Overlooked Opportunities in International Small Cap Podcast—Royce
article , video 08-25-2021

Overlooked Opportunities in International Small Cap Podcast

PMs Mark Rayner and Mark Fischer detail how their portfolio is positioned for inflation, finding non-cyclical industrial companies, and more.


The transcript has been edited for clarity.

Steve Lipper: Thanks for joining us. This is Steve Lipper. I'm the Senior Investment Strategist at Royce Investment Partners. Thank you for joining us today to learn more about the opportunities that we see in our international high-quality strategy, which is focused on international small caps as well as a similar Global Small Cap Strategy.

First, let me introduce Mark Rayner. Mark is our Lead Portfolio Manager on the International Small Cap. Mark also is a Portfolio Manager on our Global Small Cap. He's a Portfolio Manager and Principal at Royce Investment Partners. He joined our firm in 2006 and has over 35 years of industry investment experience, and he is a chartered accountant. Mark Rayner, good day to you. 

Mark Rayner: Good day to you, Steve. Good to talk as always and greetings from the UK. 

SL: Mark Fischer over to you, Director of International Research and Portfolio Manager. Mark Fischer joins Mark Rayner, both on the International Premier Strategy as well as with other of our U.S. PMs on the Global Premier Strategy. Mark joined our Firm last year in 2020 and has 13 years of investment industry experience. Good day to you, Mark. 

Mark Fischer: Thanks Steve. It's a pleasure to be here. Thanks for having me. 

SL: Well, let's dive in. Quality, if you look at the investment literature or perhaps more broadly, even outside of investing, is a term which may be somewhat in the eye of the beholder. Mark Rayner, how do we at Royce define quality? 

MR: A quality company viewed through the lens of an investor has to be one which consistently creates shareholder value over the long term: one that actually compounds shareholder value over the long-term. There's an iron law. It's simple mathematics. The only companies that create shareholder value are the ones where their returns on invested capital, or their ROICs, are consistently above their cost of capital. We want to invest in companies with returns on invested capital over the long run of at least 20%. 

SL: How do we go about identifying these long-term compounders? 

MR: Where we put all our focus is looking at companies with existing returns on invested capital, which were attractive, and analyzing the durability of those returns. Now, what do we then do? Well, we run it through two processes. The most important stakeholder is the customer. It's the customer that decides. Put simply, we want to invest in companies whose customers, A, lack the ability or incentive to be price aggressive, and B, lack the ability or incentive to leave. So in short, we're looking to invest in companies with benign and loyal customers. And we have a very detailed checklist of questions that we ask ourselves to determine this. 

We then carry forward to a much more detailed due diligence. This is what we call our enterprise quality scoring or EQS. This is based on a very substantial list of very specific questions, it's very granular, and we score companies out of 100. It's only those companies that score 70 or more which are included in our database of investible companies. Maybe I'll give you an example: a U.K. company called Spirax Sarco. Now, what Spirax Sarco does is engineered solutions for what's called industrial and commercial steam systems. 

These steam systems are used in a wide variety of industries to transfer heat. The stock's been in the Fund since inception over 10 years ago. And at the time of investment, the company had returns on invested capital at 35 to 40%. Now, where are those returns on invested capital 10 years later?

Well, they're still 35 to 40%. And the company has grown on average about 8 to 10% a year. If you can put 40% ROICs together with high double, high single digit growth for 10 years, that's where you get compounding shareholder value. Compounding shareholder value, therefore, drives very substantial price appreciation.

SL: Mark Fischer, let's come to you. We found that these quality companies don't show up uniformly but rather tend to be more often in certain industries and geographies. One thing that someone might look superficially perhaps at the International Premier portfolio is that it has a high weighting in industrial sectors, overall cyclical sectors. I know you've often said, "Well, we prefer more non-cyclical businesses." How do you square that? The apparent high weighting in cyclical sectors with a preference for non-cyclical business models? 

MF: That's a really great question, Steve, especially because Mark just spoke about how consistency in results is really important to our stock selection. We have over 40% of our Fund in Industrials, which are traditionally considered cyclical as you point out. So why is that? First, it's really important to emphasize that we're bottom-up stock pickers. This bottom-up research process will eliminate large portions of the investable universe. We don't invest in highly levered companies. So out go banks and most financials. 

We don't invest in companies with mediocre returns, so out go utilities and most real estate. We don't invest in businesses that we don't understand. So out go pharma and biotech companies, out go really high-tech capital goods businesses serving the semiconductor industry. And we don't invest in companies with fickle customers. So out go consumer discretionary businesses, and most “B2C” oriented models. So what does that leave us with? Typically, we find three sectors that we find naturally target rich. One is healthcare. So, for example, we'll invest in companies that sell consumables, niche equipment, or healthcare services. Two is IT, that's about 23% of the Fund, and this sector is traditionally considered more cyclical. 

But the types of companies that we look for, they tend to be, for example, software companies where perhaps the software is deeply integrated into its customer's work processes. Meaning it took years to implement and taking it out would be something like open heart surgery. Or maybe the company sells subscriptions with a history of consistently high renewal rates. And then there's Industrials, which, as I mentioned earlier, makes up just over 40% of the Fund. People hear Industrials, and then they think of factories with belching chimney stacks that have raw materials coming in on one end and finished products rolling out the other. 

So to really understand what we invest in, you have to look underneath the Industrials hood, if you will. And what you'll find there is that over half of our Industrials are actually professional or commercial services businesses that work out of office buildings, not in factories. Even the 10% of the fund classified as machinery is in fact invested in asset- light businesses that sell low cost but mission critical products or services to customers’ operating budgets, not their CapEx budgets.  

Perhaps I'll provide an example. Our largest holding is an Australian company called IPH, and it is classified as an Industrials business [as of 6/30/21]. IPH is the leading intellectual property services group in Australia and Singapore. If, for example, you're a U.S. multinational looking to expand your business into Australia or Southeast Asia, and you want to protect your intellectual property, then you'll go to IPH to file and manage your patents and trademarks in those jurisdictions. That can be often up to 20 years. So IPH is a services business. And yet, IPH is classified as Industrials. And so we're not a cyclical Industrials fund, we couldn't be farther from it. We invest in asset light businesses that produce durable and predictable returns. 

SL: I think IPH is a great example of a non-industrial industrial. Let's continue on the same topic with a slightly different subtopic, if you will, which is around geography. We've also found over time that we have a preponderance of those in Western Europe and less exposure generally to Asia and, and to emerging markets. Tell us how it is that we think about geography with regards to identifying high-quality companies? 

MF: I might caution that in our investable universe, real geographic exposure can often be very hard to measure. We have a company based in Switzerland called LEM, and they make something called a transducer, which is a component that measures an electrical current. They might then sell that transducer to a Finnish company, Vacon, which makes AC drives that control electric current and motors. And they might sell that AC drive to the German company, Siemens, which makes the electric motor and then sells that electric motor to the elevator manufacturer, Zardoya Otis, in Spain. 

Zardoya might ultimately sell its elevator to a Moroccan hotel company. So at the end of the day, LEM books a Finnish sale, but it really benefits from Moroccan GDP growth. And scenarios like these are not uncommon with the types of companies we look at since after all, we invest in B2B businesses that are a long way from the end customer. In the end, really, the regional composition of our portfolio is dictated by where we find the most abundant quality businesses as well as good corporate governance. And that's naturally led us to gravitate to certain countries like Japan, the U.K., Australia, Sweden, and Switzerland.  

And we do have a bias towards developed markets as a result of the superior corporate governance attributes of companies in those markets. But the reality is that we're not quite as under indexed as it would seem based on the location of company headquarters. And that is because our businesses tend to be export oriented. In fact, we estimate that our companies, on average, derive just 40% of their revenues from their home market while the rest comes from exports. So  this all means that although Western Europe in the portfolio accounts for 56% when measured by the location of company headquarters, we estimate it accounts for just a third of the portfolio's revenue exposure while almost 20% comes from emerging markets. 

SL: Mark Rayner, coming back to you. Can you discuss certain areas that you think are benefiting from long-term trends where we have found a collection of companies that we think are high quality companies that we're excited about? 

MR: If you look at the fund, there are certain topics, perhaps is a better word, which sort of come together from a bottom-up stock picking view. So one that we have noticed over many years, a global shortage of skilled labor. And we have a number of companies in the Fund, which benefit their customers through the provision of skilled labor. One example in Germany is a company called New Work. Now, in Germany, there are around about one and a half million unfilled job vacancies. And what New Work does is it helps its clients to fill these vacancies. And it does this through essentially being the LinkedIn of Germany. And possibly more importantly, whereas LinkedIn I think is probably fair to say is generating most of its revenues from ads. New Work is more of a B2B business tool. It generates most of its revenues from selling subscriptions to businesses for its recruiting tools.

Another theme maybe to touch on is the increasing use of digital work processes. We find this in a couple of countries. Japan, a country that’s renowned for its world-leading technology lags in terms of the use of digital work processes. And here we own a company called TKC, and what TKC does, it provides smaller companies and their tax accountants, with software and services, which enable them to automatically perform the tax calculations and produce the financial reports necessary to file their tax accounts.   

SL: Mark Rayner, let's come to you for our final question. One of the most common questions we're getting is about inflation, the potential for it to continue and the impact it might have on our portfolio companies. How are you thinking about that?

MR: There seems to be shortage of just about everything: semiconductors, truck drivers, used cars, you name it, and there must be at least a possibility that this feeds through to higher wages and then potentially sustained higher prices. So we may get a period of higher inflation. But what I would say and emphasize is as a very happy by product of our very disciplined investment process, we do honestly feel that the Fund is very well positioned if we were to get a period of higher prices. And the reason for that really boils down to our customer test. 

I'm not even going to offer you an example on this because it rolls right through the Fund. I mean, every company that we own, we focus on companies with pricing power. So we do think, again, happy byproducts but we are very well positioned for inflation. 

SL: I guess looking back to our very first question is a quality company can raise prices above inflation. So if we have that, then the strong position and leading companies should be well-positioned in that environment. So Mark and Mark, thank you for walking us through all those various examples about understanding where we find quality company opportunities and how we're thinking about certain near-term opportunities and positioning the portfolio and our investors for long-term success around that. Thanks everybody for listening.  




Important Disclosure Information

Average Annual Total Returns as of 6/30/21 (%) 

International Premier 9.18 33.34 14.46 14.91 9.74 9.68 12/31/10
MSCI ACWI x USA SC 6.35 47.04 9.78 11.97 6.36 6.83 N/A

Annual Operating Expenses: Gross 1.26 Net 1.19

1 Not annualized.

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.royceinvest.com. Gross operating expenses reflect the Fund's total gross annual operating expenses for the Investment Class and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund's most current prospectus. Royce & Associates has contractually agreed, without right of termination, to waive fees and/or reimburse expenses to the extent necessary to maintain the Investment Class's net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) at or below 1.19% through April 30, 2022.

Mr. Lipper, Mr. Rayner, and Mr. Fischer’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. The thoughts and opinions expressed in the recording are solely those of the persons speaking as of July 26, 2021 and may differ from those of other Royce investment professionals or the firm as a whole.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Percentage of Fund Holdings As of 6/30/2021 (%)

  Royce International 
Premier Fund

Spirax Sarco










Zardoya Otis


New Work






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.

Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund may invest a significant portion of its assets in foreign companies which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see “Primary Risks for Fund Investors” in the prospectus.) The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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