How did you become interested in international small-cap stocks?

My interest in international small-cap stocks goes all the way back to my early childhood growing up in Düsseldorf, a small German city along the Rhine River. I can still remember a scene from my first day of Kindergarten at the International School quite vividly. As the five-year old son of a German father born in Romania and an American mother with Lebanese ancestry, I was terrified of not fitting in. In the weeks that followed, however, I learned that those worries were unfounded. I fit in well not in spite of my background but because of it. Being exposed to students from more than 40 countries taught me that diversity was something to which I wanted to aspire. I can still remember thinking that, regardless of where I ended up professionally, I wanted to be in a place where I could build upon my international experience.

What drew me to small-cap investing was realizing that there are so many companies that affect our daily lives yet whose stories were seldom, if ever, told. Take a bowl of cereal, for example, a basic staple of our daily routine that nonetheless requires a rich ecosystem to produce and distribute: farmers who supply the grain; manufacturers who automate production lines and sorting equipment through advanced sensor technology; chemists who engineer the “perfect flavor”; specialized producers of folding cartons; and marketing firms and product consultants. So if only out of curiosity, I loved the idea of discovering these small, often obscure companies and then going under the hood to better understand what role they play and how they work. I soon learned that most of those companies are international small-cap businesses.

What is it about this asset class that makes it so interesting and appealing to you?

I see international small-caps as arguably the last inefficient frontier in equity investing, which in many ways is a function of supply and demand. The sheer number of international small-cap companies can be overwhelming, comprising more than 70% of the number of the globe’s listed companies. Yet sophisticated institutional investors still disproportionately gravitate to domestic large-cap companies while sell-side research firms tend to follow the money and as a result find themselves ill equipped to research and analyze small-cap companies. This dynamic leads to situations where global leaders in many industries have a predominantly native shareholder base and no sell-side coverage at all. Many of these high-quality businesses in turn do not see the point of dedicating significant time or resources to investor relations. Some even choose not to create an English website, let alone an English investor presentation. This structural inefficiency is quite acute, especially in places like Japan where it is not uncommon to see companies with one billion dollar market capitalizations go uncovered.

If this inefficiency is so prevalent, one might ask why it hasn’t simply been removed over time as more investment and sell-side research enters the space. Yet the opposite has been happening. With regulations such as MiFID II in Europe, whereby investors have to pay the sell side separately for execution and research, many investors have opted to forego research, which is expensive, and this often leaves brokers with no choice but to further cut staff in their less lucrative small-cap research divisions. Based on these industry realities, I believe the structural inefficiencies in the international small-cap space are here to stay—which creates significant opportunities for active managers who are willing to spend the time and energy to understand these businesses. This is exactly the sort of detective work that I find so fascinating in international small-caps.

Corporate governance is a key element in the Enterprise Quality Scoring (EQS) system that you and Mark Rayner use in Royce International Premier Fund’s high-quality international strategy. How do you analyze governance in international small-caps?

We see strong governance as part of the overall company quality picture. We evaluate a company’s governance along with its management quality in the “Extras” part of our EQS system. Our goal is to buy great businesses and hold them for a very long time, and few factors affect a business’s long-term attractiveness more than the ability to generate consistently high returns on invested capital. This is where effective corporate governance is vital. Even the best business models need management teams that are incentivized to create shareholder value, that align their interests with those of the shareholders, and that behave ethically. Otherwise, shareholder returns will be mediocre at best, assuming the company is still around. So I think a company has to combine prudent capital allocation with a culture of diligent and effective governance.

What qualities do you look for most when thinking about governance?

We base our analyses on some well-accepted pillars. First, we look for companies with independent and diverse Boards of Directors. There is a considerable body of research documenting the benefits of diversity in good decision making, so we favor companies with majority-independent boards that have strong female representation, a strong mix of skill sets, and separation of the CEO and Chairperson roles. Second, recognizing that incentives matter, we study management's alignment of interest with shareholders. We prefer companies whose executives generate the majority of their pay in the form of variable compensation, for example through a Long-Term Incentive Plan that awards restricted company shares that vest subject to specific and measurable performance objectives being met. We seek metrics that are not only transparent and understandable but that are also aligned with long-term shareholder value creation, such as return on invested capital, free cash flow generation, and total shareholder returns. We also care a great deal about shareholder rights.

When analyzing governance in U.S. companies, much attention is paid to issues such as controlling shareholders and auditor quality. Are these issues also relevant in non-U.S. small-caps?

Yes, very much so. Many companies in the international small-cap space have controlling shareholders, often a founding family or a parent company. This can be a double-edged sword, and we need to use our best judgment and analytical skill to understand the potential trade-offs. This kind of ownership structure can create stability but can also breed risk—the company’s actions may potentially benefit large investors at the expense of minority shareholders. We thus look for companies with a history of equal treatment, preferably with just one share class. Last, but certainly not least, we analyze a company’s audit structure and history. As the last defense against fraud or unethical behavior, auditors play a critical role in ensuring business continuity. We want companies with reputable auditors who are not entrenched, have not rotated excessively, and have not identified material shortcomings or issued qualified audit opinions. While none of these topics is novel or individually sufficient, taken together, and applied rigorously and consistently, we believe they contribute to our quality-centric approach.

Since different countries have varying disclosure regimes and governance practices, what adaptations do you have to make when accounting for local culture and practice?

Different regions have different approaches as well as different levels of experience in promoting effective governance. At the same time, cultural differences can create different management predispositions and behaviors. In mid-2015 on the back of Japan's third “arrow” of Abenomics, for example, the country moved to adopt its “Corporate Governance Code,” a set of guidelines designed to create sustainable corporate growth and increased shareholder value. In many ways, this acknowledged that good shareholder returns and strong corporate governance go hand in hand. With a rapidly aging population and a growing base of pensioners, the government saw the need to boost “Japan Inc.’s” returns on equity and viewed enhanced corporate governance as one of the keys to achieving this goal. However, despite the progress to date that has led to significantly improved governance practices and disclosures, Japan still lags its global counterparts in many ways. Its Code is non-binding, allowing companies to “comply or explain”; boards are barely 30% independent, compared to more than 80% in the U.S.; and only one in twenty executives is female. Meanwhile, though exceptions exist, Japanese management teams tend to be more conservative and risk averse than their global counterparts, often emphasizing risks while downplaying opportunities.

Can similar nuances be found elsewhere?

Yes. In Europe, for example, there are a lot of businesses where a founding family is in control, often with third- or fourth generation management. On balance, we have found this dynamic to be a positive factor because it leads management teams to prioritize long-term strategic thinking—in the words of one of our Swiss family-owned holdings, “we think in decades.” The flipside, though, is that this can sometimes result in differentiated voting rights that favor the controlling shareholders. So one of the benefits of the closely collaborative way in which Mark and I work is that we can examine the pros and cons of each situation and try to make informed and intelligent investment decisions.

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