Select Global Small Caps Companies Thriving In Down Market

Seven Questions for David A. Nadel of Royce & Associates

November 13, 2018


Why does Royce believe now is a good time to invest in international small caps?

In the bigger picture, international small caps have the best Sharpe ratio on rolling 10-year data of any equity or asset class. It also has produced the best absolute returns over the same rolling periods. That combination makes a very strong structural case for the asset class.

The timely case is very strong as well. U.S. valuations are roughly double international valuations. We are very bullish. There is a perception that the U.S. economy is doing better than a lot of the international economies and we have gone through the beginnings of our tightening cycle. That could be a little bit of a headwind for international equities once that begins happening abroad.


If valuation is half in the international markets, is it already priced in?

Probably. Valuation is very low but also based on depressed corporate profit margins. There is about a 400-basis-point gap between international profit margins, operating margins typically excluding the financial sector. Those are 7% outside the U.S. and 11% in the U.S., a huge gap.

International markets have had a low multiple put on low margins, setting things up for quite a bit of upside risk in margin expansion, slow improvement in profitability levels. International markets have been a little behind the U.S. in economic trends over the last 30 years, certainly since the Financial Crisis where the U.S. got productivity gains and swallowed a bitter pill with restructurings and recapitalizations. Much of the international developed world kicked the can down the road. Now, 10 years later, they are in position to benefit from this low base.


How much of Royce’s bullish outlook results from currency moves?

The big story of this year, of course, has been the U.S. dollar. That is always the place to go when there is broad-based outperformance or underperformance of international versus the U.S. The Australian dollar is down 10% year-to-date. New Zealand dollar is down 10%. These are just some of the places we are overweight. In Sweden, the krona is down 12%-13%. Emerging markets currencies have just been obliterated: the Turkish lira is down 40%.

These are dramatic dislocations, and that does tend to create some nice opportunity. With rising rates and any normalization with the dollar, this asset class is capable of attractive returns.


How do you expect U.S. interest rate increases to impact international small caps?

It could certainly cause dislocation initially, in the medium-term and long-term, yet it can be positive for international small caps and particularly for our type of strategy. In rising rate environments, typically international small caps have done a lot better than international large caps. That outperformance is one positive. It also implies that correlations of international small cap versus other equity classes will decrease in rising rate environments, a second positive.


How would you describe Royce’s reliance on quality in picking names for portfolios?

Ours is a quality at a reasonable price strategy. Quality-focused means the businesses we select have very strong balance sheets and generate high returns on invested capital. They tend to be nice self-funding compounders. Weaker competitors that are levered got to hang on by their fingernails with low interest rates to service their debt. Our companies do not have debt, so imagine what rising-rates will do to narrow the competitive field.


In the most recent quarter, industrials and technology were very strong small cap market outperformers. Within the industrial sector, machinery was especially robust. Two companies, Kardex and AIA Engineering, had very good quarters. Why?

Kardex and AIA Engineering reported numbers that were very encouraging. They are both in spaces that are timely.

Kardex is a Swiss asset-light logistics company focused on warehouse automation and materials handling. They are basically a play on the increasing automation of the retail sector, a play on the challenges of bricks-and-mortar as retailers move more towards e-commerce models. Kardex reported first-half revenues up and very strong EBIT, up about 20%.

AIA Engineering, an Indian company, is interesting because one of the big third-quarter themes is that emerging markets (EM) continue to struggle. It shows you can get good performance from EMs, if you are in the right place at the right time; that’s luck and timing. AIA Engineering is one player in a global duopoly. They have almost a 40% global market share. They make a grinding media, chromium balls used in the production of cement and in the mining industry, for mining coming off a trough. A lot of construction is going on in their markets and they have had continued to post strong results.


How about technology?

I have two examples, both software companies in Australia.  Australian companies are very generous with dividends, which helps to explain why Australian equities have produced the best return of any global market over the last 100 years.

Bravura Solutions provides funds management and wealth management software, similar to a DST, SunGard, or Charles River. Bravura has signed up twenty-four clients, more than the scope of firms in Australia.  They are now targeting English-speaking markets outside of Australia, particularly the UK and South Africa. Eventually they will come to the U.S. Australia has a very attractive pensions market, with a huge corporate match. There is a lot of money to be managed and it’s one of the world’s fastest growing pensions markets.

Technology One, a bigger company, is more established at probably $1-2 billion market cap, but they are one of the leading SME ERP companies, so a small and medium enterprise ERP. They compete below the ranks of an Oracle or an SAP. They have produced 18 consecutive years of profitable revenue growth. They are not slowing down, even though they are making a transition to SaaS and the cloud. This is a company with a 10% five-year revenue growth rate and over 60% returns on invested capital – a classic kind of compounder.


David Nadel is a Portfolio Manager at Royce & Associates, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.

Andrew Mathewson

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