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Holly LaFon
Holly LaFon
Articles (8375) 

Royce Funds Commentary: Why PM Mark Rayner Says, 'Stay Invested' in International Small-Caps

PM Mark Rayner discusses the recent volatility in the global equity markets and how it’s impacting Royce International Premier Fund

March 09, 2018 | About:

Royce International Premier Fund enjoyed very strong performance in 2017, up 39.8%. How are you and David dealing with the increased volatility in the global markets so far in 2018?

“Volatility” is an interesting word when it comes to investing. It seems to me it’s most often used in a negative sense—something to be feared or a synonym for risk.

David and I really don’t view volatility that way. We’re long-term investors, and I would really encourage most equity investors to think in medium- to long-term time scales, preferably an investment horizon of three years or longer.

For investors who can do that, short-term volatility ceases being a genuine risk. Rather, it becomes a potential opportunity to buy more shares of a good company at better prices.

That’s very much how David and I are dealing with the increased volatility we’ve seen so far in 2018. We always track the stock price moves of our holdings very closely. We’ve been adding to existing positions where interesting opportunities have arisen as a result of the recent stock price volatility.

The Fund is quite concentrated, typically holding around 50 names, as it did at the end of 2017. All of the companies are therefore high-conviction investments.

Has the increased volatility created other opportunities?

We track the prices of companies in a database we’ve built together over the last 11 years. This database represents the highest-quality companies we’ve found within the international small-cap asset class. Our investment process means we also have a high degree of conviction regarding the quality of these names even though they’re not in the portfolio.

The stock price volatility we’ve seen over recent weeks has enabled us therefore to cautiously add a few new names to the portfolio sourced from our database. Most of these companies we have been tracking for years.

How does the Fund’s historical volatility compare to its benchmark and peers?

Over the last five years, through the end of 2017, the Fund has consistently shown significantly lower volatility than both its index and a large basket of peer funds whilst also delivering market-leading returns. We attribute this to the type of companies in which we invest. We tend to eschew deep cyclicals, turnarounds, and loss-making companies.
Rather we focus on businesses that have historically delivered consistent and superior returns on capital and that we believe can continue to do so well into the future. These types of companies have historically tended to generate less volatile stock price moves.

The Fund was in the lowest volatility quintile compared with all funds in Morningstar’s Foreign Small/Mid Growth, Foreign Small/Mid Blend, and Foreign Small/Mid Value Categories with at least five years of history, a total of 81 funds as of 12/31/17. The universe consists of each fund’s oldest share class only. Volatility quintiles are based on the average five-year standard deviation for each of the last four calendar quarters. Higher volatility is usually associated with higher risk.

How important is valuation to your investment process?

We pay very close attention to valuation. For us, this isn’t so much the current earnings multiple as much as the value the business can create over the long run. This in turn is a product of the long-run returns on invested capital and the growth the company can generate.

This means of course that a stock with a high current multiple may actually be cheaper in the long run than a stock whose current multiple looks low. It also means that short-term share price volatility doesn’t normally change our views on which sectors or industries offer the best long-term valuations.

Of course, within our preferred sectors and industries individual companies have recently become more interesting from a valuation standpoint. But not necessarily the industries or sectors themselves.

We focus on businesses that have historically delivered consistent and superior returns on capital and that we believe can continue to do so well into the future. These types of companies have historically tended to generate less volatile stock price moves

Can you talk about two companies that have been lagging and why you and David believe their fortunes can be reversed?

Two names that stick out are IPH and ITE—both have had disappointing stock price performances over the last year or so.

IPH provides intellectual property (IP) services. It files, prosecutes, enforces, and manages patents, product designs, trademarks etc. for the IP holder.

Operating in Australia, where it is the market leader, its business in Asia has also been increasing. IPH exhibits many of the characteristics we like in companies, such as a highly fragmented revenue stream, a defensible economic moat, very high returns on invested capital, and plentiful, predictable cash flow.

Since its 2015 IPO, earnings have not quite met the expectations of both management and analysts on a couple of occasions. We did not invest in the IPO—we rarely do. We prefer to sit on the sidelines with IPOs, as any earnings misses in the first year or two so often can lead to very exaggerated and sentiment-driven stock price falls. We bought after the significant share price decline following the first earnings disappointment.

Whilst a second has followed since we have been shareholders, we think that the challenges are short term—for example, timing issues of patent filings—and not structural. It’s also a business where the long-term visibility is perhaps better than the short-term visibility, which is OK with us.

What about ITE?

Based here in the U.K., ITE is another B2B service provider. It organizes trade exhibitions and conferences. If you operate the number one trade exhibition for a particular sector in a particular region, you have a robust local monopoly, rarely attacked by competitors. Operate a number of these, and you have a portfolio of local monopolies.

Importantly for us, ITE doesn’t own the venues but rather rents them, which enables very attractive returns on capital and cash flow generation.

Although it’s been reducing its exposure over time, the company has historically done a lot of business in Russia and the former Soviet Republics, and the decline in the oil price that started in 2014 subdued conference attendance in these mainly oil-dependent economies.

Although we invested after the stock price reacted to this cyclical downturn, so far—perhaps surprisingly—its shares have failed to respond either to the quite distinct signs of economic recovery or the arrival of what we think is a very impressive new senior management team. But we continue to think that our patience will be rewarded.

What about two companies that have been doing well?

Two names I would put forward are XP Power, another U.K. business, and Relo, which is based in Japan.

XP Power designs, develops, and manufactures power control systems, which are components built into a wide variety of electronic equipment. Their primary purpose is to transform AC electrical current from the mains into the DC that electronic equipment needs to run on.

This is a consolidating niche market with ample growth driven by the increasing amount and variety of electronic equipment in modern life. XP Power’s components are used in everything from CT scanners in hospitals to semiconductor manufacturing equipment, from factory automation equipment to drug delivery systems.

We particularly liked that its diversified and growing end markets, new design wins, and acquisitions combined to push revenues 28% higher in fiscal 2016 and a further 29% in fiscal 2017.

Our view is quite simple: stay invested. Buy more of a good thing. Don’t try to time investments according to one’s analysis of the business cycle.

What’s been working for Relo recently?

Relo provides outsourcing services to Japanese corporations principally in the field of fringe benefit provision. In Japan corporate fringe benefits are a big deal—they play an important role in the attraction and retention of full-time staff. It’s a robust market that continued to grow even throughout the Financial Crisis.

Corporations are increasingly outsourcing the management of their fringe benefit systems to third-party providers in order to increase their own operating efficiencies. So Relo benefits from providing a value-added customer service in a robustly growing market, a highly fragmented revenue stream, and structurally low capital intensity.

In fiscal 2016-17, revenues grew by 12% and operating profits by 22% as margins edged up due to scale economies. After three quarters of fiscal 2017-18, operating profits rose another 18%.

As bottom-up investors, how much time do you spend looking at sectors and industries or examining business cycles?

The starting and ending point for us is the individual company. We’re looking for businesses that exhibit a certain set of characteristics, those that our experience strongly suggests will generate consistent and superior returns on capital over the long term.

We don’t think we can add much to the medium- to long-term investment returns for our investors by attempting to analyze the business cycles of sectors or industries. So while our bottom-up strategy naturally tends to lead us to certain sectors and industries (and also finds us de-emphasizing others), those preferences are not determined by our perception of the business cycle.

Although we try to avoid deep-cyclical companies and look to invest in robust compounders, it’s fair to say that just about every company has some degree of cyclicality in its business. Which is fine. If a portfolio holding or another company held in our database experiences a rough patch in its operational performance due to a temporary change in the business cycle, and the stock price reacts negatively, that’s another example of the opportunity created by volatility.

Our view is quite simple: stay invested. Buy more of a good thing. Don’t try to time investments according to one’s analysis of the business cycle. In our opinion, very few people do business cycle analysis with consistent accuracy.

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of March 6, 2018 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. Past performance is no guarantee of future results. Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. All performance information is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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