Beyond Bulls & Bears

Three Dimensions of Discipline

As New Year’s resolutions fade into guilty memories, it’s a bitter reminder that maintaining discipline, in life and investing, is just plain hard. Despite best intentions, bear markets can tempt investors to sell everything, while bull markets can whip people into a buying frenzy, both courses of action that rarely end happily.

If Conrad Herrmann, who manages Franklin Flex Cap Growth Fund, is susceptible to market temptations, he certainly doesn’t show it. He strictly adheres to three dimensions along which all potential investment opportunities are judged: growth, quality and valuation.

Sticking with those three pillars, it can get trickier to find value when the market’s tide is rising—which we’ve seen in the U.S. over the past few months. Herrmann says the investment selection process boils down to that aforementioned feat of discipline, and a dose of patience, too.

Conrad Herrmann

“What we focus on is trying to identify companies that we believe have some sustainability of potential growth. We’re thinking about how much (market) share this company can capture, about its competitive positioning, how fast the industry is growing, how fast this company is growing. Along the quality dimension, it’s the quality of the business model, the quality of the financials. It’s also the quality of the management team itself. This is a more intangible concept to evaluate, so we probably host a couple thousand meetings every year with all of our analysts out on the road visiting companies or company management coming through our offices. We like to really dig in with specific companies and get to know the management teams quite well.

On the valuation front, it’s about evaluating every company with the scenario of what can go right, what can go wrong, what is the base-case scenario and what are the probabilities associated with each of these scenarios, so we can frame every investment decision we make with the upside return potential relative to downside risk. There are always opportunities to be found, but I think patience is a real virtue in investing, and the valuation metric is very important these days. There has been a great deal of enthusiasm for equities of late, so that brings us back to a more cautious stance, to the discipline of the price that you pay for a particular security.”

Among Franklin Flex Cap Growth Fund’s holdings, Ecolab (ECL)1, MasterCard(MA)2, and Visa (V)3, are some examples of companies Herrmann says have met the three dimensions of growth, quality and valuation that he and his team seek.

“Ecolab is a specialty chemical company involved in the cleaning and sanitizing solutions space for a lot of hospitality, food and beverage, and healthcare industry companies. This is a company that we think has a very good, visionary management team. They have been able to grow at a good rate over time, and yet the company has continued to generate free cash flow and high returns on capital that exceeded their cost of capital over time. So, they really have been creating economic wealth.

“Two more recognizable names are MasterCard and Visa. Both are benefiting from a duopoly position in the marketplace from their network of transaction processing, which is really enabling them to continue to grow from the secular trend of the use of plastic over cash and checks. These are examples of companies we think are poised to continue to grow over time.”

Of course, discipline doesn’t just come into play when making an initial investment in a particular stock, but also when it comes time to sell. Herrmann shares some thoughts on how he and his team make a general determination. [php function=1]

“We bring it back to our discipline; adhering to a very sound sell discipline is something we think about as identifying when we are seeing the reverse of the growth, quality and valuation elements of the business. We will highlight companies that have a decline of greater than 15% relative to their industry competitors over a three-month cycle, and this is something that helps prompt a discussion with our analysts to  try to determine whether there is some (fundamental) change that is really going on.”

All of which sounds perfectly logical, but an investor who’s lost his shirt on a stock might not be as open to a serious debate about whether the loss is indicative of a fundamental change–or not–as much as he just wants to sell based on emotional response. But for those who can master the deceptive simplicity that makes maintaining discipline so tough, the rewards – usually – can make it all worthwhile.

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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 includes investments in technology securities, which can be highly volatile and involves special risks. These and other risk considerations are discussed in the Franklin Flex Cap Growth Fund’s prospectus.

1. As of 1/31/13, Ecolab (ECL) represented 1.67% of net assets of Franklin Flex Cap Growth Fund. Holdings subject to change without notice.

2. As of 1/31/13, MasterCard (MA) represented 2.02% of net assets of Franklin Flex Cap Growth Fund. Holdings subject to change without notice.

3. As of 1/31/13, Visa Inc. (V) represented 2.09% of net assets of Franklin Flex Cap Growth Fund. Holdings subject to change without notice.

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