Catching Waves Across The Pond

Includes: ABB, EWJ, VGK
by: Franklin Templeton Investments

It's easy to get excited about a particular market when everyone else seems to be piling in, and the headlines are screaming of new record highs. That has certainly been the case with U.S. equities of late. While many investors are paddling to catch the wave before it crests, it takes a great degree of fortitude and patience to wait for the next one to form in places that don't look particularly thrilling right now. Lisa Myers, co-manager of Templeton Global Balanced Fund is searching for equity values across the pond in Europe, where many investors don't dare dip their toes.

Growth in the euro area has been rather bleak. The International Monetary Fund recently updated its forecast for real GDP growth to contract about 0.25% this year, noting a recovery could be slower than expected because of "adjustment fatigue, weak balance sheets, broken credit channels in the periphery, and insufficient progress toward stronger economic and monetary union." However, Myers says her team's stock selection process boils down to a long-term perspective, a contrarian approach, and value - of which Europe is providing plenty of right now.

"We know there's a lot of reticence about Europe because they are embarking on fiscal austerity, there's not a lot of GDP growth, and people aren't particularly optimistic. However, we think eventually, the economies will reach a bottom from which they can begin to reaccelerate. The most exciting time for stocks is the reacceleration period. If, during a crisis period, we can identify companies we think have good businesses and the financial strength and fiscal flexibility to weather the downturn, then we hold our nose and buy because it's the rebound potential that drives returns.

"Furthermore, investors are looking at near-term economic prospects in Europe and thinking companies there are going to struggle to make money, yet Europe's economy has been relatively anemic for the better part of two years and many companies have been able to generate strong earnings and good cash flow from their global businesses. Investors are not giving European companies a look because of their zip (postal) code, despite where they derive their revenue base. High free cash flow yields are evidence of the lack of attention those cash flows are getting from investors, which we believe is an opportunity.

"Another part of the Europe story which the macro-fixated market is ignoring is the structural reforms that are starting to be discussed, which we think should increase European company competitiveness, together with company specific attention to cost cutting and capital allocation.

"We focus on long-term normalized earnings potential, or trend earnings, which incorporate the secular growth potential of a company and anticipate its total return potential over a five-year investment horizon. With so many investors focused on the short term, our differentiated time horizon arguably allows us to buy when others are not yet interested, and sell when that potential is eventually recognized."

Myers gives a few examples of specific companies and industries on her radar screen right now.

"One example is ABB (NYSE:ABB) [1], a Swiss company. It's a global industrial company that participates in power generation and automation. With the recent global economic uncertainty, companies are focused on productivity-enhancing investments that don't involve taking on ongoing fixed costs like new factories and increased headcount. Automation, a major part of ABB's business, is a great example of an area that is growing rapidly as companies look toward these types of productivity enhancing investments. At current valuations, with very little net debt, ABB remains attractive to us.

"Oil services is another area where we currently see a lot of value. While oil production has risen less than 15% over the past 10 years, the complexity of extracting oil and natural gas from the earth has increased exponentially. While there has been some current pressure in the U.S. natural gas market, we again see the market focused on the near term and ignoring the longer term structural demand for oil services. The companies are trading on some of the lowest forward P/Es we've seen them trade on in some time, and the market seems to have little regard for the nature of this oligopoly or the companies' longer term prospects.

"We added to some of the European financials during the Cyprus crisis, believing that those valuations are not reflective of longer-term normalized ROE potential."

Another place some investors are starting to feel may be bottoming right now is Japan, caught in a multi-decade deflationary spiral and attempting to get out with new policy measures. Myers is taking a cautious stance but is also finding select opportunities there.

"Japan has been late to address its issues and has languished for a long time. We continue to look for opportunities there; we have found a lot of value in autos, and selectively across various other industries, but I cannot tell you that we have broadly jumped in with two feet. We've continued to find it difficult to jump into the micro story. As stock pickers, we continue to pull apart companies in Japan and look at their competitiveness and their ability to drive earnings growth. A lot of the rally we've seen in Japan has been very much a macro rally in response to monetary policy."

What Are the Risks?

All investments involve risks, including possible loss of principal. Special risks are associated with foreign investing including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent the Templeton Global Balanced Fund focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a fund that invests in a wider variety of countries, regions, industries, sectors or investments. Current political uncertainty surrounding the European Union (EU) and its membership may increase market volatility. The financial instability of some countries in the EU, including Greece, Italy and Spain, together with the risk of that impacting other more stable countries may increase the economic risk of investing in companies in Europe. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the fund adjust to a rise in interest rates, the fund's share price may decline. The risks associated with higher-yielding, lower-rated debt securities include higher risk of default and loss of principal. The fund's investment in derivative securities, such as swaps, financial futures and option contracts, and use of foreign currency techniques involve special risks as such may not achieve the anticipated benefits and/or may result in losses to the fund. The fund's risk considerations are discussed in the prospectus.

[1] ABB Ltd. common stock represents 0.63% of total net assets of the Templeton Global Balanced Fund, as of 12/31/12. Holdings subject to change.

Disclosure: I am long ABB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.