in Bad Times
By Zhuo Ling, Lead Portfolio Manager Global Small Cap Strategy
We are very excited about the launch of the Global Small Cap Strategy on August 1st. It was truly a firmwide effort and the culmination of years of preparation. The Global Small Cap portfolio was built using a holistic approach with research support from all 15 of the firm’s investment professionals. As a first step, we pitted the ~150 companies owned across our US, Canadian, and China strategies against each other. A mosaic of exceptional businesses emerged and formed the core (~85%) of the global portfolio. Thereafter, using these best-in-class businesses as a benchmark of quality, the global team spent over a year hunting for unique stories across the world. After screening several thousand companies, 250 management meetings and over 10 conferences, 9 stocks made the cut and formed the remaining ~15% of the portfolio. These 9 companies possess all the characteristics of great businesses while offering unique growth vectors. By combining the old with the new, the global portfolio’s foundation is based on Van Berkom’s decades-long experience across major geographies. It’s fair to say that although the strategy is new, the portfolio is not.
Underpinning the Global Strategy is over 30 years of experience in Small Caps across geographies and market cycles and our core investment tenets have remained constant. We invest in businesses with excellent management and good governance; simple and predictable cash flows; dominant business models with high barriers to entry; elevated returns on capital; limited exposure to intrinsic risks that we don’t understand and strong balance sheets that don’t require constant access to capital to survive. Once invested, we become engaged long-term shareholders and avoid high turnover from market noise. Moreover, we also understand that small-cap markets are dynamic and sensitive to larger macro currents. Therefore, our research approach in each region is adapted to local realities. This combination of a core investment philosophy wrapped in adaptive in-depth research was applied to the US market 20 years ago and then replicated again for the Greater China region 10 years ago. In these two vast but diametrically different markets, the Van Berkom investment process generated significant and sustainable alpha through cycles. Having split my career between these two major markets, I am a true believer of the Van Berkom philosophy. Now, I am applying this tried-and-true process to the Global Small Cap Strategy.
In the years leading up to the launch, the global market had been strengthening. Furthermore, during the pandemic, the Fed propelled the market to a stratospheric level. Growth investing was orthodoxy, and value or even quality investing was seen as broken. In December 2021, I was attending a virtual European conference and met with my wish list of high-quality companies. The positivity of investors and the attending companies was palpable, even through a screen. A fellow investor told me it’s a market for quality-at-any-price and if that has worked through the pandemic, it should work going forward as well. Understandably, monetary and fiscal policy across the world was highly supportive and pushed interest rates to all time lows and asset prices to all time highs. It was unclear at the time when the party would end. I try and remain open to new ideas and new ways of thinking, but I am dedicated to the Van Berkom process and left the conference with very few actionable ideas. Less than 12 months later, everything pivoted 180 degrees: a war, an energy crisis, COVID zero, inflation, supply chain issues, rate hikes and a looming recession. “Buy the Dip” became “Sell the Rally”, and a sense of impending doom permeated across asset classes and time zones.
It’s not for the faint of heart to start a new strategy amid global upheavals, but all of us at Van Berkom trust the process. In fact, we have an inadvertent tradition of starting new strategies during market mayhem. The Canadian Small Cap Strategy was launched around the 1991 recession and the US Small Cap Strategy started as the tech bubble popped. A once-a-decade systematic sell-off levels the playing field and gives us an opportunity to invest in outstanding long-term compounders at very attractive prices. On this basis, a new strategy has the advantage of unique benefits:
The global portfolio was built in a post-COVID world where supply chain issues, inflation expectations and geopolitical risks are baked into the security selection process. While macro uncertainties will always be present, we were able to select companies with pricing power, limited war exposures, minimal COVID hangovers, controllable input costs, reasonable valuations, and strong balance sheets. In a sense, the clean slate allowed the portfolio to be ideally positioned for the current environment. For example, SES-Imagotag will continue to benefit from wage inflation that accelerates the adoption of their electronic shelf displays. Federal Signal is looking at years of backlog growth from suburban migration and the infrastructure bill. Houlihan Lokey and FTI Consulting are having accelerated discussions with companies about liabilities management.
From a stock-picking point of view, an environment of low interest rates and high valuations was very limiting for our style. We derive an intrinsic value based on the future cashflows of a company. This methodology breaks down for high-growth and high cash burn companies with no timeline towards profitability. When we identify fast-growing profitable companies with secular drivers, the market is often priced to perfection. Our discipline compels us to set it aside. In a sense, the current high-interest rate environment deflated the excess valuation and allowed us to buy these structural winners at a significant discount. On average, the portfolio stocks are at least 20% below their intrinsic value based on conservative assumptions with recession scenarios.
Although we are agnostic to timing, it doesn’t escape us that the current environment is ideally set up for the small-cap asset class. By the end of 09/30/2022, the All Country World Small Cap Index had a five-year annual return of 2.8%, significantly below the 30-year return of 8.6%. More importantly, for every period where the index had a five-year CAGR below 5%, the following 5 years generated double-digit returns 100% of the time (see table below). Moreover, history has also shown that in a high-inflation and rising rate environment, small caps tend to outperform larger-cap stocks because they are faster at adapting to economic conditions. This is especially true for the stocks that we look for. Companies with pricing power from niche industries or unique offerings combined with low leverage can benefit from a downturn through market share gains (organic or M&A) and can come out of the cycle in an even stronger position. For example, Ensign Group is rolling up bankrupt private operators for next to nothing. StoneX Group is getting new customers from larger banks that are shrinking their trading operations and from smaller competitors who are subscale.
Source: MSCI, Van Berkom.
We are heading into 2023 and responsible investment is table stakes for asset managers. To avoid paying for lip service, I want to focus on how responsible investment is integrated in practice into our investment process.
Since Sebastian van Berkom founded the firm more than 30 years ago, governance has always played a central role in the investment thesis. In small caps, the management team and the board have an outsized influence on the culture of the organization from the executive office all the way to frontline employees. We strongly believe that a great management team with a strong board is fundamental to the long-term success of a business. Therefore, management meetings and governance checks play an outsized role in our research process. Moreover, when governance deteriorates for a portfolio company, we never shied away from making our voice heard and push for changes through engagement with the board or through our proxy voting.
Over the last few years, as environmental and social considerations gained in importance both as risk factors and as investment opportunities, we integrated the evaluation of these factors in our investment process firmwide. Moreover, by leveraging our regular engagement with the management team and the board, we have addressed and pushed for a range of issues regarding environmental and social concerns. More recently, the firm did a comprehensive review to formally integrate ESG factors across our investment process starting from idea generation, to tracking and then eventually, reporting our overall impact.
For the Global Strategy, with over 6000 stocks in our investment universe, we believe we have the luxury of selecting only outstanding companies with a positive impact on the world while also offering superior capital returns.
More importantly, we translate this belief into practical steps within our investment process. At the idea generation phase, we prioritize investment candidates that align with one or many of the sustainable development goals outlined by the UN. At the research phase, we apply both the SASB and MSCI materiality guides to identify key areas of concern to focus our due diligence. Thereafter, we address these items directly with management or the board. At the Investment Committee review, we present the material factors identified and the company’s response as a component of the evaluation criteria. If a company makes it into the portfolio, an engagement plan is created and incorporated with our proxy voting procedures. Currently, out of the 47 companies in the portfolio, 41 have identified ESG as a corporate priority and 18 companies have set Sustainable Development Goals outlined by the UN. Our aim is to have all our portfolio companies embark on a journey towards sustainability, so engagement is very important to us. In small caps, companies often lack sophistication on ESG matters. As an active investor, we take it upon ourselves to communicate and share best practices. Running a Global Strategy has the benefit of having a holistic view of the world. We can see that Hong Kong-listed companies have better environmental disclosures than Canadian ones, and that US companies generally have a better governance structure than German ones. By leveraging our insights, we seek to engage with our portfolio companies to better manage their risks and identify opportunities in the transition to a more sustainable economy.
In the first four months (as at November 30), the strategy returned 6.76% and is 158bps ahead of the MSCI ACWI Small Cap Index. Despite the volatile market conditions, the portfolio has performed as expected. An important first step in building our long-term track record. Going forward, we will provide a quarterly update on performance with details on the best/worst performers as well as new positions and full exits.
In terms of outlook, we are all seeing and feeling the impact of higher inflation and interest rates. A recession is assumed a fait accompli. Corporate profits are bound to come down. The market is desperately trying to price in the severity of the downturn. We are not in the business of calling out short-term market directions, but we are highly confident about the long-term upside of our portfolio. The reason is simple: when the market sells off, we ask ourselves simple yet fundamental questions about the companies we own.
The answer to these questions might seem obvious. However, the market sometimes values companies as if people will stop purchasing pet foods, cities will stop cleaning sewers, bankruptcies will stop happening, or businesses will be back to pen and paper. We act (or take action) during these moments and see them as opportunities to build our position in quality companies. Our conviction is formed through channel checks, deep understanding of the industry, detailed financial modeling and thorough discussions with the management teams.
For the US portion of the Global strategy, the companies we own are in a strong position. These franchise leaders are well positioned to come out of the cycle stronger than ever given their track record of profitability, effective management teams and low balance sheet risks
For Canada, the global portfolio is only exposed to domestic champions with global footprints. On average, more than 60% of their revenues are generated outside of Canada. We believe the Canadian companies in our portfolio are uniquely positioned to take advantage of the current downturn and grow from strength internationally. A stable domestic political system, ample resources, easy access to supportive capital, productive immigration policies and proximity to the US market are all factors that support our Canadian holdings. Moreover, they are trading at a significant discount to their intrinsic value and to their global peers.
For the UK and European portfolio holdings, the region has by far the worst outlook from a consumer and investor point of view. We saw this firsthand as the team visited Germany right after the start of the war, Sweden right before their elections, and the UK in early December. A German CFO I met had an insightful take: “The troubles of Europe are all man-made and so are the solutions.” Without resolution for the Russian-Ukraine war, we believe Europe will struggle with energy security, inflation, and consumer sentiment, and the valuation of European stocks will remain depressed and potentially getting worse in the near term. That said, any reversal could be sudden and sharp, but impossible to predict. For the portfolio, we are either invested in macro-agnostic companies with global footprints such as Big Technologies (ankle tracking for house arrest) and Keywords Studios (video game developer) or local champions with structural tailwinds such as Musti (pet retailer in the Nordics) and Datagroup (IT outsourcing in Germany).
In Asia, China’s COVID-19 policy dominated the narrative. Everyone from small businesses to large multinationals were awaiting the CPC congress (Oct 16th) for policy clarity. Since then, the Zero Covid policy has been reversed and multiple economic supportive policies have been introduced. We’ve always had a contrarian view on China based on our unique insights developed by our team based in Hong Kong. We believe that with consolidated power, the Xi administration will have a decade of policy and regulatory clarity and a focus on domestic technology development and healthcare investment, electrification and renewable energy production, reduction in income inequality, and lower systematic risk factors (i.e. increased stability in real estate). These are all positive drivers for the companies in our portfolios. Through research support from Hong Kong, the Global Strategy has identified national champions aligned with the administration directives, and therefore possessing low political risks and strong policy benefits and in turn, high-quality sustainable growth prospects.
Overall, we remain convinced that the global portfolio can achieve very attractive long-term returns, despite the short-term volatile market environment. The portfolio is composed of unique and high-quality businesses led by capable leaders who are laser-focused on capitalizing on this downturn to outgrow their respective markets.
in Bad Times
By Zhuo Ling, Lead Portfolio Manager Global Small Cap Strategy
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