What is it about the South Korean market that you find so compelling?
Dilip Badlani: Korea has always been an interesting market for us. It's a very deep market for micro-caps—there are approximately 500 companies with market caps between $100 million and $1 billion.
On top of that, a lot of these companies are unlevered—half of these companies have asset-to-equity ratios of 50% or more, which is what we typically look for. The country is easily accessible for us and we have great coverage from the sell side, which helps us to identify companies that meet our investment requirements and high standards.
Jim Harvey: It's always good when we can screen a market that has this much depth because it typically leads to a robust schedule of meetings with company management teams.
Seoul is one of the least convenient cities to navigate because of its sheer size, so arranging an itinerary there can be tricky. But like many of the other Asian markets we visit, companies are perfectly willing to meet with us. While there are some exceptions, management teams are, for the most part, open to speaking with foreign investors.
Dilip: As a country, what's impressive to us about Korea is how it's evolved. In the 1980s it was largely a manufacturing center, and though it is still heavily concentrated in manufacturing, a lot of it has shifted to high tech.
A lot of these Korean companies have become global leaders that supply the likes of Samsung, LG, Hyundai—these iconic brands that everybody knows.
Many of these companies have manufacturing capacity everywhere around the world, and as these larger companies grow these Korean suppliers follow them around and are able to provide them with niche products for their specific needs.
Jim: The Korean government was a big advocate of Korea's tech influence. Eugene Technology, for instance, basically got its start during the Asian financial crisis when the Korean government was making a push for the big tech players to source more from smaller companies in the country.
Dilip: Korean GDP per capita is amongst the highest in Asia—it's a trillion-dollar economy, and unlike a lot of other countries it runs a current account surplus. So fiscally the country looks well managed. And most Korean companies, because of the history of the country, are export focused.
South Korea is the seventh-largest exporter in the world, with exports making up roughly half of the country's GDP.
Jim: The Korea Composite Stock Price Index (KOSPI) is very sensitive to the global economy: A lot of U.S. strategists look at it as a leading indicator of global growth.
Dilip: There are a decent amount of exports from Korea within Asia, and I think most investors fail to appreciate that.
As demand in these countries has grown, Korea has been able to provide the same quality of product that a lot of Japanese companies used to produce. What Korea has done in the span of 30 years has been pretty impressive.
Can you talk a little bit more about Korea's influence on other Asian markets?
Dilip: Like many other Asian populations, Korea's demographics have been a real challenge to the economy. The birth rate has really shrunk—it's among the lowest birth rates around the world.
Jim: This happened partially because the government promoted smaller families in the 1970s and ‘80s. In addition, South Koreans place a huge emphasis on education.
As is typically the case in any developed country with a focus on education and its costs, people have fewer children.
Dilip: As the economy has matured, the number of children being born has declined significantly, which reduces internal consumption.
As a result, the country is forced to target markets such as India and the Philippines because that's where demand is growing—it's an intelligent way to play the overall Asian demand story. But it's definitely a worry for the country.
You've had some success with Korean Health Care companies in International Micro-Cap's portfolio in the past, specifically pharmaceuticals. Is there any current exposure to the sector?
Jim: We've enjoyed success with a few Korean Health Care stocks in the past—we just recently sold our shares of Samjin Pharmaceutical, which made a strong contribution to first-half performance. We also owned Daewoong Pharmaceutical, which was the second-largest contributor to 2012 performance. But as of June 2014 we do not hold any Health Care stocks in the portfolio.
Dilip: Unique to the market, a lot of the healthcare companies from the U.S. and Europe have to partner with a Korean company to sell their drugs in the country—they are not allowed to go in directly.
Right now we're not seeing anything compelling in our valuation range. Typically, we have looked for and owned services companies within the industry—the marketers and distributors—not the companies producing the drugs.
Tell us about some of the companies you visited.
Dilip: On this last trip we met with 15-20 companies. Eugene Technology, which Jim mentioned earlier, is a very well-run semiconductor equipment supplier located about an hour outside of Seoul that focuses on semiconductor capital equipment.
Jim: The company had a 10-year sales compound annual growth rate of 48%, so we were able to buy a growth company at a value multiple when we discovered it.
The founder was head of Korean sales for Teradyne and Brooks Automation, two companies that we know very well because they've been held for several years in some of our domestic Funds here at Royce.
The company's main competitive advantage is that its cost structure is lower than that of its global competitors—in particular, Eugene's R&D spend is lower than other large global players because, as a small company, it has fewer product lines.
Eugene Technology provides unique thin-film deposition equipment. One of its products utilizes low pressure CVD technology.
Management believes the total addressable market for this type of equipment is $1 billion, and they are targeting a 10% market share. The company also manufactures atomic layer deposition equipment, which is a $500 million market. Eugene's share is only 6% today.
Dilip: This is a business where paying attention to cost is very important. This was our first visit with the company. Just going to its site and seeing how it operates eliminated any doubt we had about management's focus on profitability.
Jim: It's basically a nimble, second supplier to the market, usually behind a company like Applied Materials. When we met with management they described a project that took two to three years to develop internally based on a technology called epitaxy.
Today, Applied Materials is the only supplier of that kind of equipment. Eugene's product was just rolled out and the firm is targeting a 10% market share.
Dilip: Another name we picked up on this trip was textile manufacturer Huvis Corporation. This is a classic value stock trading below book value that pays a dividend.
Textiles is a tough industry, but Huvis is the market leader in a low margin niche. It generates decent returns on invested capital by being the lowest cost player in the industry. And because the industry is so competitive there's no new capacity coming on board.
Jim: The stock has been down recently. We view it as a low-risk business model that we think, given the valuation, will eventually turn around.
Dilip: Korea also has a big shipbuilding industry—it makes some of the best, biggest ships in the world. So for the LNG (liquefied natural gas) buildup that's happening globally, a large percentage of the ships are being built in Korea.
We recently bought shares of a company called HanKuk Carbon, which makes the insulation for the ships carrying LNG. It's one of only two companies that are certified to provide insulation equipment—its competitor is another Korean company.
So it's pretty remarkable that you have an industry being built around only two companies that can currently supply the insulation equipment. We think HanKuk will be a beneficiary of the global LNG build out, where demand is only likely to increase.
Important Performance and Expense Information
All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 2% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Gross operating expenses reflect the Fund's total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund's most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Fund's net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) at or below 1.69% through April 30, 2015 at or below 1.99% through April 30, 2024. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investment.
Important Disclosure Information
Jim Harvey and Dilip Badlani are portfolio managers of Royce & Associates, LLC, investment adviser to The Royce Funds. In addition to managing Royce International Micro-Cap Fund (RMI), Jim is Portfolio Manager for Royce Heritage Fund (RHF), Royce Micro-Cap Discovery Fund (RDF), and Royce Select Fund II (RS2). He also serves as Assistant Portfolio Manager for Royce Dividend Value Fund (RDV), Royce Global Dividend Value Fund (RGD), and Royce Micro-Cap Trust (RMT). In addition to managing RMI, Dilip serves as Assistant Portfolio Manager for RGD and Royce International Smaller-Companies Fund (RIS). The thoughts and opinions expressed in this piece are solely those of Mr. Harvey and Badlani 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 in the future.
This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Royce International Micro-Cap Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks The Fund may invest a significant portion of its assets in securities of companies headquartered in foreign countries, which 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 Foreign 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. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss.