Beyond Bulls & Bears

A Flexible Approach

Flexibility may be an important component of one’s physical fitness, but it turns out it may be a key component to one’s fiscal fitness, too. You likely already know that different types of assets move in and out of favor in the market at different times. And, stocks of companies of different sizes (market capitalizations) can perform better or worse depending on the economic cycle. The question is: how can an investor be flexible amid these changing conditions, while still maintaining his or her own firm investment philosophy? For some insight, we turn to Conrad Herrmann, director of U.S. growth strategies and portfolio manager for the disciplined but flexible Franklin Flex Cap Growth Fund.

Market capitalization is a way to classify a company by size, as it relates to equity value. It’s calculated by multiplying the stock price by the total number of shares outstanding, to arrive at the market value of outstanding shares. Generally, small-cap stocks represent younger and growing companies, while large-cap stocks represent companies that are more mature and often leaders in their respective industries. Large-cap stock prices may not always be higher than those of small- or mid-caps, but the so-called “blue-chip” names generally are in the large-cap group, which investors view as more stable and financially sound.  On the other hand, small-cap stocks can offer greater growth potential. These general characteristics are relatively simple when considered on their own, but take on new dimensions depending on the overall fundamentals of the economy. Herrmann explains his approach when looking for stocks across a wide spectrum of market capitalizations.

Conrad Herrmann

We will consider where we are in the overall economic cycle, but we are really thinking about how much upside potential there is relative to downside risk for every investment that we make. It’s driven by a bottom-up research approach, identifying what we believe are companies with sustainable growth potential. As we evaluate companies, we are thinking about growth, quality and valuation, and as we generate ideas, our analysts are looking across the entire market-cap spectrum to find the best opportunities.

Small-caps tend to be a higher risk, so the hurdle rate or the required return that we are hoping to achieve is going to be higher. Then we also have to consider liquidity, so a smaller-cap position may receive a lower weighting within the portfolio. Our sweet spot with the fund has typically been in the upper end of the mid-caps to the lower-end of the large-cap range, somewhere in the $5 billion to $40 billion market-cap range. These are more mature companies in terms of their lifecycle, but ones that we think are really hitting their stride.

Apple is an example of a company that hits that market cap “sweet spot” for us and has seen some nice appreciation this year. Is Herrmann taking a bite?

Apple has been a strong performer for us.1 We are still very optimistic for the prospects for the company looking forward, and it should remain a core holding. But it may be a choppy summer time period of volatility as we wait for the iPhone 5, due to come out later this year or into 2013.

Apple’s recent dividend announcement made a bit of a media splash, but nothing compared to the brou-ha-ha a recent popular social networking IPO stirred up. We were curious to hear how Herrmann judges new market offerings.

For any IPO, we read through the S-1s, the financial filings, and we will attend the roadshow meeting. But it really comes back to that discipline of just evaluating the growth prospects of the company, what the overall market opportunity is, and the quality dimension that also includes understanding the quality of the management team. Meeting with the chief officers of the company is a great way to get to know the management team and really understand the vision that they are laying out. Obviously, valuation does play a part in that as well.

So, no matter what the size or how many people “like” a particular company, Herrmann is not going to bend when it comes to his bottom-up research process, and his focus on long-term values.

As the similarly trend-averse Sir John Templeton once said, “Successful investing is not an easy job. It requires an open mind, continuous study and critical judgment. Changes of trend occur when least expected.”

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What Are the Risks?

All investments involve risks, including possible loss of principal. Investors should be comfortable with fluctuations in the value of their investments, as small and mid-sized-company stocks can be volatile, especially over the short term. Smaller, mid-sized and relatively new 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. The fund may focus on particular sectors of the market from time to time, which can carry greater risks of adverse developments in such sectors. These and other risk considerations are discussed in the Franklin Flex Cap Growth Fund’s prospectus.

 


1 As of 4/30/12, Apple Inc. represented 5.58% of net assets of the Franklin Flex Cap Growth Fund. Holdings subject to change.

 

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