R Janakiraman, fund manager, Franklin India Smaller Companies, says the fund focusses on investing in 'quality compounders.' These are businesses that are characterized by an attractive return on capital, relatively lower capital intensity, ability to generate free cash flow, significant growth potential and capable management.
What is your investment universe?
The universe of smaller companies is bigger as compared to that of large-cap companies and offers a wider choice for stock picking. The overall investment strategy of FISCF is in line with the Franklin Equity (India) style of investing. The fund follows a bottom-up approach to stock selection investing across industries with an aim to provide adequate diversification. Our stock picking is focused on merits of individual businesses with focus on long term performance.
At Franklin Templeton, we define smaller (small and mid-cap) companies as the ones which have market capitalization below that of 100th stock in the S&P CNX 500. These companies can exhibit higher growth rates than large-caps, at the same time may lack the consistency in earnings displayed by larger companies. Such companies, in many cases, are under researched and under owned. Thus, the small cap universe, while diverse in quality characteristics, offers a larger ground for a stock-picking approach.
What attributes should a stock have for it to become a part of your portfolio?
The fund focusses on investing in 'quality compounders'. These are businesses that are characterized by an attractive return on capital, relatively lower capital intensity, ability to generate free cash flow, significant growth potential and capable management. The list is not exhaustive but illustrates the idea well. The attraction of such businesses is that they compound their earnings steadily over a long period of time at a relatively lower degree of risk. Exceptions to this preference happens on a tactical basis; in general, the 'quality compounders' account for a large part of the portfolio.
It is our view that such companies tend to compound their earnings better than their peers through a business cycle. Importantly, for investors, such businesses are also characterized by a lower degree of volatility in business metrics.
What kind of stocks never enter your portfolio?
Businesses that do not have the ability to generate free cash-flow over a business cycle are the ones we try to avoid. Such businesses tend to be very capital intensive, generate poor return on capital, are very cyclical and have limited entry barriers. We reiterate that we look at the company level and not at the industry level; even in challenging industries, there have been companies that have managed to generate shareholder value, though the number of such outlier cases has been quite limited.
What will you attribute the relatively superior performance of your fund to in recent years?
Our approach is to construct a well-diversified portfolio of primarily mid/small cap stocks that have an attractive business with sound fundamentals. Significant amount of effort goes into identifying such good quality businesses. These businesses have the ability to compound earnings at an attractive rate over a long period of time. Identifying such companies and remaining invested in them for a long time has been a key reason for the fund's performance. Patience in terms of giving good businesses adequate time to perform and compound has played a key role over the past 5 years.
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