Finding Opportunities in International Small-Caps—Royce
article , video 02-23-2022

Finding Opportunities in International Small-Caps

The portfolio management team for Royce International Premier Quality Strategy identifies 14 companies, discusses recent performance, and details their optimistic outlook. 


Steve Lipper: Hello. This is Steve Lipper, Senior Investment Strategist at Royce Investment Partners. Thanks for joining us today. I'm here with the investment team that manages the Royce International Premier Fund. They're going to be giving you both a recap of last year's performance, as well as what they're doing in the portfolio and the outlook for the coming year. Joining me are portfolio managers, Mark Rayner and Mark Fischer, as well as senior analyst, Yutetsu Ametani. Let's begin with you Mark Rayner. Just looking back on 2021, it was a bit of a challenging year. Can you provide some context here? 

Mark Rayner: You're right in terms of price performance, it was a tough year. On the one hand, we were pleased that we generated a positive return for our clients, something like 6%. But clearly we were disappointed that it underperformed its benchmark. And actually, that was the first time since 2016. How do we evaluate and contextualize that?   

I think the first thing to say, and it's really important for us that we haven't changed what we do. We're really big believers in the view that if you hold a portfolio of reasonably priced companies which generate consistently high returns on investor capital, which have healthy balance sheets, and which grow at rates in excess of trend GDP, then over time good things as an investor will happen to you. 

And that's namely that companies will compound their value, and over the medium to long term, this value creation will then drive attractive stock price performance. Those are the KPIs that we look at when we're managing the Fund, exactly those: returns on net operating capital, balance sheet strength, growth rates, and earnings multiples relative to the index. 

The question is probably, well, why didn't the market honor that value creation with some sort of correlated price performance in 2021? Now we think the answer is simply that investors have continued, as we say, to focus on thematics rather than mathematics. 

There's been this now very extended tug of war between stocks which offer growth at any price fueled by ultra-low interest rates, and then cheap recovery plays.  

Recovery plays generally are indebted. High growth companies have really been able to take on cheap debt as a sort of a rocket fuel to growth. So in 2021, the factor that drove international small cap prices more than any other, and that was by very wide margin, was debt. The top quintile of most indebted companies outperformed the quintile of least indebted companies by a staggering 1100 bps. 

Now meanwhile, we actively avoided debt as we always do. We don't like indebted companies. We think great companies should have great balance sheets, and we think debt is risk. So if you look at the Fund as a whole, on average our company's actually held net cash. 

Another important factor to mention is country specific, and that's Japan. Perhaps no country saw a greater move away from what we would define as high quality to low quality during 2021 was Japan. And Japan is a country which typically is our largest weighting, which again it was in 2021. To give some more color on that it's better if I hand over to Yutetsu, our Japanese expert. 

Yutetsu Ametani: Thank you very much, Mark. Currency was a big headwind in Japan in 2021. Having strengthened the gains to the U.S. dollar in 2020, the Japanese yen was the worst performing currency in our portfolio, with as much as 10% depreciation against the U.S. dollar in 2021. Now, we can see this in the return contribution for the Fund. For the one-year period to 31st of December 2021, Japan had a negative contribution of minus 247 basis points, of which 201 basis points was due to currency. So here, nearly all of the negative contribution came from currency in 2021.

Now the second factor is the Japanese equity market exhibited a strong reversal in 2021, where essentially last year's outperformers were most likely to be this year's underperformers. Now, we think this great reversal explains why the best performing Japanese stocks for the Fund in 2020, such as tax related software vendor TKC, and material handling solution vendor Daifuku were some of the worst performing stocks for the Fund in 2021. Putting all this together, 2021 was a particularly challenging year for stock pickers like us investing in Japanese quality companies. 

MR: Thanks, Yutetsu.  I think it's also important to say though, Steve, I mean we've been talking a lot about market backgrounds, and that was undeniably tough for us, for us. But of course, in 2021, we made mistakes. We make mistakes every year. You know, the bottom-line message is we really do think we have a portfolio of very high-quality  compounders. In fact, arguably, we think that contrary to 2021 price performance the quality of the Fund has actually never been higher. 

SL: Mark and Yutetsu, thanks for walking us through that.  Mark Fischer let's come to you and perhaps turn our lens to looking forward. How do you think about the opportunities going forward from here? 

Mark Fischer: First, maybe I'd just like to emphasize that international small caps historically have proven to be a persistent source of long-term outperformance. So if you're truly a long-term investor with a multi-year outlook, let's say a 10-year outlook, then being invested in international small caps would have been incredibly advantageous. 

If you look at, for example, the 10-year returns of our benchmark every month since inception. 100% of those periods would've seen positive returns, and 95% of those periods would've seen returns beating the large cap equivalent of the index. Now you would've done even better had you had a quality focus producing both higher absolute returns and substantially higher risk adjusted returns than just investing in the broader index. But why is now a particularly good opportunity to revisit quality international small caps?  

One is that we believe we've returned to a more favorable regime for the strategy. Our strategy has been incredibly consistent in beating the index over three-year periods, with the exception of one environment, and that is during sharp market rallies when investors are willing to take on greater risk to generate higher returns, and often chase lower quality businesses, or businesses benefiting from thematics. 

And this sort of environment typically comes about when you have high equity risk premiums. So in other words, the market is particularly cheap, and then when it later re-rates sharply, it's often the junk that recovers sooner and faster. And also, when you start with large, high yield bond spreads, so you start with a market that's more risk averse, requiring a greater premium for junk assets. 

And then any subsequent move back to more risk on, will again, favor lower quality assets. Now that suggests that we've recently moved out of this environment back into one where our strategy generates future outperformance. Equity risk premiums have fallen significantly over the past 12 to 18 months, and high yield spreads have fallen by more than half since the height of the pandemic. 

The other point that I'd make though is, more generally that when you invest in quality, you're betting on the tortoise and not on the hare. What I mean by that is that quality stocks with consistently high returns continue to compound value steadily and unabatedly. So when the market's manic, chasing other stocks, quality stocks are out of favor and de-rate, those quality stocks are still compounding away, they're still generating value. 

SL: Thank you, Mark. That's particularly helpful, to understand how the strategy intersects with the market environment, how the particular period we've just been through might have been a particularly, let's call it pernicious or unsupportive to the strategy, and, and now we're entering a different regime. 

So let's take it down a level and look at the portfolio and how you guys have been looking at it and adapting to it. Mark Rayner how has the composition of the portfolio changed during the course of the year? 

MR: I think the first thing to say, and I always emphasize, that the composition is a byproduct of bottom up stock selection. So we really don't think about top-down asset allocation decisions. And in turn, this bottom-up process tends to lead us to particular industries. 

For example, commercial and professional services, software and services, healthcare, specialty chemicals, and also things like niche product manufacturers, for example. That's because these industries are really rich in the sort of attributes that we like. 

So by extension, our process steers us away from other sectors which we don't find these sort of attributes. Now, there's a sector such as energy, raw materials, or consumer discretionary stocks, for example. So to answer your question, in terms of changes in composition of the Fund, you really should not expect very meaningful swings on a yearly basis, or even over the long-term, between these target rich and target poor industries. 

Now, having said that, we're very happy to move away from the benchmark within our preferred industries. And to an extent, that is what happened  in 2021. Now that was driven really by three things—we really had our mind on doing three things. 

Firstly, wherever we could to improve the quality of the Fund, quality is obviously a word we keep coming back to, in addition, we trimmed areas of strength where cap rates in our view had become a bit stretched, and finally, we took advantage of increasingly attractive cap rates  in other companies which were somewhat more out of favor. 

SL: Thanks, Mark. That makes a lot of sense. maybe drilling a little bit to those examples,  I did notice that you trimmed somewhat in the capital goods area, and commercial professional services. Why is that? 

MR: That links back to the three motives I was just mentioning. So we reduced capital goods and a couple examples of why: so we sold a position in a Swiss company called Bossard. Now, what Bossard does, they're a value added, distributor of industrial fasteners. And we exited that because its enterprise quality score as we call it, or EQS, which is a system which we have, which is a very granular and very systematic way that we score all companies that we invest in, well, that fell below the required level. And the reason it did that is because we reevaluated its ESG credentials. 

Another example is a Dutch company called IMCD. Now, we didn't sell that, but we did quite materially trim it. Now, IMCD is a distributor of specialty chemicals and ingredients. The reason we trimmed it is, it doubled—the share price doubled over the course of 2021, and also would highlight the fact that it entered 2021  at a pretty rich multiple, we think. So that multiple became really quite stretched. We didn't sell it, but we did trim quite materially. 

On commercial and professional services couple of sells I could highlight on that. We sold a position in a Japanese company called Benefit One. We really like the business, but that was another stock that re- rated very substantially. It more than doubled during the course of the year, and that cap rate became so poor that we exited the entire position. 

One final example, Steve is, Intertrust another commercial and professional services company which we sold in the year. Intertrust, now they're a Dutch company.  They're a global leader in the provision of what's called expert administrative services. The company was subject to a private equity led bid. It was something like a 40% premium to the previous day’s closing price. We thought that was a very reasonable bid. So we accepted it and  we exited the position. 

SL: Thanks, Mark. That's really interesting, because I think as you recap those four, they're really prototypical examples of four reasons that we sell. Number one, if quality deteriorates, number two, we're trimming, number three, a valuation based full sale, number four, an exit due to a takeover. So let's go to the other side in terms of where we've added in software and services. And Mark Fischer and Yutetsu, perhaps you could walk us through that. 

MF: Steve, our additions in the software and services industry group reflected both adding to out-of-favor businesses with increasingly attractive cap rates and also the addition of four new high conviction holdings. In the U.K. we added Learning Technologies Group, which is a leading provider of digital tools and services, to help companies hire, train, manage, and retain talent. In Canada, we added Enghouse, an acquisition led consolidator of software companies focusing on areas such as customer interaction, billing and fleet management software. In South Korea, we added Douzone Bizon, which is the country's leading provider of ERP software to small, to medium sized enterprises. And finally, in Poland, we added Asseco Poland, which is the top provider of IT software and services in the higher growth region of central and Eastern Europe. 

Now there are a few things that are worth noting about these additions. They all benefit from strong customer relationships, they're asset light, and they produce attractive returns, and they operate as market leaders in structurally growing markets. 

Second is that the additions particularly of Douzone and Asseco both provide us with hard-to-find quality emerging markets exposure. And third, these are not the growth at any price tech stocks which have been driving the market through most of 2021. They're all really profitable with an average operating margin of more than 18%, and they're reasonably priced with an average forward cap rate of over 8%. And perhaps here, I'll hand over to you Yutetsu who can provide a couple of good examples. 

YA: So the first of these is OBIC Business Consultants or OBC. They provide packaged accounting software to small to medium sized businesses in Japan. And in 2021 despite delivering very strong performance with the operating profits growing at 28% year on year, the share price fell 38% in U.S. dollar times. 

Second company we added is Fukui Computer Holdings whose 3D CAD software and other business application software helps digitize the housing, construction, and civil engineering industries in Japan. The latest results indicated a very strong performance with operating profits growing at 20% year on year. 

Finally is TKC. They provide tax related software and accountancy services to small businesses in Japan. For the fiscal year that ended in September 2021, TKC's operating profits grew another 8% but share price performance again, was disappointing, 20% down for the year. So disappointingly, these three companies were some of the worst performers for the Fund in 2021. 

However, encouraged by the strong operational performances as described, we naturally took advantage of the weak price performance to increase our position in all three names. We were able to increase these positions at very reasonable valuations. So at the time of speaking the three companies generate an average ROIC of 130%, which is more than six times above the median ROIC of the Fund. And it's average forward cap rate today remains highly attractive at 10.5%, two times above the median for the cap rate of the Fund. 

SL: Yutetsu, thank you. Those are great examples of how we go where we see quality cheap and if the market in a country or an industry is not valuing companies or continuing to derate it, our investors should expect us to increasingly buy to take advantage of that and compounding what we hope and think is future attractive performance. Let's stay on the idea of specific stocks for a bit longer and talk about some of the highest conviction ideas. Yutetsu why don't we stick with you? 

YA: I would like to introduce the listeners to a company in Japan called BML, which is the leading diagnostics testing company in the country. So Steve, diagnostics testing as you may be familiar, is a critical procedure in patient diagnosis in today's healthcare system. These tests help doctors understand the state of a patient's health so they can take an appropriate course of action in patient treatment. 

However, BML customers who are hospitals and clinics typically they do not have the scale or resources needed to run these tests at an affordable price, so they outsource testing to specialist vendors like BML to reduce processing costs. 

Now typically, when we look for these companies, we find that these testing companies rely primarily on price leadership to retain customers, especially the small clinics. Now as the listeners may be familiar we do like price leadership, but we think that that's not enough to generate sticky customer relationships. 

Through channel checks, however, that we conducted, we discovered that BML is an exception in that it's also a software vendor. So BML's software helps small customers optimize their administrative processes and importantly enables the digital delivery of testing results. We think that this cross delivery of testing and software keeps customers loyal beyond just an attractive price. 

And putting this together, this integration of testing service into a software package keeps BML’s diversified customer base very loyal, and that's evidenced by a very low annual customer churn rate of 5%. In terms of growth opportunities, BML has two tailwinds: first, continued outsourcing of diagnostics testing and second market consolidation. 

And to be more specific, 50% of the domestic testing market is yet to be outsourced. And within the outsourced testing market, 50% of the market is still jointly held by some 300 small to medium businesses with negligible scale. So we think BML therefore has a very long growth runway. 

With 30% average return on net operating assets over the past five years and the strong balance sheet with a 62% equity ratio, we think BML's valuation of around 14% on a trailing basis cap rate, which is double that of the index, is simply too attractive. And we have therefore initiated a position in 2021 and steadily added into weakness. 

SL: That's great, Yutetsu. Thanks for walking us through it. It sounds like a very attractive opportunity. Mark Fischer let's come to you. What's a high conviction holding that we have today? 

MF: Steve, the company I'd like to highlight is GVS. Headquartered in Italy, GVS is one of the leading providers of high-tech filters using a range of critical applications, such as life sciences—think IV and blood filters or filters used in anesthesia. Also in mobility. So, for example, filters used to protect electronic systems and power trains in cars and in health and safety, particularly face masks. In many ways, GVS is a typical RIP company, provides a low cost but mission critical product to a diversified customer base of over 4,600 clients who rarely leave. 

And that is because GVS sells consumables with high switching costs. Now if you imagine you're a medical equipment company, you've worked in close technical collaboration with GVS to develop the filter, you've designed the filter into your product, you've waited multiple years to get regulatory product approval and certification by the FDA. Would you want to undo all of that to save a couple of cents on the dollar per filter? Almost never happens. And in fact, over half the company's customers have been customers for over a decade. And those strong customer relationships also translate into a solid operating record, including over 40% returns on net operating assets. And long term, we think GVS benefits from a number of very reliable structural growth drivers. 

People are getting older, so they require more healthcare services, and vehicles are shifting from conventional to hybrid and electric, which of course have more electronic content and therefore they require more filters. But looking back at 2021, GVS had a volatile share price. The company listed in June of 2020, almost at the height of the pandemic, and the IPO attracted many investors who saw the company as a COVID play given its exposure to face masks. Now when in 2021 sales in that division slowed, lots of that hot money exited the stock and looked elsewhere. 

And this was aggravated by the company's still very sparse sell side coverage by just two analysts despite a market cap of over two billion dollars. So the fact that the company performed broadly in line with guidance or that it's long-term views are completely unchanged has eluded many investors. So GVS's stock was down some 35% for the year, and that created what we believe to be an attractive buying opportunity for the stock. And so we've been steadily adding to our ownership throughout the year. 

SL: Thanks for walking us through that, Mark. It’s a great example of where we think the market is misperceiving and focusing, understanding the company and its drivers going forward and in an illiquid stock gives us really the opportunity to enter high quality at an attractive price. Mark, coming in for the final word, why should investors feel good about the Fund going forward? 

MR: We believe that over the long run, we will best serve our clients by following a disciplined investment process. And that's one which focuses on companies with these high returns on net operating assets, with strong balance sheets of average growth and reasonable or better valuations. 

We’ll maximize our chances of generating attractive long-term investment returns with lower volatility. And we do that by harnessing the power of compounding, which over the long run drives share price appreciation, that's our quite simple, thought  towards the way that we generate price performance. 

When the market finally returns to some state of normality, defined as this more balanced attitude to risk, that the prices of the stocks and the portfolio will begin to better reflect both their existing value as well as the value-creating power that those companies have. Now, when will that be? Mark talked about high yield and equity risk premiums are beginning to indicate that maybe that's coming and also just the general discussion that maybe COVID is moving from the sort of pandemic state to an endemic state and that life may be returning to something like normality.  

SL: Mark, Mark, and Yutetsu thanks for giving us a review and understanding of what you're doing in the portfolio today as well as an outlook. I hope all the listeners have enjoyed and been illuminated by the Royce International Premier team’s review. Thanks for spending time with us. 




Important Disclosure Information

Average Annual Total Returns as of 12/31/21 (%) 

International Premier -1.37 6.06 18.27 15.20 12.17 9.17 12/31/10
Russell 2000 2.14 14.82 20.02 12.02 13.23 9.15 N/A
MSCI ACWI x USA SC 0.62 12.93 16.46 11.21 9.46 N/A 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 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.
All performance and risk information presented in this material prior to the commencement date of Investment Class shares on 1/22/14 reflects Service Class results. Service Class shares bear an annual distribution expense that is not borne by Investment Class shares.

Mr. Lipper’s, Rayner’s, Fischer’s, and Ametani’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. No assurance can be given that the past performance trends as outlined above will continue in the future.

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 12/31/2021 (%)

  International Premier









Benefit One




Learning Technologies Group




Douzone Bizon


Asseco Poland


OBIC Business Consultants


Fukui Computer Holdings






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.

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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