Beyond Bulls & Bears

Screening for Reduced Volatility

Europe’s sovereign debt crisis continues to cause its share of mayhem for markets at home and abroad while small-cap companies have been especially mauled by savage volatility. The direction of European markets now seems to depend on the degree to which EU policymakers can engineer a solution to the crisis. While it is impossible to say with accuracy whether the worst has passed or more storms are brewing over EU markets, the impact of volatility on investor confidence is palpable.

Ed Lugo, Senior Vice President and Portfolio Manager of Franklin International Small Cap Growth Fund, notes how discipline during heightened market instability helped him keep volatility in check and identify opportunities.  From his 10/13/11 remarks: 

“The debt crisis certainly adds a lot of volatility to the international small-cap marketplace and has curbed growth dramatically. Conversely, volatility has also permitted us to focus on the small and mid-cap companies that are trading at attractive prices and appear to be well positioned in light of continuing uncertainty. These could be great growth companies that we follow for many years.”  

German Chancellor Andrea Merkel and French President Nicholas Sarkozy had hoped to go into the November  G-20 Cannes summit with a finalized Eurozone bailout package and be able to move on to broader issues about exchange rates and financial regulation. Balking at the prospect of further austerity measures, the Greek government scheduled a referendum for December which has now been cancelled, though still leaves the final form of the EU bailout plan undetermined. Large injections of capital, similar to the Federal Reserve’s quantitative easing programs in the U.S., could help European stocks rebound and boost confidence, the popular thinking goes.

Though small caps are generally considered riskier than large caps, Lugo observes that buying only high-caliber companies with strong competitive advantages, solid balance sheets, and good cash flows can help defuse volatility since, the theory goes, companies which demonstrate these characteristics may be less susceptible to unstable markets. As far as he and his team are concerned, those that do not measure up to these standards are crossed off the list, a strict screening process that results in a pretty concentrated portfolio:         

“We run a concentrated portfolio. One reason we have only 38[1] companies in the portfolio is because few small and mid-cap stocks meet the criteria we are looking for. Even with this degree of concentration, we have experienced less volatility than the benchmark over the 3- and 5-year periods ended 9/30/11[2]. This is just the opposite of how things usually work; higher concentration, as a rule, usually means greater volatility. Beta for the portfolio was 0.84[3] which reflects how the stocks we buy are typically more stable by nature than those of many other companies.” 

While Franklin International Small Cap Growth Fund has not been immune to the nerve-wracking economic environment, Lugo credits adherence to a disciplined investment strategy with helping curtail recent loss potential:

“We tend to stay out of areas which have been hardest hit. That said, we don’t pretend to be pleased by recent performance. We are encouraged by many of the good buying opportunities we are finding and are hopeful that policies enacted to resolve the European debt crisis will help stabilize those markets.”  

Until next time, Beyond Bulls & Bears leaves you with this quote from the late Sir John Templeton:

“Achieving a good record is a lot harder than most people think.”

What Are The Risks?

The fund is intended for long-term investors who are comfortable with fluctuation in the value of their investment, especially over the short term. Smaller, relatively new and/or unseasoned companies can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies. Foreign investing involves additional risks such as currency and market volatility, as well as political and social instability. Emerging markets involve heightened risks relating to the same factors. The fund also invests in technology stocks, which can be highly volatile. These and other risks are described in the fund’s prospectus.

[1] As of 9/30/11 the portfolio consisted of 38 companies.  Holdings are subject to change.

[2] Source: Morningstar Direct, 9/30/11. Standard deviation is a measure of the degree to which a fund’s return varies from its previous returns or from the average of all similar funds. The larger the standard deviation, the greater the likelihood (and risk) that a security’s performance will fluctuate from the average return. For the Franklin International Small Cap Growth Fund the standard deviation was measured against the MSCI EAFE Small Cap Index.  As of 9/30/11, the standard deviation over the 3-year period for the Franklin International Small Cap Growth Fund—Class A was 23.7 versus 27.4 for the benchmark. The standard deviation over the 5-year period for the Franklin International Small Cap Growth Fund—Class A was 20.4 versus 24.4 for the benchmark. Indices are unmanaged and one cannot invest directly in them.

[3] Source: Morningstar Direct, 9/30/11. Beta is a measure of the fund’s volatility relative to the market. A beta greater than 1.00 indicates volatility greater than the market. Based on the 3-year period ended as of 9/30/11. For the Franklin International Small Cap Growth Fund the beta was measured against the MSCI EAFE Small Cap Index.  Indices are unmanaged and one cannot invest directly in them.

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