Share prices are down considerably in many global markets, but Anne Gudefin, co-manager of Mutual Discovery Fund, offered in Canada by Franklin Templeton Investments Corp., is on the sidelines, skeptical of the opportunities.

“We began raising cash at the beginning of 2007,” says Gudefin, portfolio manager with Franklin Mutual Advisors LLC in London, England. She shares trans-Atlantic duties with portfolio manager Charles Lahr, who works in the firm’s Short Hills, N.J., head office. “We had a number of positions that had reached fair value. If the value is fair, we sell into the market.”

As a result, within the various versions of the fund, about 30% of the $1.3 billion in assets under management is in cash. (There is US$14.6 billion in AUM in the U.S. version, which Gudefin also co-manages.) Yet Gudefin, a deep-value investor, has been hesitant about investing, despite falling prices. “We want to limit the downside, because we are very concerned about capital preservation,” she says. “I want to see limited downside before I start investing. So far, I don’t see things improving, or even see share prices stabilizing. So, I’m keeping the cash.”

This approach, she adds, is consistent with the Mutual brand’s investment philosophy. In essence, it means buying $1 worth of assets for 60¢, and selling them when they reach fair value. “We are always prudent,” says Gudefin, who prefers large-cap companies with a multi-decade track record. “But probably we are more so now than we have been in the past.”

This blend of opportunism and caution has delivered solid longer-term results. For the three- and five-year periods ended Aug. 31, the Canadian version of Mutual Discovery posted average annual compound returns of 4.7% and 8.1%, respectively, compared with 1.8% and 4.1%, respectively, for the median fund in the global equity category. Reflecting the decline in global markets, Mutual Discovery lost 11.3% over the past 12 months, slightly better than the 11.6% loss posted by the median fund. Mutual Discovery has earned a five-star rating from Morningstar Canada.

Mutual Discovery also gets high marks from analyst Ranga Chand, who heads Ottawa-based Chand Carmichael & Co. Ltd.He considers the fund a heavy hitter, consistently delivering above-average rates of return with below-average risk.

“Over all 12-month rolling periods since the fund’s inception in February 2003, it has outperformed the average global equity fund 91% of the time,” says Chand.

Overall, the fund’s three-year rolling returns have been above average 100% of the time. The fund’s volatility is about 20% lower than that of its peer group.

“It’s a good holding for a diversified portfolio,” adds Chand.

Dan Hallett, president of Windsor, Ont.-based industry analysts Dan Hallett & Associates Inc., calls the fund’s managers “good stock-pickers [who are] obviously very sensitive to how much they pay for companies.”

The fund has beaten its peer group, but outperformance is not all-important. “The track record, especially over a five-year period, will never make or break my decision,” says Hallett. “It’s that and the organization and the process. I have a lot of confidence in the people and their execution of the process over a long period of time.”

Although Gudefin focuses mainly on stock selection, she is concerned about the ramifications of corporate excesses of the past few years. “So far, it has been mainly about the subprime issue. But will other kinds of mortgages be affected, too? What about the leveraged buyouts by private-equity firms?” she asks. “You could see more negative news. Banks may have to take more provisions.”

So, Gudefin is cautious about moving into the markets. “We want to find really cheap stocks,” she says.” If you take a 20- to 25-year view, there are not many that are attractive.”

Gudefin and Lahr have not been entirely on the sidelines, however. They have taken advantage of the fund’s ability to hold up to 10% in merger arbitrage situations. In principle, they participate in announced transactions and conduct due diligence on legal and regulatory issues that may affect the buyout. They buy into only low-risk situations. One such holding is chewing-gum maker Wm. Wrigley Jr. Co., which is being acquired by Mars Inc. in a US$23-billion takeover backed by Warren Buffett’s Berkshire Hathaway Inc. (The merger is subject to a special shareholder vote on Sept. 25.) “You just buy the target and wait until you get the cash from Mars,” says Gudefin. The fund will profit from the difference between the Wrigley’s share price at the time of the offer and the Mars purchase price.

@page_break@“You can get returns, on an annualized basis, in the 12%-13% range,” explains Gudefin. “It’s better than holding cash.”

The fund’s co-managers can also invest up to 10% in distressed debt, but are taking a wait-and-see approach. “I have been a little disappointed,” says Gudefin. “There have been some sectors, such as airlines. But we don’t like airlines long term. So, we took a pass. There are also home-builders, but we expect more pain. So, there is no rush to invest.”

The co-managers are also avoiding the U.S. financial services sector, even though share prices have plummeted. “It’s a big black box,” says Gudefin. “We want to see some visibility. How much do we know about all the risks they have? They have so much leverage — if one investment goes wrong, it jeopardizes the franchise. If the risk/reward equation is not there, we prefer to pass.”

From a geographical standpoint, Mutual Discovery has an underweighted 13.4% in the U.S. (vs 43.6% in the MSCI world index) and 7.2% in Britain (9% in the index). Conversely, the fund has an overweighted 9.6% in France (4.5%), 5.5% in Germany (3.8%), 4.7% in Switzerland (3%), 3.6% in Italy (1.55%) and 3.3% in Denmark (0.43%).

The co-managers prefer to be well diversified and limit single holdings to about 2.2% of the fund, although they can go as high as 5% if the value is compelling. Turnover is relatively low, at 22.2% in 2007 and 20.1% in 2006.

In selecting companies, Gudefin looks for firms with fundamentally strong businesses and high free cash flow that may be in industries that are open to consolidation. “We’re looking for management that is good at deploying capital,” she adds, “and is shareholder-friendly.

Valuation is another key consideration — stocks that are trading at a low price/earnings or price/book value multiples. Finally, there has to be a catalyst that will unlock the value in the shares; it could be the sale of non-core assets or de-leveraging of the balance sheet.

Gudefin likes British American Tobacco PLC and Imperial Tobacco Group PLC, which dominate the top 10 holdings and account for almost 10% of the fund. “Tobacco companies have very stable cash flows. That’s a good thing in good times, but even better in bad times,” observes Gudefin. “There’s also been some consolidation recently, with Altadis SA being acquired by Imperial Tobacco. That should bring more pricing discipline to the industry. We continue to see cost savings.”

BAT has been in the fund for five years. “It continues to generate a lot of free cash flow, and pays a 4.5% dividend,” says Gudefin. “It has opportunities to grow because of the exposure to emerging markets. It’s still cheap.” BAT’s P/E ratio is around 13 times projected 2009 earnings. “We’re very happy if we own good companies and remain shareholders for a long time. Our average investment period is three to five years, but some are longer.”

Not all plays work out smoothly. Among the 70 names in the fund is a large holding in Carrefour SA, a major French retailer. Gudefin took a position almost three years ago, after the new CEO began cleaning house and divesting weaker assets. The restructuring has hit some speed bumps, however; since last winter, the stock has dropped to a recent 34 euros a share from 53 euros.

“We may have to wait a bit more for upside potential to be realized,” says Gudefin. “There are many ways that the cash flow can be improved at Carrefour.”

An outside investor with a significant stake is waiting to implement changes at Carrefour. When those changes are introduced, value in the stock should become unlocked. Gudefin sees about 50% upside for Carrefour’s stock.

A native of Paris, Gudefin has a French mother and an American father who worked for Lazard Freres; Gudefin picked up her interest in value investing from him. “I like the fact that you can buy an asset nobody wants,” she says. “But you can see how it will transform itself, and become very valuable.”

In 1987, she graduated with a bachelor of arts in economics and finance from Institut d’etudes politiques in Paris. Gudefin worked for five years as a researcher for a local retail stockbroker, then went back to school. After earning an MBA from New York’s Columbia University in 1995, Gudefin landed a position as a European equities analyst for a New York-based hedge fund. “That was where I started to get involved in European value stocks,” she says.

In 2000, Gudefin joined the team at Franklin’s Mutual series of funds as a research analyst, looking at European companies. Within a couple of years, she was promoted to assistant portfolio manager and, in 2003, to lead manager of a US$5-billion fund sold in the U.S.

In May 2005, Gudefin became co-manager of the Canadian and U.S. versions of Mutual Discovery. She moved to London in 2006 to be closer to European markets.

Gudefin describes the U.S. market as “the eye of the storm.” But it’s also one of the first places she expects to invest. “I haven’t started buying yet,” says Gudefin. “We are in a wait-and-see mood, until we feel that valuations are low enough that it’s of interest.”

It would be easy to find assets that may be worth more than their current share price, she adds, “But you also have to find those which have limited downside.” IE