I attended an investor conference in Tokyo in early September, and I returned from a similar event in Munich—a short hop from where I live in London—later that month. On the face of it, the corporate landscape in Japan and Germany appears similar. The two countries are of course both economic powerhouses—respectively the third and fourth largest economies in the world and in turn its fourth and third largest exporters.
My first meeting with a German corporation was back in 1991, where the seasoned CEO spoke only in German, and the annual report was also available only in German. Fast-forward to my recent visit to Munich, where the main language at the conference was English. As the CEOs and CFOs spoke intelligently and enthusiastically about their companies using clear and concise presentations, it was hard to tell that I wasn’t in London or New York.
Germany has an excellent reputation for producing high-quality products across many industries, but unlike many other countries, Germany is still filled disproportionately with private companies. We like the German companies we hold, and the way in which many are managed—we just wish there were more of them. It’s also a country where many CEOs are engineers, as opposed to the accountants you often find in the U.K., running businesses that make high-quality, world-leading products.
This arrangement has its advantages as German CEO-engineers have often had a longer tenure at the firm, having worked his or her way up through the engineering department rather than being an external hire, which you see more frequently in the U.S. and U.K. This experience gives that person a fundamentally better understanding of the product, the benefits it creates, and the customer’s needs—subjects that are very important in our strategy’s evaluation of companies. When we meet with these engineer CEO’s, however, we want to develop confidence that they also exhibit a deep appreciation of vital areas such as returns on investment and capital allocation, which are important in our evaluation of the company’s quality.
I met with two engineer CEO’s on my recent visit.Carl Zeiss Meditec, which enjoyed a strong quarter recently that sent its shares to new all-time highs, makes and services ophthalmic devices, such as microscopes, intraocular lenses, and therapeutic eye lasers, and microsurgery devices, including surgical microscopes and other micro-surgery visualization equipment. The last 10 years have seen the company consistently produce ROICs (Return on Invested Capital) of around 30% and average top-line growth of around 8% a year.
We’ve owned shares since the Fund’s inception in 2010. The firm has a global presence that’s benefiting from ageing populations, particularly in the West, and growing healthcare spending in emerging markets. Zeiss’s differentiated product line is helped by ongoing innovations that are made possible by the company’s status as a market leader and premier brand. This has led to a steadily increasing share of recurring revenues driven by sales of consumables and servicing activities. Our confidence in this holding remains high.
I also met with the management of NORMA Group, a company that makes metal and plastic engineered joining technology products such as connectors, clamps, and pipe couplings. It primary market is the auto industry, where it makes mass-produced, low-cost items that are designed into its customers’ products and single sourced. NORMA has been going through difficult times recently and I wanted to assess whether these difficulties were more likely to be temporary or long lasting.
NORMA generates consistent ROICs in excess of 35%, but the small size of its aftermarket business gives it a degree of exposure to the auto cycle. Global auto sales have been weaker so far in 2019, which, along with some internal cost issues, has brought NORMA’s stock to five-year lows. Its valuation appears to be reflecting these short-term cyclical industry and company-specific cost issues while not giving enough emphasis to the inherent qualities and value generation of NORMA’s business model. While these short-term issues steer its stock price, we have confirmed our conviction in NORMA and we’re content to patiently wait until investors focus once more on the business’s inherent qualities.
In Japan, the opportunity set is plentiful as there are numerous small-cap companies, though the quality varies widely. Even once we’ve run our initial screens for high ROICs and strong balance sheets—which we run regardless of geography—we never run short of potential leads.
So one challenge—and it’s a wonderful problem to have—is culling the list down to what we think is an appropriate weighting for a single country in the strategy. Another challenge is piercing the information barrier. Company meetings are rarely held in English, leaving any conversation to be funneled through an interpreter. The English sections of Japanese companies’ websites often lack relevant details—when they exist at all.
Similarly, investor relations presentations sometimes look clouded to Western eyes by masses of detail and/or are filled with unfathomable charts. This may be rooted in the highly competitive nature of Japanese companies, which often manifests itself in a wariness about releasing information online or even in financial reports. On the other hand, I have discovered over the years that Japanese management teams are much more open to face-to-face conversations with investors—which is one of the reasons that we visit the country at least once a year.
I think it’s also interesting to note that company leadership in Japan works quite differently from the way it works in Germany. Typically, the leader of a Japanese business has elevated him or herself over time from the ranks of what is known as the ‘salarymen.’ Recruited straight from university, the salaryman is effectively granted employment for life in exchange for complete loyalty and dedication to his or her firm over decades. It’s fair to say therefore that the average Japanese CEO has no particular bias in his or her background and can emerge after leading any number of departments ranging from corporate planning to software, from finance to R&D.
I think two companies which I met with on my recent trip effectively encapsulate the way we approach investing in Japan. TechnoPro operates what is known as an employee leasing business. The firm hires a large cadre of around 20,000 skilled professionals that it then contracts out to client companies on rolling contracts. These businesses work especially well in countries with more restrictive labor laws and an ongoing demand for, but shortage of, skilled personnel (e.g. Japan, Germany, and France). The client companies are willing to pay a significant premium to the leasing company in return for labor flexibility and access to a ready pool of talent.
Indeed, the portfolio already owns a stake in a similar company, Meitec, which is the number two company in its industry in Japan based on revenues (TechnoPro is first). I’m happy to hold both companies based on my confidence in these high-ROIC business models and the fact that TechnoPro serves more highly diversified end markets, such as IT, construction, and electrical, compared with Meitec’s tighter focus on mechanical engineers.
I also visited with another holding that is enduring current challenges. EPS Holdings provides outsourced services to the pharmaceutical industry, specifically research, sales and site organization. These contract research organizations (CROs) offer clear benefits for corporate customers by focusing on critical but non-core activities at relatively low cost. We were initially attracted to EPS’s diversified contract mix and broad, but agnostic, leverage to the pharmaceutical industry’s demand dynamics. We became more and more concerned, however, about changes to the competitive landscape of Japan’s CRO market. The nature of the customer relationship in Japan appears to be evolving to the detriment of the CRO’s that operate there, with pharmaceutical companies increasingly able to cherry-pick from among several CRO offerings. So in contrast with our decision on NORMA, in this case we concluded the challenges were likely to be enduring and we moved on from this investment last summer.
The strategy’s consistent and rigorous evaluation process allows us, I think, to invest in countries with corporate cultures that differ in important ways from the cultures of the U.S and the U.K. Years of on-the-ground research and face-to-face meetings in countries such as Germany and Japan have enhanced the conviction-building process, which benefits from pattern recognition of similar business models and situations. Utilizing a consistent set of quality parameters over an extended period of time helps us to recognize the truly high-quality companies regardless of where they are located.
Mr. Rayner’s thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.
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.
