Q3 | 2012Putnam International Equity Fund Q&A

A policy-driven rally in Europe

Simon Davis Portfolio Manager

I believe the rally could continue, but there are important macroeconomic risks for European companies and sovereigns to negotiate.

Key takeaways European policymakers gave a well-received boost to international markets with monetary support measures. Value remains to be found in European stocks, but political developments in the eurozone as well as external growth factors in the United States and China could weigh on short-term performance. By combining a core set of defensive holdings with secular growers and cheaply valued stocks, we aim to maintain stability while positioning the fund to benefit from upside potential in a continuing recovery scenario. European markets took an upward trajectory for much of the third quarter. What was the main cause? The key factor driving this welcome change was monetary support from the European Central Bank [ECB]. In effect, the ECB pledged to do whatever is necessary to preserve the eurozone monetary union, including intervening in bond markets of countries where bond yields reflect redenomination risk. Of course, support is not unconditional in that it depends on a struggling nations willingness and ability to make significant fiscal adjustments, including tax increases, benefit reductions, and other politically difficult measures to enact. If a country agrees to make such adjustments, the ECB has offered to buy its sovereign bonds on the secondary market, providing much-needed liquidity and enabling the country to keep its debt service within manageable limits. Do fundamentals suggest the rally could continue? I believe the rally could continue, but there are important macroeconomic risks for European companies and sovereigns to negotiate. Put another way, we might ask whether European markets are at the top of a trading range or if something material has changed in the sovereign debt crisis that implies more room for European stocks to appreciate. While I believe in the possibility of the latter, the obstacles are not insignificant.

PUTNAM INVESTM ENTS| putnam.com

Q32012| A policy-driven rally in Europe

In the near term, macroeconomic data continue to worsen across the board. Furthermore, the coming U.S. election and fiscal cliff are generating considerable uncertainty, which is weighing on consumption and corporate investment. Meanwhile, the unpopularity of austerity measures across peripheral Europe is causing profound social tensions. Indeed, Spains issues have moved the economically vital region of Catalonia to threaten secession. Accounting for nearly 20% of Spains annual gross domestic product, a fiscal schism would be hugely damaging to Spains economy. Thus, even while the pledge of ECB support has removed much of the worst-case financial meltdown scenarios, macroeconomics and politics have a strong potential to weigh on European stocks in the short term. In the face of economic and political risks, would you say European companies still retain value for investors? Value is certainly there, but the question is how much of it can be realized in the short term. Taking banks as an example, the price-to-book (P/B) value of a number of banks suggests that stocks remain relatively cheap. A P/B metric puts a companys stock price in relation to the companys book value or what you are paying for a stock relative to what a company is worth after you subtract its liabilities from its total assets. In the thirdquarter rally, the sector rallied from a low valuation of less than book value 0.4 P/B to 0.60.7 P/B. If one assumes banks stand to make a return on equity greater than the cost of equity in the foreseeable future, investors would likely afford the sector a valuation above book value i.e., more than a 1.0 P/B. That suggests that an industry such as banking may continue to harbor attractive value. However, for that value to be realized, we need to return to a more stable macroeconomic, political, and regulatory climate.

One of the keys in this analysis, and for European stocks at large, is determining what will drive their growth. And for good or ill, growth in the rest of the world plays a big role in European companies health. A strong U.S. recovery, for example, would carry big benefits for German exports. Similarly, a resurgence in Chinas growth would have important implications for a host of industries in Europe. External factors, in other words, will likely go a long way toward determining European companies earnings and the growth outlook in the United States and China is anything but clearly positive at present. During the quarter, did you take advantage of the low valuations in European financials? In anticipation of positive moves by the ECB, we added to some positions in financials over the course of the summer. As I have suggested, valuations among financials had sunk to very low levels leading into the third quarter, with some banks at their postLehman valuation lows. Our strategy was additive to performance, particularly given the ECBs clear commitment to preserving the euro. In previous months, you maintained a core set of dividend-paying stocks in Putnam International Equity Funds portfolio. Did that remain the case in the third quarter? We maintain a set of decent dividend-yielding stocks as defensive plays in the core portfolio, while seeking to build a high-active-share portfolio a portfolio that is materially different from the benchmark. Accordingly, we take stock-specific risk where our conviction is high.

PUTNAM INVESTM ENTS| putnam.com

Interestingly, among stocks that traditionally have paid high dividends, there were some speed bumps that we managed to avoid during the quarter. A number of incumbent telecommunication companies, which investors historically have liked because of their yield characteristics, cut their dividends, taking many investors by surprise. Our European telecom analyst anticipated difficulty in this sector, and so we avoided these stocks in favor of cable companies, which performed better as a group. What is your outlook for international equities? We still see a number of areas among international equities that may benefit from depressed valuations combined with ECB monetary policy support. On the negative side, declining earnings estimates and the twin headwinds of economic deterioration and political uncertainty could limit market performance. Therefore, until we get clarity on issues ranging from the U.S. fiscal cliff to the trajectory of Chinese growth, it is hard to see any short-term drivers of outsized market gains. Consequently, we remain invested in companies that we believe are driven more by what their management can do in terms of cost cutting, as well as companies exposed to secular growth trends that we believe will outperform, even under difficult conditions.

Q32012| A policy-driven rally in Europe

Annualized total return performance as of September 30, 2012 Putnam International Equity Fund (POVSX)
Class A shares (inception 2/28/91)
Last quarter 1 year 3 years 5 years 10 years Life of fund Total expense ratio: 1.37%

Before sales charge

8.34% 19.68 2.47 -6.91 6.31 7.11

After sales charge

2.14% 12.82 0.47 -8.01 5.68 6.81

MSCI EAFE Index (ND)

6.92% 13.75 2.12 -5.24 8.20 4.59

Quarterly returns are cumulative. Recent performance may have benefited from one or more legal settlements. Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or a loss when you sell your shares. Performance of class A shares before sales charge assumes reinvestment of distributions and does not account for taxes. After-salescharge returns reflect a maximum 5.75% load. A short-term trading fee of 1% may apply to redemptions or exchanges from certain funds within the time period specified in the funds prospectus. The funds expense ratio is taken from the most recent prospectus and is subject to change. To obtain the most recent month-end performance, visit putnam.com. MSCI EAFE Index (ND) is an unmanaged index of equity securities from developed countries in Western Europe, the Far East, and Australasia.

The views and opinions expressed are those of Simon Davis, Portfolio Manager, as of September 30, 2012. They are subject to change with market conditions and are not meant as investment advice. Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. The use of derivatives involves additional risks, such as the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. Request a prospectus or summary prospectus from your financial representative or by calling 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.
Putnam Retail Management | One Post Office Square | Boston, MA 02109 | putnam.com
EO16827677110/12