Q:  Would you provide a historical overview of the fund? A : The fund was launched in October 1991 and it was originally created as Franklin California Growth Fund. At inception on December 30, 1991, the fund was initially conceived to invest in the top 250 companies in the State of California by market capitalization. But later on, we changed that to active management in July 1993. Back in the early 2000s, the SEC introduced some regulatory changes specifying that if a fund had a particular name, it had to be 80% invested as the name suggested. So we felt keeping California in the name would make it too restrictive for us, and that was why the fund name was changed to Franklin Flex Cap Growth Fund. In addition to the name change, the fund’s investment criteria were modified, but the philosophy, process and approach of the fund remained the same. Those changes presented us with increased flexibility in seeking out innovative companies with strong growth prospects regardless of where in the United States the company is domiciled. Q:  What is your investment philosophy? A : Our core philosophy is the belief that investing in high-quality companies with the potential for long-term sustainable growth can provide significant opportunities for investors. We do this by working within a collaborative environment, utilizing fundamental, bottom-up research to focus on companies that meet our criteria of growth, quality and valuation. Q:  How do you transform this into an investment strategy? A : The fund seeks to follow a growthoriented approach within a very collaborative environment using bottomup research to identify what we believe are best growth opportunities. We look for opportunities over a business cycle and we enter an investment with a holding period in mind that would be at least two to four years. We invest primarily in the equity securities of companies operating in any industry across the entire market capitalization spectrum. Our three main criteria for investing in a company are growth, quality and valuation. First, along the growth dimension, we focus on companies that we believe can produce sustainable earnings and cash flow growth over the course of the business cycle and can generate returns that exceed their cost of capital. Second, along the quality dimension, we think about the quality of both the management team and the business itself. We want to see companies that exhibit good stewardship – having good strength, breadth, depth and integrity of management. Also, we want to see strong balance sheets, good profitability, and high free cash flow generation. Third, on the valuation dimension, we consider a range of potential outcomes based on our analysts’ assessment of multiple scenarios, ultimately assessing whether the growth and quality aspects of the enterprise are properly reflected in the stock price or not. Q:  How do you define “sustainable growth”? A : Our definition of “sustainable growth” refers to our evaluation of the overall market opportunity and the competitive positioning of a participant within that market opportunity. We focus on the overall size and growth of that market and how sustainable that may be over time. We think along the lines of secular versus cyclical growth and whether it’s just the course of an economic cycle that is spurring the growth within the particular industry, or whether there are some secular underlying drivers of that industry growth. we believe in being part owners of the business with a holding period of at least several years. The factors that we consider in terms of the competitive positioning of a company are pricing power, cost structure, an intellectual proprietary advantage that a company may have, some unique process and whether it is patent protected, recognition of brand or franchise strength, brand awareness within its industry, as well as barriers to entry. These are the elements that we consider before we make a determination of a company’s positioning within an industry and how sustainable their advantage may be. Q:  What valuation metrics do you apply when assessing a company? A : We look at returns on invested capital and the cost of capital. It is left at the discretion of our industry analysts to determine what the appropriate valuation metric for a company may be in determining fair value, but oftentimes it is rooted in a discounted cash flow model. It is important to note that we think about a multitude of scenarios in our valuation. In a best case scenario we evaluate if a company will capture more market share going forward, and if so, what potential growth or operating margin leverage might they actually realize through different efficiencies. we also try to consider a worst case scenario. For instance, if new entrants came into the market and claimed their share, how that might affect a company’s future. Q:  Would you describe your research process with some examples? A : We employ a bottom-up fundamental research process in a very team-based operational model. Our culture is one of collaboration and transparency. The research staff consists of over 30 dedicated research analysts broken out into seven broad macroeconomic sector teams. Each analyst has been given one or more industries to follow across the entire market capitalization range. Their job is to deliver investment ideas to portfolio managers. It is the individual analyst who will consider whether security prices reflect sustainable growth relative to the business and financial risk of that business. We have daily morning meetings to process the flow of information. Our analysts will discuss events and reiterate what rating they have assigned that particular security, and likewise it is a forum for our managers to share what actions they may be taking within their respective portfolios. We also have a weekly research meeting where we highlight a different sector team. During this meeting an industry analyst will give an overview of their particular industry and the dynamics of that industry and how it’s positioned in the marketplace. They will present the growth of the overall industry, what risk they see, the regulatory environment, the demand structure and so forth. They will give a handful of names which they highlight as their favorites within that industry. Then, often several times a week, our analysts will host a round table meeting to delve down even further for a complete evaluation of an idea in great detail with the participation of different managers and relevant analysts. While an analyst is presenting their detailed recommendation on a particular company, we have discussions about the assumptions going into the model and the different levels of risk. We will at that stage discuss the business and financial risk in order to understand what makes the company tick. For example, FLIR Systems, Inc., a company of over $4 billion in market cap that we have owned for several years, is engaged in the design, manufacturing and marketing of thermal imaging systems. Historically, sales have grown 20% a year and earnings per share have averaged about 26% over the last five years and return on equity has been 27%. With mass adoption of infrared technology for the commercial, industrial, and military applications, this company is expanding its market presence worldwide. The original idea generation came about from our aerospace and defense analyst who identified this company through various meetings and industry contacts. He followed up with the company and discovered that it actually shows high margins, good geographic and product diversity, cost leadership advantage, as well as technology leadership. In terms of its competitive positioning, we felt that FLIR was in a leadership position through their thermal imaging and infrared technology capabilities. We also had a multi-year secular growth outlook for this business with a longterm future growth rate of better than 15%. Another example is MasterCard Incorporated, the global payment solutions company. Their franchise and processing capabilities support both the credit and the debit card markets. They work with about 25,000 different financial institutions in 210 different countries around the globe. This company went public several years ago, and our financial services analyst identified the opportunity while researching the overall payment processing industry. We believe MasterCard has a relatively stable pricing environment with minimal event risk. The business model assumes no credit risk and, in our view, that is appropriate. It is also a company with significant market share and limited competition. In terms of quality, they have an experienced management team with the ability to generate solid returns. Their operating margins are over 40% with incremental margins of over 85% and limited capital expenditure that generates solid returns on invested capital. Q:  Could you explain with an example how you determine the growth potential of a company? A : We try to determine a company’s growth potential as they are layering on new products and applications by assessing what the overall market potential may be, how much market share they can capture, and what the adoption rates are for their products or services. For example, with FLIR on the commercial side, one area of opportunity is the automotive business where highend automobiles are being built with systems that provide the capability of detecting an object on the road at night before the driver actually sees it, by utilizing FLIR’s thermal imaging technology. The availability and adoption of this technology commercially is one of the factors for consideration. Q:  What are the main steps of your portfolio construction process? A : As of September 30, 2009, the portfolio had 63% of its assets invested in larger cap names, which we define as companies greater than $10 billion in market capitalization. Another 36% was in mid-cap companies with market cap between $2 billion and $10 billion, and then the remainder in small-cap. We take liquidity constraints into consideration, so the lowest market capitalization we might consider is probably in the range of $500 million to $1 billion. Total assets under management within this strategy amount to about $3.5 billion as of September 30, 2009. We seek to find the best investment opportunities over time and we operate within the constraints of our prospectus, with limitations on individual security position size of 5%. We also limit the portfolio to a single industry exposure of 25%. We have a predominantly domestic-focused strategy, which means that foreign exposure is limited generally to about 10% or less. Our portfolio of about 70 to 90 holdings has broad sector and security diversification, and the weightings are determined by our conviction rather than by a benchmark. We are aware of benchmark levels but we are not slaves to the benchmark. The portfolio turnover tends to be in the range of 30% to 50%. We have invested in many companies with a long-term perspective, but we may also adjust the portfolio weightings as market prices change on a regular basis. Since we adjust the portfolio through the course of a business cycle, if we feel that the downside risk is greater than the potential return, we will either cut exposure to a particular holding or sell the entire position. Q:  Could you define your sell discipline? A : We want to hold companies that we believe are creating value over time. However, market conditions may change, which may result in a situation where the original assessment is revaluated and the appropriate changes are made. An overriding sell discipline is whenever we determine the upside potential is diminished relative to the downside risk. One aspect of our sell discipline is our conviction check list which highlights on a rolling three-month basis any company that has outperformed or underperformed its industry group. We will sell an underperforming stock when we determine that our original assessment was wrong or if we are unable to identify the reason for this underperformance. We will sell our position at any time when we detect a deterioration in the fundamentals, if the management team changes and we have less conviction with new management, if there is a loss of market share or their new product is not well received in the market, or in the case of an accounting practice change that may call into question the quality of the earnings. We will also have a discussion if our target valuation is exceeded and the stock is trading richly in the marketplace. That might be an indication to trim the position. Q:  What risk control measures do you have? A : We attempt to control risk through a combination of a broad portfolio diversification and our bottom-up research process. While we try to control risk effectively on a security basis, we also have a check and balance in place where we host peer review meetings and delve into a portfolio from a topdown perspective as well. In addition, a risk analyst within our team will run various risk reports for us, and we also have a formal review process on a quarterly basis. The risk analyst will examine BARRA risk reports, as well as attribution analysis, to make a top-down determination of risk exposures.