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Small Cap Compounders
Franklin Small Cap Value Fund
Interview with: Steven Raineri

Author: Ticker Magazine
Last Update: Apr 13, 10:52 AM ET
Managing the growth trajectory of smaller companies can be challenging, and investors are not always patient with a companyís management and/or development plans. Steven Raineri, portfolio manager of the Franklin Small Cap Value Fund, likes to methodically build a portfolio of small-cap companies whose track record and capacity of compounding earnings come at an attractive price due to temporary problems.

ďWe are trying to put together a portfolio of companies that are cheap relative to their earnings power and are compounders of value. However, we need to see some sort of earnings growth out of small cap companies because that is what will make them successful investments over the long term.Ē
A: Not really. I think in catalyst investing itís important to recognize that the catalyst are often evident and are mostly priced in. Itís not to say we will never buy a stock thatís not catalyst driven. For example, Maple Leaf Foods Inc, the Canadian consumer packaged meats company, is our number one holding. The longer-term catalyst was they were deleveraging the company in the middle of a multi-year, billion-dollar reinvestment program, restructuring the company and, streamlining it. We didnít feel like that was priced into the stock.

Q: What is your investment process?

A: Itís predominantly a bottom-up approach. We whittle the small-cap universe down by looking at the leverage and track record. We focus on stocks that have low price-to-book or price-to-earnings ratios. Weíll go to conferences, meet with management teams, and plenty of times we wait and get familiar with the name.

We will examine the senior management team and analyze their past decisions to determine if they are the right management team for the companyís position in its life cycle. For example, if a company is in growth mode but has a restructuring focused CEO or vice versa, there are going to be problems more likely than not.

Q: Who makes the final decision regarding sector allocation?

A: I do. We have analysts covering key sectors like financials, industrials, material, tech, healthcare, or energyóbut I oversee the research effort.

The team understands every one of their companies that could reasonably be a candidate. They have to know their sectors, companies that we own and the competitive set well and be constantly learning and evaluating what we do.

Itís a collaborative environment among the team members in our office and other Franklin Templeton investment professionals around the globe. It doesnít matter where the ideas come from, as long as they make money for our clients. No one has a monopoly on new ideas.

Q: Do you prefer to meet management?

A: We do like to at least have a conversation with the companies we are investing in. Itís not always a prerequisite before investing. When we are invested, we have more regular meetings when the company is facing some challenges or we want to let them know our thoughts on various topics. We could speak to a company ten times in a year, three times in a month. It really depends.

We like and do site visits. I canít imagine any company where we have invested in that we have never spoken to. We are advocates for our shareholders and we are active managers. We believe itís important that the management teams know whatís expected of them.

Q: Can you give some examples to illustrate your research process?

A: AAR Corp is one of the larger names in the portfolio. It is an independent provider of services to the commercial aviation and government markets. We have owned AAR since 2011 when we saw a company trading at a cheap price relative to book value but not generating great returns on equity (under 8%).

They had a reasonable track record with some earnings and revenue growth, but they had challenges coming out of 2001, after 9/11, most of their customers were bankrupt. They supplied transport to the military and so they were feeling the after-effects of reduction in troop activity in the Mid-East coming out of the Afghan-Iraq Wars. But we thought the airline maintenance, the parts business, and the supply chain businesses were all attractive long-term opportunities. We could see some pattern of success and the balance sheet was in decent shape.

Over the last two years, the company took a focused approach to improving return on invested capital. They have also substantially de-leveraged the balance sheet.

The stock has had a decent run over the last year. Airline traffic growth is going to benefit them and their maintenance activities. Moreover they have had some great contract wins and some slight uptick in activity in the military side. This was a company with a decent track record of success, was out of favor, and had a decent valuation. Several years since our initial investment, the company is now in position to meaningfully grow earnings again.

Q: How is your portfolio constructed? What is your benchmark?

A: With between 75-125 names, our portfolio is constructed with a view that some diversification can help us mitigate the risks of what we donít know, despite our best efforts to understand the businesses and industries. We are benchmark aware but are not held to that. We have been trying to take a little more balanced approach to our overweights and underweights.

We want to make sure that the reasons why we are overweight in certain sectors (such as industrials) relative to our Russell 2000 Value benchmark, is because we have these wonderful companies that we would never want to part with. Moreover, we have added banks over the last year but are still underweight relative to the benchmark; it has to be an active decision.

Turnover is relatively low in the thirty percent rage.

We are cognizant that we are human and make mistakes, so everything that we do from the security selection, to the scaling, to the portfolio construction, we want to continuously consider the possibility that we can be wrong and make adjustments if necessary.

Q: How do you define and manage risk?

A: We know small caps can be more volatile than the larger companies, however, to us, risk is the potential for an impairment of our capital. Risk is always present but not always evident. Our entire investment process and philosophy is rooted in eliminating or minimizing risk at the security and portfolio level. That is why the price we pay for the stock and how we allocate capital to each holding is important to us. Our portfolio doesnít have a single company with an allocation above 300 basis points. More at the individual security level we like to have 3-to-1 reward to risk on the individual, ideally not more than 40 basis points of a decline in the portfolio on a more permanent basis.

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