An Undervalued Affair

The past two weeks have been nothing short of tumultuous for markets in Asia. The week ending 17th August saw Japan’s Nikkei 225 Average experience its biggest one-week drop ever, down 11.1%. South Korea’s KOSPI lost 10.4% and Hong Kong’s Hang Seng Index fell 9.2%.

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This week saw a reversal of fortune for these markets with bourses making back almost all of the losses suffered the week before. Year-to-date, Asian markets are still performing very well.

There is always money to be made in these situations. But for those who do not see volatility as a friend, investing in a fund with a long-term strategy may be more the thing for you. If that fund happens to be in the business of looking for deep value and risk arbitrage situations that are abundant in volatile markets, all the better.

The Fund

The Franklin Mutual Global Discovery Fund is part of the Franklin Mutual Series of funds. The investment objective behind these funds is long-term capital appreciation, which for the Global Discovery Fund, is done through investing in different asset classes such as equities, globally. The Fund follows a “deep value” approach and looks primarily to invest in undervalued securities, risk arbitrage and distressed companies that are deemed to have suitable risk-return parameters.

Franklin Mutual Global Discovery Fund

Fund Size US$483.5 million
NAV US$13.90
Management Fee 1.5% per annum
Entry Fee 5.25%
*As of 30 June 2007

Steven Craige, client portfolio manager of the Franklin Mutual Series Funds says that, "as deep value investors, we buy securities when they trade at significant discounts to our own estimate of their intrinsic value. We invest in undervalued equities, merger arbitrage situations, the distressed debt of companies undergoing reorganization, and some private special situations."

For the Global Discovery Fund, a company that is trading at an estimated 30% to 40% discount to its intrinsic value would be an attractive investment, provided that the potential downside risk is no more than 10% - 15%.

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An example Craige gave is Keppel Corp., a Singaporean conglomerate with assets in refining, real estate and the world’s leading shipyard for jack-ups and semi-submersibles trading at approximately 50% discount to its intrinsic value back in January 2006. Since then, Keppel has appreciated 131% in value to date.

Craige adds that even if a security that has an upside potential of up to 60%, but a corresponding downside potential of 25% to 30%, that would not be attractive to the fund. "We search for investments with an acceptable level of both return and risk and we focus on limiting the downside for our shareholders", Craige said.

The Global Discovery Fund also looks into risk arbitrage and distressed companies that become potential takeover targets. This past April marked an all-time high for the value of worldwide announced transactions in a single month, according to Thomson Financial. The combined value of deals announced in April came to $626.3 billion.

Correspondingly, the mergers and acquisitions portion of the fund has grown 8% to 12% of late because of the surge in M&A activity worldwide.

As mentioned before, this fund is strictly for long-term investors. Craige emphasizes this again, "Long-term investors only. As our average investment for our shareholders is for at least three to five years, an investor should stay in our funds for at least that amount of time to get the full benefit of our investment strategy and proprietary research."

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It’s interesting to note the Global Discovery Fund’s situation with regards to the current U.S. subprime mortgage crisis that has preoccupied markets of late. The fund exited most of its positions, which had direct exposure to the subprime mortgage market at the end of 2005 and at the beginning of 2006. This was because Franklin felt that the positions had reached close to its intrinsic value.

But it does have secondary subprime mortgage exposure through its holdings in stocks such as Citigroup and Bear Stearns . And for better or worse, the fund looks set to keep its Bear Stearns holdings. Craige says that, “we like the discount at which the business is trading to what we estimate is the intrinsic value of the business. The price of Bear Stearns is close to trough levels of valuation which it has reached during other times of financial stress.”

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Bear Stearns this past July declared two of its structured finance funds as having very little value. The two funds made bad investments in bonds linked to subprime mortgages and faced margin calls from banks and redemption requests from investors. Before their difficulty, the funds combined controlled assets of more than $20 billion.

And now, Bear Stearns is talking to Chinese institutions, particularly the CITIC Group, to sell a small stake of itself to China’s top financial conglomerate. Chief executive James Cayne, is seeking a Chinese partnership -- and possibly a much-needed capital infusion for the embattled firm

So one man’s distress is another man’s good fortune. When asked whether now would be considered an opportunity to enter into the subprime market and pick up assets at firesale prices, Craige said that Franklin was waiting for the right time to re-enter the space.

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