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He smelled trouble a long time ago

dparkinson@globeandmail.com

Don Reed is humble and experienced enough to admit two things:

1. He's not always right.

2. Even when he is proven right, no one wants to hear "I told you so."

Mr. Reed - president and CEO of Franklin Templeton Investments Corp. and lead manager of the Templeton International Stock Fund - was chatting with reporters before the company's annual investment outlook forum yesterday about how he went underweight financial stocks a few years ago, long before it was cool.

The conversation echoed the prescience of that investment strategy: By the end of the day, another crisis of confidence in the financial sector had dealt deep losses to stock markets. The S&P/TSX composite index slumped 306.52 points, the Dow Jones industrial average was off 283.10 points and European markets fared little better, with financials accounting for much of the losses.

With the MSCI World Financials index down almost 35 per cent from its May, 2007, peak, investors in Mr. Reed's fund would be right to feel fortunate to have benefited from his insight.

But the man himself freely admits that at the time he decided to go underweight a few years ago, he hadn't specifically been looking at the subprime mortgage market that proved to be the sector's ticking time bomb.

"We saw that U.S. consumer credit had gotten way out of line with many companies we follow in financial services," he recalled, saying he saw that as a warning sign of an overextended credit market.

He also doesn't spend a lot of time boasting about his early call on financials - partly because people don't like to be reminded that they failed to heed his warnings, but also because he knows a lot of investors simply won't remember he said it in the first place. It's one of the market's occasionally messy truths that until investors start to see evidence of a negative threat actually manifesting itself in the direction of prices, they have trouble absorbing the message, and the credit bubble experience was no different.

"If we'd asked people here a year ago how many of them knew what subprime was, we wouldn't have seen a lot of hands," he said.

A messy and tumultuous year later, the term is an all-too-familiar part of the investing vernacular - much to the chagrin of the multitudes who hadn't known enough about the threat before it hit markets in earnest last August.

The harsh lesson learned, where does Mr. Reed now have his sights set?

He maintains a considerable overweight position in telecommunications stocks. He said stocks in the sector have attractive valuations and good growth potential in wireless and data transmission, something the market has somewhat overlooked after punishing the sector over concerns about eroding long-distance revenues, and the balance sheets for many names in the sector are in good shape. He added that the sector is a good defensive play in the current volatile markets.

Regionally, he sees opportunities in Britain, where valuations have fallen to bargain-basement levels. London's FTSE 100 index is trading at a trailing 12-month price-to-earnings ratio of a mere 10 times, compared with the five-year average of more than 18 times.

Mr. Reed's investing strategy is generally bottom up - the focus is on finding individual stocks that offer value, and building the portfolio one stock at a time. However, his approach is a pragmatic one for the current troubled marketplace: He's looking for regions or market segments offering good value or potential, then hunting for the strongest individual names within those pockets of health.

That doesn't mean completely shunning the financial and real estate sectors, though, despite the fact that neither sector looks in any kind of shape for a recovery yet. Indeed, he still owns individual names in those sectors, on the premise that some solid companies have been dragged down by the general weakness in the segments and offer good opportunities when the recovery comes.

It's an approach that takes a lot of homework, a lot of patience and a lot of willingness to try to explain your vision to investors who often see only the market landscape immediately before them.

And the five-year performance record of the Templeton International Stock fund - 10-per-cent average annual returns, a shade below that of the fund's international benchmark, the MSCI EAFE index - provides the evidence that, as Mr. Reed acknowledges, even a seasoned pro such as himself doesn't always get it right.

But if he can get the big ones right, the way he did on financials, then in the long run, I suspect Mr. Reed's investors would happily put up with a bit of occasional gloating.

© 2007 The Globe and Mail. All rights reserved.

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