Long-term Opportunities Abound

The cautious optimism that rang in the second quarter turned out to be little more than false hope as a tenuous rally in equities buckled under the weight of mounting credit losses, soaring oil prices, renewed inflationary pressures, and an increasingly muddled economic outlook.

Fortunately, periods of greatest stress have historically ushered in eras of greatest opportunity for long-term equity investors. The hyperextension of momentum-driven commodities and industrial cyclicals has nearly equaled, in scale, the contraction of the rest of the market, with consumer-related stocks and financials retreating to the greatest extent. While the performance of the S&P 500 energy and materials sectors relative to the S&P 500 is currently at an all-time high, many health care, consumer discretionary and technology stocks are trading at, or near, historical valuation troughs, creating numerous long-term opportunities.

Consider that the energy sector of the MSCI World Index, now $3.3 trillion in market cap, is currently trading at a price/10-year average annual free cash flow of 45 times, yielding 2.2% average free cash flow. Consider also that the diverse stocks that represent the top 30 holdings of the Templeton Institutional Global Equity Composite, also $3.3 trillion in market cap, are currently trading at a price/10 year annual free cash flow of 18 times, translating to a 5.5% average free cash flow yield.

Consequently, Templeton's top holdings are currently priced at over double the free cash flow yield compared to the global energy sector, at roughly the same total cost. This is critical: The ability to generate cash in a period of diminishing consumer appetite and limited access to capital allows companies to continue self-funding growth while competitors languish under the weight of debt burden and credit drought.

Technology and telecommunications sectors have been trading at discounted valuations and generating high free cash flow. The best tech and telecoms offerings feature diverse global revenue streams, which should help mitigate the impact of a U.S.-led slowdown or an inflationary flare-up in emerging markets. During the second quarter, Templeton's technology holdings delivered solid returns, outpacing the benchmark, while overweighted telecommunications stocks kept up with the benchmark's holdings, but retreated in absolute terms after an extended period of outperformance.

Health care is another attractive sector from a value perspective: Concerns over politics, pricing pressure and patent expirations have compressed industry profit multiples to levels that undervalue the earnings potential of many firms. Also, we were overweighted media stocks, which continue to sell off amid a competitive push from phone and Internet companies. Nonetheless, few areas of the market have seen a wider gap in cash flow growth (rising) and price performance (falling) in recent years.

Our financials holdings have sustained their relative outperformance throughout the credit crunch in large part due to the careful avoidance of firms reliant on risky loan growth and overburdened balance sheets. Still, the value of our financial holdings has suffered significant absolute declines; some of our positions have been adversely impacted by exposure to structured credit derivatives. We have remained underweighted the sector. In future quarters, financials may need to continue dilutive capital raising to mend broken business models; the return of the industry's lifeblood-cheap credit- appears nowhere on the horizon.

Our limited exposure to energy and (especially) materials stocks cost us in terms of relative performance, though we continue to believe that our cautious approach to the expensive materials sector should ultimately be rewarded in the same way that our cautious approach to technology stocks was rewarded after the bursting of the dot-com bubble. From a long-term value perspective, we are currently finding far more attractive places to allocate investment capital.

Please click for more information on the following funds:
FTIF - Templeton Global (Euro) Fund
FTIF - Templeton Global Balanced Fund
FTIF - Templeton Global Equity Income Fund
FTIF - Templeton Global Fund
FTIF - Templeton Global Income Fund
FTIF - Templeton Global Smaller Companies Fund
FTIF - Templeton Euroland Fund
FTIF - Templeton European Fund