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Mutual Fund Q&A: 
Small Cap Compounders
Franklin Small Cap Value Fund
Interview with: Steven Raineri

Author: Ticker Magazine
Last Update: 10:52 AM ET April 13 2017

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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.

Q: What is the history of the fund?

A: 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?

A: 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 wonít buy under $400 million of market cap.

Q: How is investing in small caps different?

A: There are hundreds and hundreds of companies in the small-cap market space so itís crucial to know these companies well. In addition, there isnít 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?

A: 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?

A: Itís a crucial part of what we do. But itís 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 doesnít end when it gets in the portfolio. In fact, it always intensifies when itís in the portfolio, so itís a long process.

Q: How would you describe your investment philosophy?

A: 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? Thereís 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 donít want management teams taking undue risks for short-term gains. When partners are properly incentivized along to create long term shareholder value itís 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 itís 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?

A: If a small-cap stockís 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 importantóEBIT growth and margins, as well as asset turnover, too. These are the key components of return on assets and return on equity.

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?

A: 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?
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