Q:  Can you give an overview of the fund? A : Franklin Small Cap Value Fund was started by Bill Lippman, chief investment officer, U.S. Value, Franklin Equity Group, in March 1996 and currently manages about $1.9 billion in assets. Bill and I are co-managers of the fund. Our preparedness to hold companies for five years or longer helps us in navigating through business cycles and periods of extended market volatility. Q:  What core beliefs guide your investment philosophy? A : Over the long term, we believe investing in small cap stocks (less than $3.5 billion market cap) at attractive valuations can provide solid results for our shareholders. Q:  How does your investment philosophy translate into the investment strategy? A : We are bottom-up stock pickers looking for bargains among the under-researched and unloved. We look for historically successful small cap companies with low leverage, good corporate governance and meaningful earnings power that are trading at bargain prices for reasons we believe are temporary. Although it is not a requirement, we prefer dividend-paying companies. In fact, about 75% of the stocks in our portfolio pay a dividend. The companies we invest in are often operating under some sort of cloud. This could be caused by an earnings report that missed expectations, or the industry might be out of favor, for example. It is our job to determine if the cloud is a nice puffy one that will float away, or one that could turn into a tornado. As long-term shareholders we want the companies we own on the best strategic long-term footing with a strong balance sheet. Our belief is that some of the more challenging situations at times present the best opportunities, but without an adequate level of financial strength, it will be difficult to survive through the present challenges and thrive if and when conditions improve. Q:  What analytical steps are involved in your research process? A : We utilize various methods to uncover stocks that are trading at bargain prices on metrics such as price-to-earnings, book value or cash flow, or that may have hidden assets or intangibles not reflected in the valuation. Because of our long-term orientation, we consider ourselves more like partners and want to make sure we have the best partners, therefore, good corporate governance is a fundamental part of our analysis. We are trying to answer one question – is management’s best interests aligned with shareholders’? The proxy statement is examined to identify excessive option issuance, related party transactions, and also whether compensation is based on reasonable metrics such as return on invested capital. We also seek strong balance sheets where the debt-to-capitalization is generally under 50% and debt-to-operating-earnings ratio is under 2.5. It is not just the total level of debt but also the structure of the debt, maturity schedule and debt terms that all go into developing a profile of the company and understanding of the near- and long-term pressures. We want to make sure the company is not on the verge of insolvency. A prior track record of success is also necessary. We examine historical financial statements up to 10 years for companies that have had a relative upward trajectory in sales and earnings, an attractive ROE and the ability to persevere through prior downturns and business cycles. We study the business model, the outlook for the industry and its structure, and test our thesis. Talking to company management is an important part of our research. As part of the process we will set a target price utilizing various methods such as discounted cash flow analysis, and multiples of price-to-book value, earnings per share and Earnings-Before-Interest-Taxes-Depreciation-and-Amortization (or EBITDA) looking out over the next three to five years. We are typically looking for companies that have at least 50% upside over the next three years with a reward-to-risk ratio of 3-to-1. Q:  Can you give few examples to better illustrate your research process? A : Autoliv Inc. is a leading supplier of automotive safety systems. We started buying the stock in September 2008 near $38 when the market cap of the company fell from around $5 billion to $2.7 billion as the automobile industry was facing its worst recession in decades. At the time it was trading at approximately ten times adjusted earnings, generating an attractive return on capital and was paying a healthy dividend. The company had been growing earnings for years, had a good management team, a very solid position in the global marketplace, and a strong balance sheet. Nonetheless, the company was out of favor because of a weak economic and industry environment. Our belief was that even though conditions seemed challenging, and any recovery was very uncertain at the time, the company was well positioned to benefit if/when conditions improved and the price we were paying was attractive. Autoliv is currently trading near $67. Another company we have owned for a long time is Bristow Group Inc., a provider of helicopter services to the worldwide offshore energy industry. We started buying this company in early 2002. At the time the stock was $17, the price of oil was $20 per barrel and they were earning around a $1.80 a share. The company had been growing earnings but then hit a rough patch in the late ‘90s and early 2000 as the economy started to slow. The price seemed to reflect the challenges facing the company, and we felt that it would be in a very good position to prosper once conditions improved, although we did not know when. Today, with the stock at $57, earnings are expected to more than double since our original purchase and the price-to-earnings multiple has also expanded. Bristow is well positioned in the industry and management has an intense focus on return on invested capital. The market for the helicopter services is tight, allowing for improved pricing. Also, the company recently completed what appears to be an attractive complementary acquisition and is now bidding on a large search and rescue contract in the U.K. Finally, a quarterly dividend of 15 cents a share was initiated in 2011, and it was increased to 20 cents in 2012. In summary, we are looking for companies trading at attractive valuations with predictable business models, strong balance sheets and capable management teams that are thinking and behaving like owners. Q:  How do you go about analyzing opportunities? A : It really comes down to all the characteristics we have discussed – the track record, financial strength, earnings power, business model, management and valuation. Those companies that appear the most attractive will receive the greatest attention. It is a fluid process, and we are always on the lookout for good ideas. Q:  How do you build your portfolio? A : There are approximately 110 securities in the portfolio, which is normal for us. Portfolio construction is a purely bottom-up process and is benchmark agnostic. We are looking for the best risk-adjusted opportunities that can put be together by continually evaluating the investment thesis for each of our investments. Q:  Do you hold cash or stay fully invested? A : Our overall philosophy is that cash is a residual of the process. Generally speaking though, somewhere around 3% to 5% is about normal for us. Operationally we want to have money when there are opportunities. Q:  How do you define risk and what do you do to manage or contain it? A : The permanent loss of capital is what we are concerned about, and we try our best to avoid it. Pure volatility in and of itself can actually present interesting opportunities. Risk is managed by constantly reevaluating the investment thesis of each company and by also limiting position sizes to not much more than 2% of the portfolio. Every stock in the portfolio is assigned a price target that is monitored routinely and adjusted when necessary based on incoming information. A stock will be sold if it takes on too much leverage, makes a value destroying acquisition, or the long-term outlook for the business changes for the worse. In addition, if it reaches our price target, we will consider selling it or resetting the target if warranted. For instance, we invested in several coal producers years ago that generated significant capital gains for our shareholders. Even after prices dropped we kept small stakes in these companies because we felt that the demand for coal would keep rising once the economy turned around. However, the U.S. shale gas revolution changed the energy supply-demand equation and our long-term outlook for coal. As a result, we exited our small remaining positions to seek more attractive opportunities elsewhere.