Balancing Perception, Reality, Equities and Fixed Income
April 17, 2012

Never underestimate the power of perception to influence people’s fiscal behavior. Perception is such a significant influence, in fact, that economic tea-leaf readers have developed a myriad of surveys and indicators to monitor individuals’ perceptions of the investing environment because perceptions can—and do—move markets. When sentiment is negative, investors tend to shift out of assets they perceive as “risky” and into assets they perceive as “safe.”  Ed Perks, portfolio manager of Franklin Balanced Fund and Franklin Income Fund, is well aware of the role perception plays in the markets and even took note of it in a previous post to these pages: see “Perception vs. Reality.” Here he picks up the thread with his strategy for determining a strategic mix between equities and fixed income when market perceptions change, and what he sees as the fundamental reality today. His thoughts, in brief:

  • We’ve seen a gradual decline in market volatility levels in the first quarter and, at the same time, an increase in risk-tolerance among investors.
  • Despite market turbulence, corporate profits have remained strong.
  • We think rewarding shareholders, achieving dividend growth, and engaging in share buy-backs should be a big part of the corporate story in 2012.
  • Dividend-paying common stocks offer an interesting opportunity amid the reality of today’s yield-scarce environment.

Rewinding back to the first half of 2011, news of possible sovereign debt defaults and a global growth slowdown (or even a double-dip recession) had fearful investors fleeing equities. Toward year-end, market sentiment started to shift. Major U.S. stock market averages saw their best first-quarter performance in more than a decade as investors’ perception of risk also began to shift.

Ed Perks

“I think we’ve seen a gradual decline in volatility levels, and I think you can relate that to, at the same time, an increase in risk-tolerance among investors. The flipside to that is—and we did experience this late last summer/early fall—risk aversion in the market can happen relatively quickly and can happen significantly in short periods of time. When we did have that period of volatility in the markets, much of it appeared to be related to the perception that there were significant macro or systemic risks in the marketplace. I think it was easy to jump to that conclusion, looking at the media reports and some of the events that we were dealing with, such as the debt ceiling debate and the challenging fiscal situation in the U.S., and in Europe, the fears related to a sovereign and financial system crisis. Those were real events. But, at the same time, the reality was that the economy was reasonably healthy and improving gradually.”

At a time when many investors perceived the environment to be particularly dire, Perks’ research showed him a different reality. Looking at individual companies, corporate balance sheets appeared to him to be in relatively good condition. He credits that individual company focus with helping him and his team stay focused on getting through that period of volatility, and on finding longer-term opportunities.

“For the last several years, companies have been focused on extending maturities, reducing debt and decreasing interest expense. That’s been positive. And at the same time, we’ve seen corporate profit margins stay reasonably robust. Despite the turbulence in the markets from one quarter to the next, profits have been generally strong and that’s something we think bodes well for equities going forward. We are seeing companies address that with actions such as rewarding shareholders, achieving dividend growth and engaging in share buy-backs, which we think should be a big part of the story in 2012.

Certainly this recent equity outperformance relative to fixed income impacts how we view opportunities in the market. From a fixed income standpoint, with long-term interest rates relatively low, we have seen corporate credit spreads continue to decline. While still being attractive on a longer-term basis, it is really the absolute yields available in fixed income that have, I think, put it more on par with other investment opportunities. So the relative value across different segments of the markets looks far more balanced to us today. In an effort to proactively manage our interest-rate risk, we’ve been selling down some of our longer-duration fixed-income securities in favor of other securities.”

And what are those other securities? Largely, common stocks. Perks believes dividend-paying common stocks offer a compelling opportunity amid the reality of today’s yield-scarce environment. We’ve heard that theme before, too.

So while Perks does adjust his asset allocations in response to changing market perceptions at times, Perks’ views can go against the grain not only on a fundamental level, but also on a sector- or stock-specific level. Investors can quickly get seasick amid market chop, so he fixes his focus on the horizon to ride out the waves. His view on the pharmaceutical sector is an example:

“First and foremost, our security selection process is really driven more by fundamental, bottom-up analysis and a little bit less so by sector-oriented themes. Pharmaceuticals have recently lagged the broader market, but when you step back and look over the past year, they’ve actually been quite strong performers. The challenges that pharmaceutical companies face, I think, are pretty well covered by the media. For example, when a large drug comes off of patent protection there is a risk to that company’s financial performance. So it’s very important that we focus on company-specific fundamentals. If we think the reality is that fundamentals are better for a particular company going forward, then that’s an opportunity that we might want to consider regardless of current sentiment.”

You can almost see Sir John Templeton smiling as this resonates with his own thoughts on investing: “There are times to buy blue-chip stocks, cyclical stocks, corporate stocks, U.S. Treasury instruments, and so on. And there are times to sit on cash, because sometimes cash enables you to take advantage of investment opportunities. The fact is, there is no one kind of investment that is always best.”

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What Are the Risks?

All investments involve risk, including the potential loss of principal.

The Franklin Balanced Fund’s share price and yield will be affected by interest rate movements. Bond prices generally move in the opposite direction of interest rates. As the prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. These and other risk considerations are described more fully in the Franklin Balanced Fund’s prospectus.

The Franklin Income Fund’s portfolio includes a substantial portion of higher-yielding, lower-rated corporate bonds because of the relatively higher yields they offer. These securities carry a greater degree of credit risk relative to investment-grade securities. The fund’s share price and yield will be affected by interest rate movements. 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. Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. The fund is actively managed but there is no guarantee that the manager’s investment decisions will produce the desired results. These and other risk considerations are discussed in the Franklin Income Fund’s prospectus.

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