Our sell discipline is to recognize that we’ve reached fair value, in many cases that’s happening concurrently with fundamentals improving and people getting more positive on the outlook for these companies. When it goes onto what we call the source-of-funds list–not a sell list–the thinking there is that you don’t have to get out of these stocks right when they go onto the sell list, but use this as a source of funds when you’ve got a better opportunity to go into, and that’s really the value-based sell discipline that we have.

So when it tips the scales there and you’ve got something better to put the money into that’s when you’d make those moves?

Exactly. And remember, too, with the turnover at 20%, 25% per year, this is not a churn-and-burn type of portfolio; we’re really not moving it over too much.

Let’s talk about the fixed-income side of the fund [managed by Hasenstab].

I’m in touch with [Hasenstab] on a fairly regular basis. He’s more macro-oriented, he’s going to take into account views on interest rates and currencies; it’s more central to his decision-making. Today he’s got relatively short duration so he’s not optimistic that we’re going to see massive declines in long-term interest rates, and because there are flat to inverted yield curves around the world today, you are getting paid to sit on cash or short-term instruments. We don’t have any interest-rate exposure in Japan, but we do have a meaningful exposure to the yen, and other than that, the overweights would tend to be in peripheral Europe and some of the non-dollar block currencies in Eastern Europe.

Who would benefit from having a fund like this?

I think a lot of folks who don’t have a lot of international in their portfolio. The typical–if that’s the right word–but it’s not the only [person], but somebody that perhaps has a decent, diversified portfolio, wants to get a little more international exposure and perhaps is more interested in having a balanced exposure without having to fiddle around with a number of different funds. [With] this one, you know what you’re getting; it’s a proven long-term track record, with a strong equity and fixed-income component. We try not to deviate too much from a 65%-35% split, so if equities should drop down to 60% or up to 70%, I will work with Michael to rebalance the portfolio. It’s basically a one-stop-shop for international diversification, so one decision and you’ve got it.

What would be the benefit to advisors to have that all in one fund rather than pick a couple of best-of-breed funds?

I guess it would come down to simplicity, first of all, and for certain size portfolios maybe that’s a little more realistic, Second, you can look at the equity side and the fixed side and we do have best-of-breed on both sides. The Templeton Global Bond Fund, which Michael Hasenstab runs, you can look at that performance–he’s top-decile all the way back; and on the equity side, certainly over the longer time periods, we have very competitive performance. It was a good year, last year, but 2005 was a little rough, so some of the shorter-term numbers are good, but they’re not great. So we do have best-of-breed on both sides; why complicate things when you can keep it simple? You get the asset allocation built-in, you get some modest rebalancing of the portfolio, which happens inside the fund as opposed to having your advisor or somebody else do it outside. It’s a simple, self-contained little diversifying instrument for somebody.

A lot of people are advocating a larger allocation to international. If you were allocating for an individual is there a percentage that you would put into international?

This gets right to the personal nature of the recommendation–I’ll speak for myself, I have about 40% is non-U.S. assets that I keep in my own [portfolio] and that seems like reasonable amount. That’s just one example. If you look at the academic work that’s been done, using what in my view might be some questionable assumptions about the nature of the world, they come up with an optimal portfolio of roughly 40% international equities and 60% domestic if its an all-equity portfolio. That’s the academic answer–if you want to maximize your risk-adjusted returns, that’s what you do.

What else do advisors need to know about the fund?

On the equity side and on the bond side we have longstanding processes and philosophies, which have been operating under the Templeton name for decades, so we’re not a flash in the pan, we’ve been around before, we believe we have commonsense approaches to investment which work–they don’t always work, and they can be out of favor–but because we’ve been in business for a long time, and we have a brand name that out clients understand, they understand the way we approach investment, we can stick with it, and even through he tough times stick to our guns.

E-mail Senior Editor Kathleen M. McBride at [email protected].