Where are you finding the most interesting high quality small-cap opportunities?

I’m actually finding the best quality small-cap opportunities in the companies we already own. During 2020, we added several new names from our “on deck” list of Premier Small-Cap Quality companies as their valuations became more attractive, especially during the first half of the year when there was so much indiscriminate selling. The Russell 2000 Index rallied from the March trough to finish 2020 strong—which is typical in the first phase of small-cap recoveries. However, lower-quality companies drove this phase of the rebound, with nonearners in the Russell 2000 significantly outpacing small caps with earnings. Nonearners within the index rose 148.3% versus 80.2% for earners from 3/18/20-12/31/20.

In which sectors have you been most active?

Cyclical sectors continue to represent attractive areas to find high ROIC, durable business models at attractive valuations. Industrials, Information Technology, Financials, and Consumer Discretionary have consistently been among our top sector weights based on bottom-up stock selection. With rising vaccination rates, an accommodating Federal Reserve, and aggressive fiscal spending policy, U.S. GDP growth projections are robust for the next two years, which bodes well for more economically sensitive businesses. Valuations for small-cap cyclicals also remain below their long-term historical average, recently trading at the same multiple relative to the rest of the Russell 2000 as they did in October 2008, in the teeth of the Global Financial Crisis.

Are there any themes that you’ve been seeing as you examine companies?

One overarching theme is that many “quality business models” proved their durability and justified their reputation during the recession. Even those in industries hit hardest by the pandemic bolstered their competitive position and are now poised to emerge with greater earnings and cash flow power as the economy reopens. Many of the defensive measures that companies took to preserve cash flow have evolved into permanently reduced cost structures, such as smaller real estate footprints from permanent moves to hybrid or full work from home models. These actions, combined with the proactive moves many of our companies made while their smaller or more highly leveraged competitors were focused mostly on survival, have strengthened their moats, broadened their addressable markets, and/or increased their long-term, “normalized” operating margins relative to pre-pandemic levels.

Can you discuss what’s driven the share prices success of a company you hold?

One company would be Inter Parfums, which is a global developer and designer of prestige fragrances primarily under licenses of higher-end brands such as Mont Blanc, Coach, Jimmy Choo, and Guess. With most of its sales coming from traditional brick-and-mortar department or specialty stores or travel retail such as duty-free shops, revenue fell 24.5% in 2020. Yet operating margins fell by only 170 basis points to a still healthy 13% for 2020, reflecting the company’s high variable expense and capital light business model. So far in 2021, the stock is up more than 20%, with better-than-expected growth from improved store traffic as vaccinations are rolling out and pandemic restrictions are loosening.

What is your take on its prospects going forward?

After postponing most new product introductions throughout 2020, Inter Parfums has a particularly robust launch schedule for its major brands while product from new licensees is further accelerating sales. The company also continued to play offense during the pandemic by buying a 25% stake in a leading online perfume retailer in Europe that offers a solid platform from which to broaden e-commerce distribution. Additionally, Inter Parfums signed a long-term fragrance license with Moncler, the Italian luxury outdoor fashion brand. With the initial fragrance launch planned for 2022, Moncler has the potential to be Inter Parfum’s largest seller over time due to the brand’s appeal to the large Gen-Z demographic.

Can you tell us about a high confidence holding whose stock price has been down so far in 2021?

Multi-line industrial company ESCO Technologies operates three business segments: Aerospace/Defense, Utility Solutions, and RF Shielding and Test. ESCO has a leading position in a number of niche markets with favorable demand dynamics, 56% recurring revenue thanks in part to the Aerospace/Defense content that’s designed into long-life aircraft or submarines, and an increasing percentage of sales from higher margin proprietary products. However, the pandemic has temporarily depressed ESCO’s growth rate, largely due to declines in its commercial aerospace business, which accounts for approximately 25% of total revenue.

What do you think will help its stock recover?

One positive sign is that aircraft build rates are improving from the lows as air travel recovers. Airlines all over the globe are repositioning their fleets for a post-pandemic world while upgrading to newer models that are more environmentally friendly and cost competitive. ESCO’s sales should track this recovery over time. Meanwhile, lost in the focus on commercial aerospace headwinds is ESCO’s momentum in its U.S. Navy business. Orders for two submarine classes were released in recent quarters, for example, on which ESCO has more than $25 million in content per ship.

Are there other factors that underscore your confidence?

ESCO’s Utilities Solutions customers have had to push out infrastructure diagnostics and inspection work done by Esco. However, this is required and regulated maintenance, so there’s a limit to how long it can be deferred. There’s also the robust secular trend in higher spending on projects given the industry’s focus on grid-hardening, remote diagnostics, and cybersecurity software, as well as growth in the adoption of renewables. Finally, ESCO offers upside more generally from its history of supplementing internal growth by reinvesting a portion of its free cash flow into high-ROIC, bolt-on acquisitions. In fact, ESCO recently announced the purchase of a small Italian-based supplier of utilities test and diagnostic equipment that fills product gaps and opens distribution in areas in Europe and Asia that ESCO doesn’t currently serve.

Why do you think the current environment is well suited for high-quality small-cap companies to deliver attractive returns over the next few years?

Along with the more favorable valuations in the cyclical sectors we prefer, I also suspect that small-cap returns are more likely to be tied to future earnings growth as opposed to multiple expansion. Stock selection should begin to take precedence as investors focus on companies that have visible prospects for long-term earnings growth rooted in favorable secular demand trends, company-specific competitive advantages, and/or high return on reinvestment opportunities. These characteristics are inherent in the business models that our Premier Small-Cap Quality strategy favors.

What other potential advantages for quality do you see?

Inflation and rising interest rates, byproducts of robust economic growth, are a source of rising concern for investors. However, they should be less of a headwind for quality companies. If current inflation proves to be more than transitory, quality companies should fare well since pricing power is a key facet of many of their business models. Inter Parfums, for example, has a portfolio of franchise brands for which consumers are willing to pay up. Rising interest rates should provide a cost of capital advantage to a strategic acquirer such as Esco, given its low leverage and ability to self-fund growth through consistent free cash flow generation.

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