As the pace of global growth continues to slow, Mark discusses why our Quality at a Reasonable Price (“QARP”) strategy is focused squarely on fundamental quality in international small-cap stocks.
At the end of June 2018, Royce International Premier had increased exposure to companies in industrials and technology while having lower exposure to those in materials and financials. What factors have guided your own and David’s thinking around the portfolio so far in 2018?
These moves should be seen in the context of two important points, I think. Firstly, as we always stress when talking about our Quality at a Reasonable Price (“QARP”) strategy, David and I spend the bulk of our time looking at companies, with far less attention paid to macroeconomic or political factors. So any changes to sector and industry weightings are very much driven from the bottom up.
Secondly, it’s also important to highlight that the Fund’s assets grew by 45% from the end of 2017 through the end of June 2018 due to new subscriptions. Therefore, a sector or industry weighting can be reduced simply by position weightings not growing commensurately with the overall growth of the Fund.
International Premier Sector Breakdown
Sector Weights 12/31/17 vs 6/30/18
That’s precisely what happened with Materials and Financials. On an absolute dollar basis, we actually increased our investments slightly over the six-month period. In the first six months of 2018, then, our bottom-up process led us to what we thought were better opportunities in technology and industrial companies than those we saw in other areas.
Are these weightings consistent with how you and David have historically built the portfolio?
Yes, the Fund has always had higher weighting in Industrials and Information Technology. Given our QARP strategy, which focuses on companies with strong balance sheets along with consistent and superior returns on invested capital, we simply find these large and diverse sectors much more target rich whereas, in comparison, we’ve tended to be more constrained in the Materials and Financials sectors.
For example, we usually avoid investing in mining companies, whose revenues are dictated by the spot pricing of commodities, or in banks due to their balance sheet structures.
How has the slower pace of global growth affected your view of companies?
It hasn’t had a dramatic effect—in fact, I’d say so far it’s had very little if at all—for a number of reasons. Macroeconomic factors are often shorter in duration and do not always go to the heart of which companies will create the greatest shareholder value over the long run. For us, the driver is always the company’s fundamental quality, which we measure as those capable of delivering superior and consistent returns on invested capital. For us, this is an iron law.
In contrast, we think growth is nice to have—but it’s not a must have. Whether a company is likely to grow over the next few quarters at, above, or below trend is not of the highest consideration in our investment view on a company.
What are your thoughts about rising interest rates?
Rates have been abnormally low for a long time. In my home country of the U.K., for example, they have been at a 300-year low for almost a decade!
Rates, however, finally seem to be on the rise around the world. Again taking the U.K. as an example, base rates were recently increased by 0.25% to 0.75%. That may not sound like much, but it’s actually a 50% increase.
This suggests that economies are continuing to return to normal after the Great Financial Crisis. As our holdings in International Premier have strong balance sheets, we don’t think that rising interest costs will lead to much, if any, pressure on their earnings, which is not likely to be the case with the financially leveraged companies we avoid.
Indeed, as many of our companies hold net cash, rising interest rates may actually benefit them in terms of increased interest income.
Has the decline in the Turkish market led you to any interesting investment opportunities there?
Not to any great extent. The Fund does not hold any Turkish investments currently—in fact, it’s never held any. Moreover, there are also no Turkish companies in the large database of high-quality international small-cap companies that we’ve been gradually building over the last several years.
David and I have visited Turkey on a couple of occasions, but each time we simply failed to find the kind of robust business models that exhibited the specific set of characterizes we always look for.
Furthermore, we were often left with the impression that the businesses we encountered may not actually remain the same businesses in the future. Too many management teams seemed eager for the kind of growth that looked likely to expand, we think mistakenly, beyond their current franchises.
Or we found businesses with dominant parent companies that had all too often unexpectedly saddled them with new, often quite unrelated, businesses.
What are your thoughts around Brexit?
Being English and living in England, this is a subject which is of great interest to me. In addition, the Fund has a significant exposure to the U.K., which we see as a very target rich market.
However, even with all of the constant media coverage, we typically don’t allow top-down issues to cloud our investment process.
Brexit offers a very good example of why. The outcome is unknowable. Do we get a hard Brexit, and therefore some economic turbulence in the U.K. and Europe, and most likely a weaker GBP? Or a softer Brexit, leading to more business as usual and a strengthening GBP? Or perhaps even a second referendum and no Brexit at all?
We’re not going to position the portfolio in anticipation of one of these events. Instead, we’ll continue to look selectively at longer-term U.K. opportunities as they arise.
Can you discuss two companies that have been lagging of late and why you and David believe their fortunes can be reversed?
Let me start with one of our Swiss companies, LEM Holding, which designs, manufactures, and sells voltage transducers. These are components designed into third-party electrical products, such as electric motors, which enable the contact-free measurement of the motor’s current or voltage for control purposes.
We’ve held shares in the Fund since 2012, initially drawn to its dominant, global number one position in a growing niche business that sells to diversified end markets and customers. Over the years LEM has performed very well both as a business and a stock. However, it’s lost about a quarter of its stock market price so far in 2018.
What’s the thesis behind your optimism, then?
LEM’s operational performance remains positive. A recent quarterly report saw revenues and earnings again growing by double digits. We suspect that the share price decline this year has been driven mainly by profit taking. Multiples did admittedly become quite high in 2017.
However, with the business generating returns on capital of greater than 50% and growing revenues at mid- to high-single digits, it is only a matter of time, we think, until the often underestimated power of compounding starts to drive the stock price upwards again.
What’s the second example?
I’ll take one from the other side of the world—Australia. Hansen Technologies develops, installs, and supports billing software for companies in such sectors as utilities, energy, and telecoms. David and I are often drawn to software companies that address a mission critical customer need and can exhibit a very close and long-term customer relationship. And as unashamed non-technologists, we also look for an application we can easily understand.
We saw all of this and more with Hansen. In June of this year, however, the stock price fell materially after the firm reported first-half earnings that missed market expectations. Yet in our view Hansen is a very robust long-term business. We see the earnings miss as driven by the fact that the company has very long sales cycles. Its earnings flow is not always captured in its six-month reporting cycles.
We are very much of the opinion, therefore, that the stock price decline was an overreaction to what will be shorter-term muted earnings. Our long-term investment thesis on the company remains unchanged.
Can you also talk about two companies that have been doing well? What factors have led to their recent strong performance?
I gave you a European and an Australian example of recent underperformers, so let me balance that with a European and an Australian stock that have done much better of late—Sartorius Stedim Biotech and Bravura Solutions.
Sartorius Stedim is listed in France but headquartered in Germany. It designs, manufactures, and sells principally single use or consumable products used by biopharmaceutical companies in everything from initial R&D through full-scale drug manufacturing.
The business has a large number of characteristics that we find very attractive, such as drug-agnostic exposure to the high-growth biopharma market, an oligopolistic market structure, and products that are mission critical but nonetheless a small proportion of its customers’ total cost. These products have technology-based barriers to entry that are further raised by the strict certification processes imposed by the FDA and other regulatory authorities around the globe.
After some years of strong price performance (whilst unfortunately we were not owners), we watched as the stock then lagged for a couple of years, which we estimated was due to short-term factors. We first bought shares in early 2018. Since that time, strong earnings announcements and favorable long-term guidance have reignited the stock.
Bravura Solutions is another Australian software company, which develops and sells for the wealth management and investment fund administration markets. Again like Hansen, it exhibits the features we look for in a software company: a market and product application we can readily understand that also delivers mission-critical customer benefits. Bravura had an added interest—when we first talked with management, its stock was trading below its IPO price (from the previous year), making it available to buy at unusually attractive current earnings multiples.
This was despite the company offering a market-leading product, developed after a multi-year period of substantial R&D and taking market share in a nicely growing market. Further strong earnings, broker upgrades, and customer wins have led to some substantial investment gains for us since we first bought the stock in 2017.
Important Disclosure Information
Average Annual Total Returns as of 6/30/18 (%)
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 30 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 at www.roycefunds.com. All expense information is reported as of the Fund's most current prospectus and include management fees and other expenses.
Mr. Rayner’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. 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.
