Greencore (GNCGY), a sandwich and convenience foods manufacturer operating in Ireland and the United...
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Edwin Lugo, manager of the Franklin International Small Cap Growth Fund, is finding value in overseas overachievers despite the gains of recent months.
Q. What accounts for your fund's outperformance this year? [The Franklin International Small Cap Growth Fund—FKSCX—has returned 38% so far in 2009, beating the foreign small/mid growth category by four percentage points, according to Morningstar. It was in the top 1% of the category’s funds in 2008—Editor.]
A. In 2008 in the fourth quarter we started adding to positions in the retailing side. We found a lot of impressive companies trading at attractive prices. They include Carpetright (LSE: CPR; OTC: CGHXF) and Signet (LSE: SIG; NYSE: SIG). Carpetright is the largest carpet retailer in the UK, where they have 30% of the market. Signet is a jeweller—you may know them as Kay Jewellers or Jared Jewellers.
Q. Jewelry and carpeting—aren't these supposed to be dying businesses?
A. They definitely got hit. But [Carpetright] is a business that generates over 40% return on capital. It's the lowest-cost provider. In December the price became very attractive. We felt very strongly that over the long term they would maintain their competitive advantage and [likely gain] market share because its number-two competitor is going out of business. Signet is number one in the US with Kay and Jared. They'll come out of this with more market share; it's very similar to Carpetright.
Q. In general, as a small-cap growth play, you're going to be more risky and volatile than the overall market, right?
A. Small caps are a riskier asset class, without a doubt. But what distinguishes us from other managers is our focus on downside risk. We spend a lot of time debating what could go wrong with a company in terms of cash flow, margins, sales growth, competitively. And when we buy the company we try to get it close to its worst-case price—that's what we did with Signet and Carpetright. [Measured by standard deviation year to date and over a three-year period,] we're providing less volatility [than the market] and higher returns.
Q. What's your general view on the market now?
A. [On] a scale from 1 to 5, 5 being fairly valued and 1 being distressed—what we saw in the fourth quarter of 2008 and first quarter of 2009—we're probably at a 3.5. But by no means am I seeing overvalued.
Q. Along the lines of UK carpeting or US jewelry sales, Japanese office space doesn't seem like a terribly promising business. Yet you own Daibiru (Tokyo: 8806).
A. Daibiru owns 21 office buildings—these are class A properties in good locations; they have 11 in Osaka and ten in Tokyo. Keep in mind that Japan blew up a long time ago in real estate, so you don't have the fluff that you had in the US, UK, Ireland, or Spain, and we're buying something that's more realistically valued.
We had the 21 buildings separately appraised and we realized that the value of those buildings is [40% to 50%] higher than what the stock price indicates.
Q. You also own RHJ International (Brussels: RHJI). Is that the private equity firm that's in the running to acquire Opel (the troubled European subsidiary of General Motors—Editor)?
A. Yes, it is. Back in the fourth quarter of 2008, [the company] was roughly trading at a 250- to 300-million euro market capitalization. And at the time they had 400 million euros in cash plus 150 million in equity holdings. Now it's trading at its cash level pretty much, and you're only getting the businesses for free. So we've seen some of that value being realized.
Q. Would you have to review the case for them if they end up with Opel, which I assume would be their biggest investment?
A. They sweetened their offer recently for Opel. What they want to do is throw in 300 million euros—so, that would take up most of their cash. But 200 million wouldn't be due until 2012. And it seems that by cutting 10,000 workers, closing off a few plants, and doing some restructuring they can turn around the business.
Just running some back-of-the-envelope numbers, it looks very positive. Keep in mind: No one knows if RHJ is going to get it. The original case was that you were getting their businesses and a third of the cash for free—that was the premise. If the Opel deal happens, fantastic. If it doesn't, you've still got value there.
Q. Do you start out with fundamental screens to select your concentrated portfolio? (The fund currently holds 30 stocks—Editor.) Or do you sometimes have companies that you like and run against whatever criteria you use?
A. A combination of both. At the end of 2008, we were adding to industrials and consumer discretionary. We bought companies such as Savills (LSE: SVS), one of the leading real estate brokers in the UK. They were trading at prices that [assumed] oblivion was coming to the world when we started purchasing them. And then we added industrial companies such as Schindler (Zurich: SCHN), the number-two elevator company in the world after Otis (which is owned by United Technologies (NYSE: UTX)—Editor).
Schindler is based in Switzerland, and [it has] dominant share and a competitive advantage. They have over a billion Swiss francs on a net cash basis, so they were not going bankrupt. I've followed Schindler for a long time and never had a chance to buy it, but I finally did for the first time in my career when it got down to a ridiculous level. It's a fantastic company and mostly family-owned.
Q. Where are you finding the biggest bargains now?
A. The areas we're finding opportunities today, despite the market’s move, are in industrials and some technology names that recently came into our view. And there are some insurance companies that are also very attractive overseas, such as Fairfax Financial (TSX: FFH; NYSE: FFH).
Q. Thank you.
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