Recession

High-Quality Opportunities In International Small-Cap Stocks

PM Mark Rayner discusses Brexit and details the opportunities created by 4Q18’s steep decline.

Q4 hedge fund letters, conference, scoops etc

Recession

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Although they haven’t been as extreme as their domestic cousins, international small-caps also saw a negative fourth quarter followed by a strong recovery so far in 2019. The MSCI ACWI ex USA Small Cap Index was down 14.4% in 4Q18 and gained 10.1% year-to-date through 2/28/19. What kind of opportunities has this recent volatility created for Royce International Premier Fund?

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I like the suggestion in the question that volatility represents opportunity. Too often market participants view stock price volatility as risk. David and I really don’t see it that way. Risk, in our eyes, is the permanent loss of value as opposed to shorter-term stock price volatility. The latter offers us the potential to profit from buying or selling temporarily mispriced assets. Having said that, I do also appreciate that the sort of stock price declines we saw in 4Q18 can make investors feel quite uncomfortable.

We saw a very diverse set of opportunities late in 2018. We added to many existing positons in the portfolio while also adding a few new names, including IMCD, a Dutch company that distributes specialty chemicals; Loomis, a Swedish cash handling services business; and SimCorp, A Danish firm that develops software for the asset management industry.

Has there been a common theme to these opportunities?

All of the investments we made during the correction added to or built new positions in what we believe are high-quality names. Often their prices seemed hurt by investor perception of greater cyclicality in their earnings than we think was warranted—that’s been the common theme. The quite substantial price declines we saw across the market did not therefore tempt us to lower our quality standards and buy what appeared to be optically cheap, lower-quality stocks. All of our new positions came out of the company database David and I have been building and monitoring over more than a decade. SimCorp, for example, is a return to a name we previously held in the Fund.

What are your thoughts around the looming deadline for Brexit?

That’s a difficult question. As a Brit, of course I have my personal thoughts as to whether we should leave or remain. But I put those to one side because what’s of more relevance to our investors is the fact that the U.K. is a very important market for International Premier. This is not home country bias, but we simply find in the U.K. a significant number of the high-quality businesses to which we’re attracted.

The problem with Brexit, which as it stands is due to take place on March 29th, is that the outcome is still unknowable. One possible outcome is the U.K. leaving the European Union with no withdrawal agreement in place—the so-called ‘hard’ Brexit. The long-term economic implications of this can be debated, but it seems likely that it would be disruptive to the U.K. economy for some time and perhaps lead to a material fall in the value of the British pound.

On the other end of the spectrum, there is still the potential for a second referendum, a subsequent Remain vote, and no Brexit at all. Under this scenario, the recent pre-Brexit softness in the U.K. economy could well be reversed and be accompanied by a meaningful rally in sterling.

How has this view affected portfolio holdings?

Firstly, David and I are not going to place bets on the form of Brexit by taking a material overweight or underweight position in the U.K. In this or any other situation, we are bottom up rather than top down investors.

Secondly, our U.K. investments have always been, and remain, heavily weighted towards the exporters. Victrex, for example, which produces an ultra-high performance plastic called PEEK, generates 98% of its revenues outside the U.K. That means our U.K. holdings have lower-than-average exposure to the U.K. economy, which should benefit them competitively if there is a material deterioration in the currency, likely somewhat shielding them from the full effects of a hard Brexit, if that is indeed what we get.

Three more of our six U.K. holdings in the portfolio—Spirax-Sarco, Croda, and Consort Medical—also each have export ratios of more than 90%. Going forward, we will evaluate U.K. opportunities that may arise from any Brexit-related stock market volatility on a case by case basis. We have a shopping list, as it were, in our database of companies that we think can respond best to either of the two extremes. So while we can’t predict, we can prepare as best we can for whatever Brexit outcome we receive.

Has the recent slower pace of growth in Europe and China affected any of your portfolio decisions?

I would say hardly at all, actually. This stems from our investment approach. As very much bottom-up investors, we spend relatively little time following and analyzing macroeconomic data. Quite simply, we feel our time is much better spent trying to understand companies rather than economies.

Secondly, the types of companies we like to invest in are typically generate ample cash and offer mission critical products and services to their customers. Therefore they tend to be, we think, somewhat less affected by economic cycles.

Thirdly, we only buy companies with conservative to strong balance sheets. So even in the choppiest of economic seas they are likely to have sufficient ballast to see them through to calmer waters. Our companies are not acyclical of course, but we think these fundamental strengths make them better positioned against, and less affected by, the reverberations of economic cycles than the market as a whole.

“We only buy companies with conservative to strong balance sheets. So even in the choppiest of economic seas they are likely to have sufficient ballast to see them through to calmer waters.” — Mark Rayner

What happens when the market disagrees with your view of a company?

Well, of course the market can often disagree with us on our investments. Hopefully, though, these disagreements generally prove to be only temporary. Often we find that poor economic news can negatively affect the sentiment towards our stocks, and therefore their market prices, to a greater extent than it does their actual earnings.

However, this often leads to some interesting investment opportunities. Fuchs Petrolub was an example of this. The stock price of this German specialist lubricant manufacturer was negatively affected in our view by, among other things, a global slowdown in the auto industry. So in 4Q18 we lifted this stock out of our database and into the portfolio, where incidentally it was previously held some five years ago.

However, this often leads to some interesting investment opportunities. Fuchs Petrolub was an example of this. The stock price of this German specialist lubricant manufacturer was negatively affected in our view by, among other things, a global slowdown in the auto industry. So in 4Q18 we lifted this stock out of our database and into the portfolio, where incidentally it was previously held some five years ago.

What can you tell us about the rationale behind the Fund’s recent investments in semiconductor-related companies?

This really links into the subject I was just mentioning; that is, the market’s perception of a company’s macroeconomic sensitivity versus the reality. The semiconductor industry has historically been brutally cyclical. The conventional wisdom is that due to the plethora of semiconductor applications these days, the industry will be less cyclical going forward. That may well be the case, but David and I would still be very cautious in investing directly in the industry for a variety of reasons, one of which remains the high level of cyclicality.

For example, I attended a conference in December 2018 and watched the presentation of the CEO of a Swiss company that’s the global #1 in valves for semiconductor manufacturing equipment. Following from the market’s decline in the second half of 2018, he was asked about the market demand for semiconductors in 2019 and replied, “I can give you a prediction. But the one thing I can guarantee you is it will be wrong.” That’s from a 30-year veteran of the industry. If he doesn’t know, David and I surely don’t know either.

That being said, however, we can find companies in the semiconductor space that are less cyclical, and less complicated from a technology point of view, that offer the superior visibility that we look for. But as with Fuchs, they can get tarred with a general macro brush that results in interesting price declines.

Can you give us an example?

XP Power is a U.K. company that designs, produces, and sells power control solutions. These are small, low-cost components designed into any device that houses a semiconductor. They are required in order to convert the AC from the mains to DC, which is needed for semiconductors to function. So the end markets are very diverse: Everything from industrial printing machines to drug delivery devices, factory automation equipment to audiovisual broadcast equipment. Therefore, taken as a whole, XP Power’s market demand is much less cyclical than that for the semiconductor manufacturing market.

Now around 25% of XP Power’s sales do go to the semiconductor fabrication market, and the company does have the word ‘semiconductor’ in its description. But we would argue that this is not in reality a semiconductor company. And driven, we think, by poor sentiment more than anything else, the stock is down more than 40% from highs and at multi-year lows. So we’ve been consistently adding to our position in XP Power as well as to a couple of other companies in this space, following a similar logic.

Can you discuss another holding that’s been lagging of late and why you and David believe its fortunes can be reversed?

In addition to XP Power, another price laggard that springs to mind would be Hansen Technologies, an Australian company that develops billing software used by utility, pay-tv, and telecommunication companies. This is application specific software, with a mission critical customer benefit that also has high switching costs. Simply put—for the customer it’s expensive, risky, and time consuming to switch its supplier of billing software. These are all attributes we are drawn to.

However, sales lead times can be very long for Hansen, which means that earnings growth doesn’t necessarily correlate with the six-month reporting cycle. This can, and sometimes does, lead to the company reporting earnings below market expectations. Admittedly we have found ourselves surprised on more than one occasion at just how negatively the stock market can react to such reports, which tend to ignore the company’s consistently high ROICs (returns on invested capital) and M&A-driven growth. We are at such a stage currently, with the stock at multi-year lows. But our conviction remains high as to the long-run prospects for the company.

Can you also talk about two companies that have been doing well? What factors have led to their recent strong performance?

SimCorp, which I mentioned earlier, is a good example. As an application-specific software company, it’s a mirror image of Hansen, with similar attributes. SimCorp develops software for the front, middle, and back office of asset management companies. As with Hansen, new license sales can be lumpy for SimCorp and not correlate with reporting periods. Such an occurrence led to a sharp drop in its stock price in the second half of 2018, which led us to buy back shares of the company, which we had previously held in the Fund. A subsequently strong earnings release for Q4 has seen the stock price power back to new highs.

Can you give us one more example?

Bravida’s stock price has been trading near all-time highs after a strong performance over the last few months. Headquartered in Stockholm, Bravida provides B2B engineering services in the field of electrical, heating, plumbing, and air conditioning systems. We have been holders of this high-ROIC company since early 2016, attracted by, among others things, the economies of scale it enjoys by being the number one provider in the Nordic region, allied to the opportunity to make well-priced M&A in a fragmented but consolidating market. Despite consistently solid operating performance, the stock has struggled over time to be fully appreciated by the market. However, a very strong earnings report in early January seems to have finally brought the strengths of Bravida’s business model to the market’s attention.

Article by The Royce Funds

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