Q: How has the fund evolved over the years?
The Franklin Mutual Beacon Fund has a long history as a deep value equity investor. Originally launched in 1962, it became part of Franklin Templeton Investments in 1996 when Franklin Resources acquired Mutual Series and its flagship funds.
At Mutual Beacon, we look for value in places often missed by others, relying on our ability to analyze complicated business, legal, and regulatory factors. We have a real passion for finding opportunity within complexity, for identifying potential catalysts, and for actively engaging with company management.
The Fund invests primarily in equities and has the ability to hold debt or other instruments as well. Generally, we don’t consider ourselves debt investors; the fund doesn’t buy and hold bonds just to collect interest. Instead, our interest is in acquiring the securities of companies in severe crisis or bankruptcy – circumstances where success or failure depends on figuring out things like underlying asset values and legal claims. Then we actively participate with management to unlock that value.
Recently, the fund has evolved in two key ways. Historically, no more than 35% of assets could be invested outside of the United States, but the portfolio no longer has that limitation and is fully global. Also, over the last five years our holdings have decreased from approximately 100 positions to a core of 40 to 50 mid- and large-cap equities, plus a few special situations like merger arbitrage or distressed debt.
The fund’s objective is capital appreciation, with income being secondary to that. Currently, assets under management are about $4 billion; as a whole, the Mutual Series Group manages approximately $68 billion as of September 30, 2017.
Q: What core tenets guide your investment philosophy?
Fundamentally, we are value investors and believe that value is tangible and can be measured by things like assets, cash flow, or the worth of a break-up or an acquisition.
Like most value investors, it’s our belief that the markets are inefficient. While markets are reasonably efficient in the long run and in the aggregate, they can be widely inefficient in the short-term and in specific situations. And because the market’s tendency to be wrong increases in tandem with complexity, our best opportunities are found when things are highly complicated and require specialized knowledge.
One of the advantages of this fund is its fairly low turnover; on average, positions are held for four to five years. As a result, when confusion surrounds a company to the degree that there’s a strong chance the market will get it wrong, we can remain patient while working with management to unlock value.
Q: What is your investment process?
Because we aren’t macro-political analysts, we seek misvalued companies or credits and don’t pay great attention to macro events. Our focus is 100% on places where we have an advantage at understanding market misevaluations. Typically, these are at a company-specific level, but sometimes require legal or regulatory analysis
When a disaster happens that sends other investors running – like a stock that’s down by 20% one morning – it’s our tendency to run towards the disaster, to figure out what happened and why, and determine whether the market’s reaction is appropriate. Corporate events, such as mergers and acquisitions, spinoffs or break-ups, or management changes, can also offer us the chance to unlock value.
If the market is wrong about a company and it’s also trading at an extremely low multiple of cash flow, we then consider whether the prospects for its business are actually as dire as everyone else seems to think. Our analysts build a financial model and we talk to the company, its competitors, and others in the industry to isolate the key issues and what the business is actually worth.
Often, there’s an element of mystery surrounding valuation, so trying to scale these unknowns relative to valuation is important. So we hone our estimates based on what the reasonable scenarios and valuations might be, then look for the biggest asymmetries between upside and downside.
Q: Can you describe your research process with a couple of examples?
Symantec Corporation illustrates how we use complexity to our advantage. At the time of our initial investment the market was pessimistic about the company’s prospects, but we were able to unlock value over multiple years.
Originally a provider of software tools, Symantec had expanded into software security. Its biggest consumer brand is the antivirus solution Norton, which is a great business.
However, things weren’t going so well when we started looking at Symantec: it had gone through several management changes, its margins were significantly worse than those of its peers, and it wasn’t growing particularly quickly. Also, a few years earlier, Symantec had made an expensive acquisition when it merged with the storage company Veritas Software in 2006. It was trying to create growth, but there weren’t any real synergies between the businesses.
All this was bad, but we would argue that it was priced into the stock. It was trading at roughly 10% free cash flow yield, which basically means the market thinks earnings will never grow again.
However, we saw the potential for things to get better because Symantec’s software business generated strong cash flow and it had a lot of cash on the balance sheet. The company could simply improve margins and become more efficient, or it could separate its two business segments which would probably be worth more individually. That cash flow could then be used to manage the balance sheet more aggressively, retire shares, and improve the earnings per share – even if the top line didn’t grow.
After investing and actively engaging with management about strategy, Symantec split its businesses. The security side has since made smart acquisitions, expanding further into security with the purchase of Blue Coat Systems and becoming a leader in identity protection with its purchase of LifeLock.
Simultaneously, Symantec sold the storage side of the business. This was about a year-and-a-half ago when the high-yield debt market was really poor. After tapping into the expertise of our debt team, we realized we could buy a lot of the Veritas debt at about a 15% yield to maturity. Not only did we like the business, but also we took advantage of this disruption in the credit market.
Today, Symantec is much more well-run and is focused on enterprise and consumer security, an industry which has a big tailwind. All the factors where there was potential to unlock value have been realized: a sleepy management has been replaced, the businesses broken up, margins are rising from significant cost-cutting programs, and capital has been forcefully deployed after some debt was taken out.
Q: Could you cite another example from a different country?
Baidu Inc is the dominant search engine provider in China, and exemplifies a case where the necessary information was available but we had to be patient and give management time to behave rationally – which they eventually did.
Search is a fantastic business and we believe any company that is the scale provider in its region ought to make huge margins. A couple of years ago when we looked at Baidu, its margins puzzled us because they had dropped dramatically.
Upon further investigation, it turned out that while Baidu was making a lot of money in search, it was expanding into online-to-offline commerce. Moreover, the company was investing into a slew of other businesses – like food delivery, mapping software, and building an online travel agency.
Separately, these businesses might be good investments and could even be worth a lot of money if backed by venture capital. But because Baidu reported everything as one segment, all investors saw were its shrinking margins and profits.
In April 2016, Baidu split the business into two segments and changed its reporting to show the profits from search and the loss to running everything else. This information was publicly available in its corporate filings.
Because we know the search industry reasonably well and felt good about that part of Baidu’s business, our next step was to look at its other losses and how the market was evaluating the company in terms of a price/earnings (P/E) multiple. In our view, all we really needed was the confidence that Baidu’s management wouldn’t lose money forever.
We met with them, but more importantly, tried to judge management based on their actions rather than their words. After looking at other things they’d done, we concluded they were probably rational people, so we invested in Baidu.
Initially, our investment didn’t work out well. Baidu’s search business became worse than expected and the company was also sued, which led to a regulatory crackdown that forced Baidu to clean out its customer base and scrutinize advertisers.
However, at the same time as headwinds were preventing the company’s search business from growing, management was dealing with the rest of the business. The money-losing online travel agency was merged with the leading travel provider in China, Ctrip, in exchange for stock. Baidu also became more transparent about its online video business which has the potential to become the Netflix of China.
Over the last six to nine months, the stock has gone up materially as the market has finally given Baidu credit for things we saw two years ago.
Q: Would you provide an example in a different industry?
B/E Aerospace Inc is another story where the value of one business segment can be hidden by another. The company manufactures products for commercial and business aircraft cabins and is also the largest independent distributor of aerospace parts. It spun off the distribution business into an entity called KLX Inc, while the airplane interiors segment stayed at B/E Aerospace and was eventually acquired by Rockwell Collins, Inc.
The KLX management team believed that because they had built a great distribution business in aerospace parts, they could do something similar in energy, distributing parts for things like drilling rigs. They diversified KLX into two segments, KLX Aerospace Solutions and KLX Energy Services – right at the time that oil prices went down.
This created a quite a complex situation: not only might investors not want to own a spinoff, but the energy-parts distribution business wasn’t well-understood and people generally disliked it.
We believed the stock was relatively undervalued because of this mix of market dislocation and a shortage of natural investors. Subsequently, the energy market bounced back a bit and investors started to understand the business and give the company credit. Because we still see potential in it, we remain shareholders today.
Q: What is your portfolio construction process?
With 40 to 50 core equity positions and a handful of positions in merger arbitrage or distressed debt, the portfolio is reasonably diverse and has a low correlation with the market.
Most positions are between 2.5% and 3.5%. Anything smaller than 2.5% typically occurs because a company is being acquired or sold, or because liquidity prevents us from building a larger position. There’s no hard limit regarding maximum position size, though it would be unlikely for one to exceed 4%.
We always have a view on what the downside and upside could be and know the level at which we would buy or sell a stock based on its risk-reward. This is monitored daily with a strict eye on value. These views aren’t static, though. Our take on the upside and downside changes as information becomes available, and buy and sell levels are constantly updated.
For example, say the stock of a reasonably large company is down 10% following the announcement that its CEO is being fired. The question we’d ask is whether the CEO is worth that much valuation. Probably not – there are plenty of competent executives available to hire.
The MSCI World Index is the fund’s benchmark, but we are actively managed and index agnostic when thinking about positions, stocks, and sectors. All the Mutual Series funds have active share that is almost always above 80, so it’s clear the benchmark has little influence. Also, as a result, our performance can diverge significantly from the benchmark.
Q: How do you define and manage risk?
At its core, risk is the impairment of value and for us, managing this starts with security analysis. If we get this right, then each individual position has little downside and by definition the portfolio itself will have little downside.
The fund’s diversification also helps mitigate risk. We’re not concentrated 80% in one industry or country, and thus get plenty of diversification benefit. Finally, we meet with Franklin Templeton’s risk and portfolio analysis group once a quarter. They go through the portfolio using traditional quantitative metrics and give us feedback.
