Cindy Sweeting
Executive Chairman,
Director of Portfolio Management and Lead Portfolio Manager,
FTIF Templeton Growth (Euro) Fund

TEMPLETON GLOBAL EQUITY GROUP

The recent period of significant weakness in global equity markets has been one of the most trying times in our investment careers. It is also one of the most promising. We believe the scale and comprehensive scope of the downturn have created conditions that will favor Templeton's value-driven investment approach over the longer term. Sir John Templeton would say, "to buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest rewards". He also said, "too many investors focus on outlook and trend. Therefore more profit is made by focusing on value". The investing philosophy pioneered by Sir John decades ago — searching for bargains where the public is most frightened and pessimistic - continues to guide our investment decisions at Templeton. The current valuations of some of the world's highest quality stocks have rarely been so attractive. We believe the ubiquitous fear and pessimism in today's market environment have created compelling opportunities for value-oriented investors with a long-term horizon.

Investing amid Volatile Markets

A bear market in stocks is a bull market in opportunities for investors with patience and fortitude. At Templeton, we strive to buy normalized earnings power at the lowest multiples we can find and seldom in our investment careers has the market discounted quality earnings so dramatically. While current conditions present interesting value opportunities in nearly all sectors and industry groups, we have focused in particular on out-of-favor sectors and stocks with strong balance sheets, high free-cash flow yields, long-term earnings power and reduced valuations. One area of interest as we position ourselves for an eventual rebound is in the consumer industries, which were among the first impacted by the economic recession and will likely be among the first to anticipate the ultimate recovery. A number of technology stocks are also attractive; many of the industry's best companies have lost their premium valuations and now offer low or no debt balance sheets, high free cash flow yields, and exciting growth opportunities at more reasonable valuations.

Health care is another sector we currently favor. Share prices in pharmaceutical businesses reflect commonly held concerns about generic competition, patent expirations, low R&D productivity and high embedded costs. We like a number of companies in the industry for their low financial leverage, high free cash flow and dividend yields, significant self-help potential and secular demographic tailwinds. We are taking advantage of the market's pessimism to continue selectively adding to our healthcare and pharmaceuticals weightings.

On a geographic basis, European stocks on average trade on a multiple of about 8 times what we consider a normalized level of earnings, which is about the cheapest they have ever been. The United States looks a little less cheap —about 10 times normalized earnings —but is also historically depressed, and we consider it to be a generally attractive entry point into a number of stocks in that market. Overall, we believe value investors can currently find an abundance of compelling opportunities throughout Europe, Asia and America.

Market Sentiment and Deflation

More broadly, the markets today are pricing in expectations of deflation, as the virtuous cycle of credit creation has been replaced by the vicious cycle of credit destruction. This deflationary sentiment is driving extremely low government bond yields and depressing equity valuations to their lowest levels in decades. Policymakers—the U.S. Federal Reserve and Treasury Department, along with their global counterparts—know that sustained deflation equates to economic depression, a disastrous prospect, and one to be avoided at all costs. Consequently, their policy choices have been aggressively re-flationary on a scale that is without historical precedent. The magnitude of their actions and the swiftness in which they have been implemented is encouraging, and if successfully achieved, the subsequent reflationary environment would be positive for equities.

We believe that financial assets will benefit from the eventual recovery in risk tolerance, and more specifically, that equities will ultimately benefit as the massive amounts of cash on the sidelines are put back to work in financial markets. The exodus of capital from the leveraged positions and derivatives that captured investor interest before the credit crisis likely represents an extended hiatus away from complex risk assets. Equities, which have significantly outperformed all traditional asset classes over the long-term, should ultimately benefit from this trend.

Catalysts for Recovery

Looking ahead, we believe recovery depends foremost on restoring stability to the financial system and we are encouraged that this has become the top priority of the Obama administration and other global policymakers. Restoring confidence, improving liquidity and protecting solvency in the financial system are all essential to the stabilization process.

The deleveraging process (or the general reduction of debt) is another crucial factor, and governments and regulators will need to work hard to facilitate orderly credit contraction. This process ultimately represents a transition to a lower-debt world. Consumers and businesses alike must pay down debt and restructure their balance sheets to achieve more responsible, sustainable liquidity levels. Governments will have to continue to expand their own balance sheets and bear the ultimate debt burden in order to stabilize the financial system and create a base for a transition back to growth in the global economy. To some extent then, governments are likely to take the place of consumers and corporations in stimulating the global economy.

Posted: 26 March 2009