The Recovery Rally and Global Valuations

A year ago, valuations across most of the world were at multi-decade lows. Since then, global markets have rebounded significantly, which has broadly brought valuations back to median levels. Even after the market's recovery rally, we believe equities continue to be attractively valued relative to other asset classes, and what we consider to be quality stocks are the cheapest we have seen in years relative to riskier stocks.

Interestingly, we have not seen any standouts in terms of overvaluation or undervaluation on a global industry and/or sector basis. This is reflected in the eclecticism of the companies entering Templeton's Bargain List. The list is comprised of companies that our analysts have determined are mispriced by the market and most undervalued relative to their business prospects based upon our five-year normalized earnings, cash flow forecasts, or asset valuation.

As an example, we have not generated quite as many names in emerging markets, which have performed strongly over the last 12 months as investors have moved back into growth stories such as China and India: the MSCI Emerging Markets Index returned 81.55% in U.S.-dollar terms for the one-year period ended 31 March 2010.¹ One of the drivers of emerging markets performance has been the enthusiasm of investors for emerging markets ETFs (exchange-traded funds). A great deal of "new money" has been channeled into emerging markets in the last 12 months, which has significantly contributed to the rise of valuations in that area. On a longer-term view, we are positive on emerging markets and still have very good representation of these markets in our funds. But, with many companies now appearing fairly valued, we are not finding as many new names as we did 12-18 months ago.

On a sector basis, we are still very positive on the health care sector, particularly the pharmaceuticals industry. Health care valuations, in general, remain historically depressed, and select stocks have exhibited excellent fundamentals, including what we are discovering to be some of the lowest net debt/market cap ratios of any sector. In addition, many have the ability to garner significant revenue growth from emerging markets over the next several years. Countries such as China or India are focused on improving the health care delivery systems for their citizens, and we believe that the larger global pharmaceutical companies can benefit from this trend. Emerging market sales provide an extra increment of revenue growth that can be very significant to the bottom line.

We also continue to favor the information technology sector. Technology still offers exciting growth prospects through innovation and expansion, but now also offers, in our view, some of the best balance-sheet profiles of any global sector, as well as the ability to generate tremendous amounts of free cash flow for growth, acquisitions or shareholder returns.

In terms of the market as a whole, recent trends in corporate earnings provide us with confidence. In a very difficult operating environment, several companies across the industry spectrum produced very solid earnings reports over the last 12 months. The cost and debt reduction initiatives necessitated by the financial crisis have made many companies stronger and more competitive, and the mix of organic demand and official stimulus in emerging markets is a powerful earnings-growth catalyst for global enterprises.

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