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The year 2010 turned out to be yet another roller-coaster ride for equity markets. Stock markets began the year in a recovery mode that peaked in April, declined significantly through July and then rallied again through year-end. On the negative side of the ledger, the sovereign debt crisis in Europe, emerging inflation, anemic hiring, enforced austerity and continued housing weakness weighed on investor sentiment at various points during the year. Nevertheless, corporate earnings continued to be robust against this backdrop. In general, large corporations managed their costs aggressively. In fact, a focus on costs and margins was a key driver in the market’s recovery.
For Mutual Series, equities have remained the core of our portfolios. Throughout 2010, we moved capital from positions that had reached what we considered fair value to new, undervalued opportunities. We found potential in large pharmaceutical firms with valuations that implied little innovation would ever emerge again from their laboratories. Similarly, valuations of some telecommunications firms, particularly in Europe, implied their businesses are in terminal decline. In short, we continue to find investments that seem to offer a margin of safety by trading at a discount to intrinsic value. Toward the end of the year, the cash holdings in most of our funds increased as we trimmed some position weights as they headed toward our target prices.
The Mutual Series team complements its equity value strategy by opportunistically investing in merger arbitrage situations and distressed securities. Although merger and acquisition (M&A) activity rose in 2010, merger arbitrage opportunities were often disappointing. A rising trend of protectionism, volatility in underlying values and uncertain fundamentals meant these opportunities were not as rewarding as we might have hoped. In 2011, factors such as the ongoing strength in the economy and in the market, continuing accumulation of cash on corporate balance sheets and corporate managements’ need for revenue growth may be harbingers of significant potential for M&A.
Distressed debt in 2010 brought few new opportunities as credit markets continued to strengthen and most firms obtained needed new financing. Many of our portfolios’ investments in credit performed well, but there were limited opportunities to allocate additional capital to distressed debt. The large opportunity set on the horizon continues to be the leveraged buyouts from 2005–2007, which still generally look to have unsustainable capital structures despite the market rally since 2009. We remained active, but overall, our credit exposure declined as the market rallied in 2010.
For 2011, we see a few positive signposts around the world. We think select equities have attractive valuations that US and European corporate earnings and forecasts remain strong, and that many of the companies in which we invest generate revenue in many parts of the globe.
However, we have some concerns: In the US, persistently high unemployment, significant budget deficits at every level of government and a rise in interest rates following quantitative easing (QE2) programmes are all troubling. Although the US economy may be able to sustain higher deficits in the short term to stimulate the economy, we wonder about its ability to address longer-term structural deficits. In Europe, the region may have averted the worst of the liquidity crisis in 2010, but the underlying stresses remain as regional governments debate and implement austerity measures.
In Asia, growth has continued but at an uncertain pace, with Chinese authorities attempting to navigate changes in global markets and changes in currency regimes while keeping growth on track. Beyond China, the implications of adjustments in developed world monetary policy and exchange rates ripple through Asian markets. These are the kinds of macroeconomic issues that help create company-specific opportunities for us and on which we have traditionally been able to capitalize. We look forward to doing so again in 2011.
(The author is Chairman, President and Chief Executive Officer of Franklin Mutual Advisers)
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