This Fund Tries To Profit From Carnage

The following is our latest Fund Analyst Report for Franklin Mutual Quest MQIFX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Franklin Mutual Quest struggled relative to the world allocation Morningstar Category norm and the MSCI World Value Index in 2017. Still, the merits that have propelled this fund to long-term success remain. Namely, it should continue to benefit from a strong management team, time-tested process, and attractive fees. The fund draws from the same resources that back all of Franklin’s Mutual Series offerings. It earns a Morningstar Analyst Rating of Bronze, in line with other Mutual Series funds rated by Morningstar Analysts.

The process that drives this fund is similar to other Mutual Series offerings, but it holds more debt than its siblings. Cheap stocks and merger-arbitrage plays normally take up 55%-75% of the fund's assets, with the remainder of the portfolio consisting of distressed debt and cash. Typically, the fund's mix of investments tends to serve it well in market downturns, as in 2011, but it is not immune to periods of turbulence.

Experienced managers Shawn Tumulty and Keith Luh invest the equity portfolio with a value bias, which met with a headwind in 2017 as growth stocks rallied. A few bad stock picks, such as Eastman Kodak KODK,

While the fund's results can be lumpy in the short term, it has delivered for investors over the long haul. Tumulty and Luh have the expertise necessary to profit from the market's carnage. They serve as the distressed-debt experts for Mutual Series and have worked together since late 2005. Tumulty took the reins of this fund in December 2009 and brought in Luh as comanager one year later. Since Tumulty’s start date in 2009, the fund has performed admirably, landing in the world allocation category's top decile through February 2018. Although the fund slightly trailed the MSCI World Value Index during that stretch, its risk-adjusted results handily beat the index's and the category norm's.

Process Pillar: Positive | Jonathan Wallace, CFA 03/29/2018 This fund's integrated value approach receives a Positive Process rating. As with other Mutual Series offerings, it's focused on cheap stocks but also includes merger-arbitrage plays on announced acquisitions and distressed debt. While the managers pay attention to standard valuation metrics like price multiples, they concentrate on firms' enterprise values as a function of what each individual business line is worth. Their activity in merger-arbitrage helps them keep tabs on what informed buyers are willing to pay. Once they find companies whose securities are trading at a material discount to their estimates of intrinsic value, they look across the capital structure and invest where they see the best risk/reward opportunities. Positions often migrate across that structure. An initial stake in a bankrupt firm's senior collateralized debt can lead to buying its junior unsecured debt as management becomes comfortable with its restructuring plan, or it may lead to an exchange for equity following the reorganization.

The managers court risk by investing in troubled firms, but their expertise, combined with an insistence on an appropriate margin of safety on price, provide some protection. They're also willing to wait years for theses to play out and readily go to cash if compelling alternatives are lacking. In addition, they're quick to sell once securities reach their estimates of fair value.

Management aims to layer downside protection into the structure of the portfolio. It holds a diverse mix of roughly 100 equity and fixed-income securities. Cheap stocks and merger-arbitrage equity positions typically take up 55%-75% of the fund's assets, while the remainder of the portfolio comprises distressed debt and cash, as opportunity dictates.

As of December 2017, the fund's equity stake was within that range at 62%, while 24% of its assets were in debt. As bankruptcy plays, whether liquidations or reorganizations, move according to the courts' timing, they can reward investors independent of market movements. Yet, they also come with their own brand of uncertainty.

While the fund has no cap on overseas investments, its foreign-equity exposure has averaged around 25% of assets since mid-2013. Most of these stocks are multinationals like top-10 holding

Performance Pillar: Positive | Jonathan Wallace, CFA 03/29/2018 The fund's investment process can lead to bouts of underperformance, as evidenced by the fund's struggles in 2017. Still, patient, long term investors have done well here. The fund's long-term performance warrants a Positive Performance Rating.

Since the longest-tenured manager, Sean Tumulty, inherited the lead role in December 2009, the fund’s 8.3% annualized return through February 2018 outpaces the world allocation category average and lands in the top decile of that peer group. While the fund has slightly trailed the MSCI World Value Index over that span on an absolute basis, the fund’s risk-adjusted returns are superior to both the category and the index. The fund's solid long-term results owe to holding up better than most in market downturns, like 2011, while keeping the pace in rallies, like 2013.

The fund’s struggles in 2017 stemmed from several factors. Its value tilt will typically cause it to lag when growth stocks lead the way, as in 2017. A few bad stock picks, such as Eastman Kodak, Teva Pharmaceuticals, and General Electric, weighed on performance. The fund also had some struggles with its bond sleeve. The fund had exposure to Puerto Rican debt, which suffered from the impact of Hurricane Maria. Lastly, the fund’s policy of hedging foreign currency risk back to the U.S. dollar also weighed on performance.

People Pillar: Positive | Jonathan Wallace, CFA 03/29/2018 This fund's Positive People Pillar rating reflects its comanagers' shared experience and expertise. Shawn Tumulty and Keith Luh have jointly led this fund for little more than seven years, but their history of working closely together as fellow distressed investing experts extends beyond that. Tumulty, the longer-tenured of the two, began as an assistant manager in 2003 under former lead Anne Gudefin. When Gudefin left Franklin in December 2009, Tumulty initially had sole charge of the fund. From the start, he consulted Luh, who had been an analyst here since November 2005 and officially became a named manager at year-end 2010. Neither came to the fund as rookies. Tumulty, who joined Franklin in 2000, has been in the industry since 1989 and Luh since 1996.

Tumulty and Luh are part of Franklin's veteran Mutual Series team. Tracing its lineage back to pioneering value investor Max Heine and his protégé Michael Price, the team is composed of 27 investment professionals, who have been with the firm or its predecessor for 13-plus years on average. They divide coverage by global industry, region, and asset class. Tumulty and Luh both specialize in bankruptcies, liquidations, and reorganizations.

Tumulty invests more than $1 million in the fund, and Luh at least $500,000.

Parent Pillar:

Neutral 03/28/2017

Publicly traded but family controlled and managed,

Franklin’s recent struggles highlight, albeit to an extreme, the challenges facing active management. Between mid-2014 and early 2016, the firm’s AUM fell by more than one fifth as investors increasingly opted for passive strategies and flagships like

The step toward passive investing illustrates the firm’s tendency to add to its investment capabilities rather than foster excellence across its lineup. The firm’s U.S. strategies are the most wide-ranging, and of the 36 U.S. open- and closed-end funds with a Morningstar Analyst Rating, half are Neutral. On the fixed-income side, although

Price Pillar: Positive | Jonathan Wallace, CFA 03/29/2018 Fees remain competitive, earning the fund a Positive Price rating. Its legacy no-load Z shares, which hold 70% of the fund's $5.3 billion asset base, charge a 0.79% expense ratio. That's at least 15 basis points below the world allocation institutional peer medians, placing in the group's cheapest quintile. The newer broker-sold A shares, which house most of the fund's remaining assets, also sport a Low Morningstar Fee Level, with a fee of 1.04%.

The fund is not particularly tax-efficient; its tax-cost ratio is twice that of the world allocation average and more than 3 times that of the world-stock average.