Finding Value in Beaten Down Markets

Peter Langerman
Chief Executive Officer,
Mutual Series

Stock markets continued to decline in the first quarter of 2009, falling to 12-year lows in early March. Then on March 10, news broke of a memo from Citigroup's CEO to his employees stating that the bank had earned money in the first two months of 2009, which sparked a rally in the markets. Although welcomed by investors, it is not clear whether this performance is sustainable.

At Mutual Series, we remain cautious because serious issues in the global financial markets remain. Global markets are well below their levels in late 2007, and investor sentiment is negative. We believe this negative view, however, is sending stock prices to levels that are enabling value investors such as us to find attractive opportunities in most sectors.

Among undervalued stocks, we are seeing some good opportunities in the U.S. and across the globe in companies with quality balance sheets and strong management teams at attractive valuations.

The Mutual Series team complements its value investment strategy with two others-distressed investing and arbitrage situations. The most common distressed investment we undertake is the purchase of debt securities issued by financially troubled or bankrupt companies at a substantial discount to face value. After the company's reorganization, often in bankruptcy court, the old debt is typically replaced with new securities issued by the financially stronger company.

Altman-NYU Salomon Center Defaulted Debt Index
Growth of a $10,000 Investment, March 31, 2006-March 31, 2009

Within distressed investing, we have seen the prices of leveraged loans reach compelling levels, as collateralized loan obligation structures have struggled and broken while leverage has left the system. This new price discovery has been driven by levered vehicles emerging as forced sellers and being replaced by unlevered buyers who require higher yields. For the first time in years, we have been able to create equity-like returns with senior secured risk profiles.

We are also noticing slightly more traditional Chapter 11 reorganizations and bankruptcies-not just filings by poorly managed companies with bad balance sheets, but lately include better companies with bad balance sheets. Given the lack of visibility into earnings caused by the current economic environment, to date we have played the top level of these capital structures and are taking advantage of equity-like returns in what we believe are over-collateralized loans. We continue to believe that the number of opportunities within this asset class will increase over time as default rates rise to reflect the grim realities of higher leverage ratios against the backdrop of economic weakness.

The other piece of our investment strategy takes advantage of arbitrage situations. At present, there are few M&A deals in the pipeline given the lack of financing. Nevertheless, we have seen some selective, large deals that we believe have been quite attractive in the pharmaceutical and consumer staples sectors by companies with fairly predictable cash flows, strong balance sheets and little debt. There could be M&A deals at some point among technology companies with those same characteristics.

Please click for more information on the following Mutual Series funds:

FTIF - Franklin Mutual Beacon Fund
FTIF - Franklin Mutual Euroland Fund
FTIF - Franklin Mutual European Fund
FTIF - Franklin Mutual Global Discovery Fund