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Advisor select

Steven Raineri is the lead portfolio manager of the Franklin Small Cap Value Fund. He has been with Franklin Templeton since 2005 and has more than 20 years of experience in th +

Franklin Small Cap Value Fund
FRVLX (Class A)
FRVFX (Class C)
FVFRX (Class R)
FRCSX (R6 Class)
FVADX (Advisor Class)
Fund Family
Franklin Templeton Funds
Fund Advisor
Franklin Advisory Services, LLC

One Franklin Parkway
San Mateo, CA 94403

T: 800-342-5236

Small Cap Compounders
Franklin Small Cap Value Fund
Apr 13, 2017

Q: What is the history of the fund?

This strategy evolved to a small cap fund in 2001 from an all cap fund launched in 1996. I joined the firm in 2005. 

Our mission is to be a core small cap value fund holding for our clients by generating an attractive risk adjusted return over the long-term.  The investment horizon is typically three-to-five years but we are prepared to hold stocks even longer than a decade as we have done several times in the past. Time-Horizon Arbitrage is a core part of our strategy.

Q: What is your market capitalization limit?

We 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.

Based on Russell 2000 industry benchmark, we can go as high as $9-10 billion, but we are not looking to purchase securities that are over $5 billion of market cap value. On the lower end, we can go as low as $30 million or $40 million but practically we won’t buy under $400 million of market cap. 

Q: How is investing in small caps different?

There are hundreds and hundreds of companies in the small-cap market space so it’s crucial to know these companies well. In addition, there isn’t much information out there on these small companies and that plays into our strength of doing detailed research. Before investing in a company, we could be shadowing it for six to nine months, watching how it behaves, and understanding the company, the industry, its competitors and what the long-term prospects are, while waiting for the right moment. 

Effectively these are companies that have been doing reasonably well on their own but they either fell on hard times, or the industry was out of favor, or the company missed an earnings report for some reason. When we are looking out three to five years and beyond, a lot of that drops away and the company could go back to its former self, and perhaps better, in terms of growth, earnings and profitability, and ultimately creating shareholder value.

Q: What is your definition of long term?

At a minimum, we are considering what it will look like three years forward. We know it takes quite a while for these ideas to develop and be profitable. For instance, we held StanCorp Financial Group for 17 years before the company was acquired at a very attractive price.

Q: Is farsightedness crucial to your investment process?

It’s a crucial part of what we do. But it’s also important to make sure we get the entry price correct and try to time it reasonably well with our position sizing. A full position could be 200 basis points or more, but we are not invested at that level from the beginning. It typically takes many months and several earnings reports and more information because we are always concerned with our risk levels and getting the investment story right.

There is no guarantee that we are right and so aside from all the work we do on the company and the management team, we want to make sure the homework doesn’t end when it gets in the portfolio. In fact, it always intensifies when it’s in the portfolio, so it’s a long process.

Q: How would you describe your investment philosophy?

We believe that investing in the stocks of small-cap companies with successful historical track records, good corporate governance and low leverage that are trading at cheap prices relative to long-term earnings power due to factors that appear to be temporary should generate attractive returns over the long-term.

The definition of risk for us is an impairment of capital, not necessarily volatility, which smaller companies tend to experience; therefore leverage is a crucial factor for us. We typically do not invest in companies with debt-to-capital ratio over 50%. Why? There’s a higher risk of a loss if we are wrong.  

Corporate governance is also important. When we own 3% to 10% of a company for three to five years plus, we are effectively partners. Therefore, among other things, we are looking for the best partners. Having the proper incentive structure in place is important. We don’t want management teams taking undue risks for short-term gains. When partners are properly incentivized along to create long term shareholder value it’s less likely that they are going to make that mistake or exercise poor judgment. So reading proxies, voting our own proxies, and having expansive discussions with management teams is crucial.

We believe that there are three skills successful management teams excel at - strategic vision, operational excellence and capital allocation. Mastery of those can go a long way towards creating shareholder value.

With regards to capital allocation, we buy companies that invest in their own business first, maintain a strong balance sheet, and if they have excess cash and if the stock is significantly undervalued, go ahead with a buyback. We want a company to be successful. We want our small-cap companies to grow into mid caps. We know that it’s hard for a company to do that when it is leveraging up and buying back stock.

Q: Do you focus on any key financial metrics?

If a small-cap stock’s earnings are not growing, it is more likely over time the stock is not performing. So one of the key metrics we look at obviously is earnings per share growth. Operating earnings or EBIT is important—EBIT growth and margins, as well as asset turnover, too. These are the key components of return on assets and return on equity. 

  • Inception: March 11, 1996
  • AUM: $2.9 billion

We also look at a 10-year historical record to assess if a company has been successful, if book value has dropped or is growing. Over time we assess if there is a pattern of growing sales and earnings or volatile results and deep losses and a lot of inconsistency. 

Q: What kind of value is attractive to you?

We are trying to put together a portfolio of companies that are cheap relative to their earnings power and are compounders. We also are looking at underlying assets and determining if there are valuable intangibles. However, we need to see some sort of earnings growth out of small-cap companies because that is what will make these companies successful over the long term. 

Q: Do catalysts play a role in your investment approach?

Not really. I think in catalyst investing it’s important to recognize that the catalyst are often evident and are mostly priced in. It’s not to say we will never buy a stock that’s 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 didn’t feel like that was priced into the stock.

Q: What is your investment process?

It’s 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. We’ll 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 company’s 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?

I do. We have analysts covering key sectors like financials, industrials, material, tech, healthcare, or energy—but 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.

It’s a collaborative environment among the team members in our office and other Franklin Templeton investment professionals around the globe. It doesn’t 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?

We do like to at least have a conversation with the companies we are investing in. It’s 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 can’t 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 it’s important that the management teams know what’s expected of them.

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

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?

With between 75-125 names, our portfolio is constructed with a view that some diversification can help us mitigate the risks of what we don’t 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?

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 doesn’t 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.