Podcast: International Small-Cap Opportunities
article , video 06-21-2023

Podcast: International Small-Cap Opportunities

Portfolio Manager Mark Fischer and Assistant Portfolio Manager Mark Rayner talk to Francis Gannon about the asset class, their recent trip to Japan, and three high-confidence holdings.

This transcript has been edited slightly for clarity.

Francis Gannon: Hello and welcome. This is Francis Gannon, Co-Chief Investment Officer of Royce Investment Partners. Thank you for joining us.

“When confronted with the various challenges of inflation, high rates, recession, supply chain disruption—you name it—it’s those businesses with the highest quality that we think are most likely to emerge as winners.”
—Mark Fischer

Our conversation today is with Portfolio Manager Mark Fischer and Assistant Portfolio Manager Mark Rayner, who, along with Senior Analysts Yutetsu Ametani and Evan Choi, manage Royce’s International Small-Cap Premier Quality Strategy, which we use in Royce International Premier Fund. We're going to look back at performance in this very volatile period and look forward to the opportunities the team is seeing in the market today.

I should note that the International Small-Cap Premier Quality Strategy advanced 7.2% during the volatile first quarter of 2023, outperforming its benchmark, the MSCI ACWI ex US Small-Cap Index, which was up 4.7% for the same period. The portfolio also beat its benchmark for the 1-, 5-, 10-year, and since inception (12/31/10) periods through the end of the first quarter of 2023. Mark Fischer, perhaps that's a great place to start with this very volatile period we've been in. Why should one consider international small cap now?

Mark Fischer: Small caps in general, and international small caps in particular, are often overlooked, and when they're not, they're often misunderstood. One of the most common misconceptions is that international small caps are inherently more risky. Why invest in international small cap when you can invest in international large cap or stick to U.S. stocks altogether?

Well, there's actually a strong case for having a structural allocation to international small cap. One is that investing in international small cap has historically produced good long run outcomes. If you take a hypothetical investor who had invested in our benchmark at its inception in the mid 1990s, that investor would have achieved positive five-year returns in over 80% of monthly rolling periods. And, by the way, those returns would have also beaten the large-cap equivalent of the index in over 80% of monthly rolling periods, and they would have been achieved with lower volatility than investing in, say, emerging markets or even U.S. small caps.

Meanwhile, international small cap is an asset class where active management has a reason to exist. Active managers, we think, can and should outperform their benchmarks over the long term because it's really an ideal hunting ground for stock pickers. It's incredibly vast. We have more than 10,000 companies in our investable universe, and it's highly inefficient—almost 30% of the companies in the benchmark have only one or even no research analysts covering them. It also offers important diversification benefits because, as you might expect, international small caps have a lower correlation to U.S. large caps than U.S. small caps or international large caps do.

So incorporating an allocation to international small caps in a multi-asset portfolio can increase both returns and lower volatility. But, despite these benefits, the reality is that many investment managers and asset allocators choose not to take advantage of this opportunity. Even though international small caps have more than double the overall market value as U.S. small caps, less than 1% of mutual fund assets in the U.S. are invested in international small caps. Maybe this is because it's a capacity constrained asset class, maybe because information is often sparse and understanding these businesses takes work. But that's precisely where the opportunity is, in our view.

Our investment strategy is based on the quite simple belief that in the long term share prices are driven by company value creation, and that the only companies that create value are those whose returns on invested capital exceed their cost of capital. These companies, if they can successfully reinvest their capital, can then harness the power of compounding returns, which is incredibly powerful.

Our value proposition to our clients is that we use a very rigorous process to buy only those companies that have produced consistently high returns on invested capital with low financial leverage and long-term structural growth opportunities. We want to exercise valuation discipline, so we seek to pay a reasonable price for these companies, which we define as companies whose cap rate, or earnings yield, is better than we'd get if we invested in U.S. Treasuries—a “risk-free” rate.

Now this approach has worked in the past, and we believe that over longer periods of time, quality companies with the highest and the most stable returns outperform the overall market by a substantial margin and also with much higher risk-adjusted returns. But we also think that this approach is particularly timely now. International small caps and U.S. small caps typically have rotating periods of outperformance, but in recent years international small caps have lagged U.S. small caps, which we believe increases the probability of future outperformance.

Meanwhile, the U.S. dollar is historically strong relative to other currencies. When we assess it on purchasing power parity—if you believe that currencies mean revert over time—then a U.S. asset allocator now has an opportunity to use a very strong U.S. dollar to buy foreign assets and then perhaps benefit from currency tailwinds down the line.

So when confronted with the various challenges of inflation, high rates, recession, supply chain disruption—you name it—it’s those businesses with the highest quality that we think are most likely to emerge as winners.

FG: Great, thank you. Mark Rayner, let's spend a second on current opportunities. Mark Fischer referred to quality being out of favor for a long period of time. Japan has also been out of favor for a long period of time, and yet this year is doing quite well. You both just recently returned from a trip there. What did you find?

Mark Rayner: It's interesting, Frank. Remember, we are very bottom up. So we like to say that we invest in companies rather than seeking exposure to countries or industries. For any company from any country or industry to get into the Fund, it has to score a certain level.

Japan has a number of structural attractions to us. It's the second-largest small cap market in the world after the U.S., and it's pretty inefficient. The amount of companies that you find there with market caps of a billion dollars that have no, or virtually no, sell side coverage—and often that sell side coverage is not the best quality, to be honest. The companies, or certainly the listed companies, are incredibly well capitalized. These are typically net cash balance sheets.

Of course, as Mark mentioned, currency is important. The yen has been historically weak. It's trading at something like a 30% discount to the U.S. dollar on purchasing power parity. Also, there have been a number of improvements to corporate governance in Japan in recent years. It's not perfect. It's certainly not up to Western European or U.S. standards, but it's improving, and the corporate governance code there has motivated companies to improve their return on invested capital by promoting better capital allocation.

In March, we went to visit Japan for the first time actually for about three years because it's been locked down due to COVID. We saw over 30 companies. These were a mixture of companies we own and prospects for the Fund and for our data database.

A couple of observations: one is inflation. Japan is famed for having had decades of deflation, but certainly there are now inflationary pressures emerging in Japan, and this is destabilizing quite a lot of businesses because they simply haven't had the need to pass on cost increases in the past. They're just not used to passing on prices, so it's really sort of sorting out the strong from the weak companies.

One of the things that we do in our investment process is called the customer test. The core element is focusing on pricing power. We really only want to buy companies where we think there's pricing power. So we think generally our companies are going to be in a pretty strong position to pass on any rising input costs which they suffer.

Because we typically invest in B2B companies, quite a few of those provide outsourced services to their customers, so they actually help their customers decrease costs. An example is BML. They provide outsourced diagnostic testing services, so evaluating blood samples, for example, which may be taken at a hospital or a clinic. These hospitals are struggling, increasingly so, they hire the specialist to conduct diagnostic testing. They're increasingly outsourcing to companies like BML to improve product quality and also, importantly, to reduce costs.

One of the other things that we noted is the importance of going to visit companies. We're a small team, but we're pretty globally located—Mark and Evan in the U.S., I sit here in the U.K., and Yutetsu is based in Hong Kong. We think we have pretty good management access in markets which are important to us.

We went to see a company which we own called Riken Keiki. We had a very value added and insightful factory tour there. They make devices which detect gases. They’re installed at their customers’ plants, and they detect over 1,200 different hazardous gases. It's a business we really like because they sell low cost but mission critical products to the OpEx budget of a very diversified customer base, which is an indicator of pricing power. There's a high degree of recurring revenues in their business which come from the aftermarket servicing of these devices and also the sale of relatable consumables.

But one area where we did want to dig in further and better understand was why they have persistently high inventories on their balance sheet. We got to appreciate further where this comes from. When they make the detectors, the detectors have electrodes in them. And those electrodes need to settle—they basically need to sit in a temperature-controlled room and age. Now, that process can take up to three months. We visited that room, and the company talked us through the manufacturing process. We could see with our own eyes where the inventory was being held. Management talked a lot about how one of the focuses of their R&D department is to improve that aging process, to improve the inventory and the capital allocation that we were talking about just now. They're hoping to decrease that aging process from three months to maybe just two or three weeks over time.

FG: I think that's a great example, Mark. Thank you for sharing. I'd love perhaps if you could spend a little time on a high confidence holding that's in the Fund today that is kind of emblematic of the process.

MF: One would be Lectra, which is the global leader in providing cutting equipment, consumables, and software to customers in the fashion and automotive industries. Their products cover the entire product journey, so from computer aided design software used in product creation to intelligent cutting room equipment used in manufacturing to then e-commerce distribution platforms and product lifecycle management solutions, they serve the who's who of the fashion world, so everyone from H&M to Hermes, and also they serve the majority of tier one auto suppliers.

These customers face end consumers who are becoming ever more demanding. They want more customization; they want shorter trend cycles. Companies most often produce based on forecasting and guesswork, which means they often carry too much inventory, and they're vulnerable to markdowns, which hurt profitability. And then at the same time, they must also contend with stakeholders who care more and more about the environment, so they must operate more efficiently. They must reduce waste. Lectra’s solutions help customers solve these pain points: they enhance product quality, reduce inventory and unsold items, and help them use less material, which also improves the environmental footprint and reduces cost.

The company serves a diversified customer base. Their largest customer is less than 4% of total sales, and they enjoy high visibility because more than two-thirds of revenues and profits are associated with the sales of recurring consumables or software maintenance and subscriptions with very high renewal rates. It's also a growing business. It's grown sales by about 14% a year over the last five years. Long term, we think they're really well positioned to benefit from digitalization in their customers’ end markets.

But in late April, the company announced results for the first quarter of 2023, which sent the shares down over 10% on the day. While gross profit and margins increased year over year, what dominated the market's attention was that orders for new equipment were down some 30% year over year, and as a result guidance for 2023 was cut.

When we see these types of situations, we try to assess whether there's been a permanent impairment of value. And for us here, the answer is clearly ‘no’. The slowdown in equipment sales we think is transitory. It reflects an uncertain macro environment. The company continues to be highly cash generative with mid-teens margins. It has an asset light and net cash balance sheet. So when we initiated a position in Lectra late last year, we deliberately kept the position small to allow us to take advantage of situations like this. And so the recent result offered, we think, a welcome window of opportunity for us to continue to build our position in the company.

FG: Thank you both for your time today. I think you both would agree that this is a great environment to be investing in and perhaps uncovering international small-cap premier quality businesses. Any final thoughts Mark or Mark?

MF: We're very optimistic about the future. What we found historically, since the late 1990s, is that when five-year annualized returns in our asset class have been less than 5%, the next five years have been mid teens annualized, or more than twice the average since inception. So empirically, that is very helpful. We've also been through a period in which quality has lagged, as we mentioned. We think that the next decade is likely to look very different from the last because behind all of this pricing volatility, there's an operational reality that can't be ignored.

In the face of various economic challenges, the businesses that are going to gain market share, that are going to emerge stronger, that are going to weather the storm are those companies with pricing power, those companies with strong balance sheets, those companies that are not exposed to a very fickle consumer, and those businesses with asset light balance sheets that aren't as subject to supply chain dislocation.

We have all of those characteristics in the holdings in which we invest. On top of that, our companies are also recession resilient because they sell low cost but mission critical products or services that are in demand come rain or shine. When their customers come under pressure and they slash their budgets, in the long term, our companies are going to continue to sell these products. Therefore we think that our companies are very well positioned operationally going forward and should therefore over time also benefit from strong share price performance.

FG: I think that's a great point, Mark. I think people should focus on the fact that there are such great secular changes taking place in economic trends around the world that are altering the long-term investment landscape where the next decade, is not gonna be anything like the previous decade. Thank you both for your time today and thank you for joining us.

Important Disclosure Information

Average Annual Total Returns as of 3/31/2023 (%)

NET               GROSS
International Premier 7.25 -9.21 7.85 2.21 6.50 5.85 12/31/10  1.44  1.59
4.70 -10.37 15.04 1.67 5.06 4.36 N/A  N/A  N/A
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, 2024.

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. Gannon’s, Mr. Fischer’s, and Mr. Rayner’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 3/31/23 (%)

  International Premier



Riken Keiki








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.

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.

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.

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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