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The Evolution of International Small-Cap Investing at Royce
Posted by: Holly LaFon (IP Logged)
Date: June 18, 2013 11:43AM
Portfolio Manager and Director of International Research David Nadel provides a close look at Royce’s involvement in international small-caps, stemming from our initial positions in the mid-1990s through developing proprietary metrics for looking at non-U.S. companies.In the mid-1990s we began to invest opportunistically in non-U.S. equities in our primarily domestic portfolios, typically in international companies with a strong U.S. presence. Our approach evolved from there as we came across many micro- to mid-cap companies across the globe that offered unique business models that did not exist within the U.S. As time went on, we steadily broadened our overseas exposure to include this class of companies.
In December 2006 we launched two new funds—Royce Global Value Fund and Royce European Smaller-Companies Fund—and we renamed Royce Select Fund III Royce Global Select Fund (now Royce Global Select Long/Short Fund). David Nadel joined Royce some six months earlier, bringing with him his experience investing in non-U.S. smaller companies while he was based both in New York and in Hong Kong. At the same time our London-based analyst Mark Raynerjoined Royce, bringing 20 years of experience focused on European small-caps. In 2010, David was named Director of International Research.
Since then David has helped Royce refine our investment approach in the international investment arena, heading up Royce’s International Team supported by Mark Rayner and later George Wyper, Jim Harvey, and Dilip Badlani. In 2008 we launched Royce International Smaller-Companies Fund and, in 2010, we introduced Royce Global Dividend Value, Royce International Premier, and Royce International Micro-Cap Funds.
Can you discuss Royce’s attraction to international small-caps?We see international small-cap as a rapidly growing asset class. There is upwards of $50 billion in the U.S. dedicated to actively managed international small-cap, and net inflows have been adding around 7-8% per year to this asset class for the last few years.
From our perspective, non-U.S. small-caps offer a large universe of companies that we believe can benefit from disciplined active management due to its inefficiencies. To give you a sense, there are more than 2,700 small-cap companies outside the U.S. representing $3.8 trillion in aggregate market cap, more than three times the U.S. small-cap universe of 831 companies aggregating to $1.2 trillion in market cap.1
One of the guiding principles of our investment approach is to try to capitalize on market inefficiencies in order to generate strong absolute returns while paying constant and close attention to risk. As we see things, the large number of non-U.S. smaller companies, combined with limited research coverage, often creates mispriced equities, providing opportunities for disciplined, long-term investors like Royce. Having such a large universe affords us the luxury of focusing on quality first so that we are able to apply our strict valuation criteria to a more selective and higher-quality subset of the total universe.
There are a number of specific characteristics that attract us to non-U.S. small-caps—at least the higher-quality companies in which we choose to invest. First, many non-U.S. smaller companies occupy strong market shares which they have built over very long operating histories and during which they have survived repeated economic turmoil.
Semperit, a manufacturer of specialized rubber products and one of our larger non-U.S. holdings, is the globe’s largest maker of escalator hand-rails and the largest European maker of surgical gloves; positions it has consolidated over much of its history (which dates back to its founding in 1824). Santen Pharmaceutical, founded in Tokyo in 1890, is the largest Japanese and Chinese provider of ophthalmic pharmaceuticals, including one key drug in-licensed by Merck.
Second, many of our companies have competed globally for years and have a geographically diversified base of revenue, costs, and even currencies. Victrex, a manufacturer of high-end plastics, usually generates 98% of its revenue from outside its home market of the U.K.
Third, non-U.S. smaller companies have a strong culture of paying dividends. Spirax-Sarco, the global number one in steam systems, has increased its dividend for 44 straight years. Domino Printing, a U.K.-based R&D and manufacturer of industrial printing equipment, has increased its dividend for 36 straight years. Dividends are an important part of total return in our international portfolios, and indeed dividend yields in Europe and many Asian countries are about twice as generous as those of U.S. small-caps.
Lastly, some non-U.S. small-caps provide Royce with unique pure-play exposure to businesses that are not currently replicated in the U.S. For example, U.K.-based Ashmore Group is the global number one pure-play in emerging market fixed-income asset management. France is home to Vetoquinol and Virbac, the world’s two leading pure-play animal pharmaceuticals companies.
What are the cornerstones of Royce’s investment philosophy in the small-cap international space?We look for the same attributes that we look for in U.S. companies—strong balance sheets, high returns on invested capital (ROIC), and the ability to generate free cash flow.
While much of international investing seems to be macro-driven, consensus-oriented, and growth-obsessed, we use a fundamental, bottom-up approach. Specifically, we look to target companies whose balance sheet is comprised at least half by shareholders’ equity and companies that have generated on average 15% or higher returns on invested capital during the past five years. The way I see it, good businesses should indeed have strong balance sheets since there should be no need for external financing if their returns are strong enough to make the business self-funding.
One of our top holdings, Mayr-Melnhof, is the global leader in recycled carton-board and generates enough excess cash to maintain operations for two years without any additional cash flow. We think companies like this are in a position to take market share from weaker players during tougher periods of economic cycles.
We have an experienced team of six portfolio managers and analysts dedicated to foreign investing. The team travels extensively to source and analyze companies around the globe, meeting with the management teams, competitors, and suppliers of around 300 non-U.S. companies each year. We’re always on the search for globally-structured, self-funding businesses with strong market positions.
Can you explain in more detail how our quality standards apply to non-U.S. companies?Initially, we use a wide range of screening tools, including quantitative screens that focus on equity ratio, liquidity, market cap, balance sheet strength, and ROIC. These quantitative measures function as signposts of quality, but by themselves are not sufficient to select the equities that ultimately meet our standards for inclusion in the international portfolios. For the companies that pass these quantitative screening requirements, we will meet with management teams—a key part of our qualitative due diligence—and put our proprietary Enterprise Quality Scoring system (EQS) to use.
EQS ranks companies based on five factors that make up the acronym “SCORE”: attractiveness of Sector, a company’s Competitive position, Operating efficiency, financial track Record, and theExtras we see as strong indicators of quality, such as franchise sustainability, corporate governance, etc.
Companies receive a score of 0-10 in each of the five categories with a total score adjusted to a scale of 100. Companies with an EQS of 51 or higher are considered for potential investment, and those with an EQS of 70 or higher are considered “premier.” I say “or higher” because I don’t think we’ve ever scored a non-U.S. company higher than 91—I think we’re tough graders!
EQS creates a track record of our assessment of the quality of the business. Put another way, it measures our conviction in the business model. It is separate from valuation, and we’ve been very deliberate about distinguishing the two because we want to avoid the common pitfall of targeting statistically cheap companies but winding up with low-quality holdings.
In terms of valuation, we target a 15% cap rate at entry and a 7-8% cap rate at exit, implying that we seek an intended return of 100%. We calculate cap rate by dividing EBIT by Enterprise Value, which equates to a company’s earnings yield before taxes. The cap rate is the inverse of a multiple. Our 15% cap rate at entry equates to 7x operating income, or roughly 10x post-tax earnings, and our 7-8% cap rate at exit equates to 14-15x operating income, or a high-teens post-tax earnings multiple.
We establish fundamentally derived sell triggers for each position when we first begin to buy shares. We update them regularly so that when a position reaches an initial sell trigger, it results in a position review rather than an automatic scale.
We typically sell incrementally once companies achieve our estimate of intrinsic value, better risk/reward potential exists in other investments, business progress fails to track our assumptions—or what we view as the financial margin of safety becomes impaired—and when companies are acquired, typically selling prior to the close of the deal. The international group uses a second valuation methodology which ties valuation back to our hurdle of a 15% five-year average trailing ROIC. The advantage of this method is that it analyzes a fuller market cycle of five years, and therefore is particularly helpful in the more deeply cyclical sectors.
Important Disclosure Information
David Nadel is a portfolio manager and the Director of International Research of Royce & Associates, LLC, investment adviser to The Royce Funds. He serves as portfolio manager for Royce Global Value (RGV), International Smaller-Companies (RIS), Global Select Long/Short (RGS), European Smaller-Companies (RES), International Premier (RIP), and International Micro-Cap (RMI) Funds. David also serves as assistant portfolio manager for Royce Low-Priced Stock (RLP), Value Trust (RVT), and Global Dividend Value (RGD) Funds. The thoughts and opinions expressed in the interview are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. There can be no assurance that companies that currently pay a dividend will continue to do so. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus). Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies.
There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future.
Royce Fund Services, Inc. is The Royce Funds' distributor and a member of FINRA and SIPC.
1Reuters as of 3/31/13
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