Seeking Opportunity within Complexity
Franklin Mutual Beacon Fund
Author: Ticker Magazine
Last Update: Nov 29, 1:18 PM EST
|Investors prefer to put their trust in companies that are easier to understand rather than invest in complicated businesses. As a result, the market tends to be wrong on many occasions, especially when analyzing complex situations. Portfolio Manager Christian Correa and the team at the helm of the Franklin Mutual Beacon Fund specialize in determining underlying asset values in such contexts with the objective of unlocking hidden value.
“We have a real passion for finding opportunity within complexity, for identifying potential catalysts, and for actively engaging with company management.”
Baidu Inc is the dominant search engine provider in China, and exemplifies a case where the necessary information was available but we had to be patient and give management time to behave rationally – which they eventually did.
Search is a fantastic business and we believe any company that is the scale provider in its region ought to make huge margins. A couple of years ago when we looked at Baidu, its margins puzzled us because they had dropped dramatically.
Upon further investigation, it turned out that while Baidu was making a lot of money in search, it was expanding into online-to-offline commerce. Moreover, the company was investing into a slew of other businesses – like food delivery, mapping software, and building an online travel agency.
Separately, these businesses might be good investments and could even be worth a lot of money if backed by venture capital. But because Baidu reported everything as one segment, all investors saw were its shrinking margins and profits.
In April 2016, Baidu split the business into two segments and changed its reporting to show the profits from search and the loss to running everything else. This information was publicly available in its corporate filings.
Because we know the search industry reasonably well and felt good about that part of Baidu’s business, our next step was to look at its other losses and how the market was evaluating the company in terms of a price/earnings (P/E) multiple. In our view, all we really needed was the confidence that Baidu’s management wouldn’t lose money forever.
We met with them, but more importantly, tried to judge management based on their actions rather than their words. After looking at other things they’d done, we concluded they were probably rational people, so we invested in Baidu.
Initially, our investment didn’t work out well. Baidu’s search business became worse than expected and the company was also sued, which led to a regulatory crackdown that forced Baidu to clean out its customer base and scrutinize advertisers.
However, at the same time as headwinds were preventing the company’s search business from growing, management was dealing with the rest of the business. The money-losing online travel agency was merged with the leading travel provider in China, Ctrip, in exchange for stock. Baidu also became more transparent about its online video business which has the potential to become the Netflix of China.
Over the last six to nine months, the stock has gone up materially as the market has finally given Baidu credit for things we saw two years ago.
Q: Would you provide an example in a different industry?
B/E Aerospace Inc is another story where the value of one business segment can be hidden by another. The company manufactures products for commercial and business aircraft cabins and is also the largest independent distributor of aerospace parts. It spun off the distribution business into an entity called KLX Inc, while the airplane interiors segment stayed at B/E Aerospace and was eventually acquired by Rockwell Collins, Inc.
The KLX management team believed that because they had built a great distribution business in aerospace parts, they could do something similar in energy, distributing parts for things like drilling rigs. They diversified KLX into two segments, KLX Aerospace Solutions and KLX Energy Services – right at the time that oil prices went down.
This created a quite a complex situation: not only might investors not want to own a spinoff, but the energy-parts distribution business wasn’t well-understood and people generally disliked it.
We believed the stock was relatively undervalued because of this mix of market dislocation and a shortage of natural investors. Subsequently, the energy market bounced back a bit and investors started to understand the business and give the company credit. Because we still see potential in it, we remain shareholders today.
Q: What is your portfolio construction process?
With 40 to 50 core equity positions and a handful of positions in merger arbitrage or distressed debt, the portfolio is reasonably diverse and has a low correlation with the market.
Most positions are between 2.5% and 3.5%. Anything smaller than 2.5% typically occurs because a company is being acquired or sold, or because liquidity prevents us from building a larger position. There’s no hard limit regarding maximum position size, though it would be unlikely for one to exceed 4%.
We always have a view on what the downside and upside could be and know the level at which we would buy or sell a stock based on its risk-reward. This is monitored daily with a strict eye on value. These views aren’t static, though. Our take on the upside and downside changes as information becomes available, and buy and sell levels are constantly updated.
For example, say the stock of a reasonably large company is down 10% following the announcement that its CEO is being fired. The question we’d ask is whether the CEO is worth that much valuation. Probably not – there are plenty of competent executives available to hire.
The MSCI World Index is the fund’s benchmark, but we are actively managed and index agnostic when thinking about positions, stocks, and sectors. All the Mutual Series funds have active share that is almost always above 80, so it’s clear the benchmark has little influence. Also, as a result, our performance can diverge significantly from the benchmark.
Q: How do you define and manage risk?
At its core, risk is the impairment of value and for us, managing this starts with security analysis. If we get this right, then each individual position has little downside and by definition the portfolio itself will have little downside.
The fund’s diversification also helps mitigate risk. We’re not concentrated 80% in one industry or country, and thus get plenty of diversification benefit. Finally, we meet with Franklin Templeton’s risk and portfolio analysis group once a quarter. They go through the portfolio using traditional quantitative metrics and give us feedback.
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