Value Investing

Germany and France: Looking for Quality In Small-Caps

Germany and France: Looking for Quality in the Eurozone by Royce Funds

While concerns over economic growth in Europe have been escalating, Royce International Micro-Cap Fund Portfolio Managers Jim Harvey and Dilip Badlani are finding small-cap opportunities with long-term benefits.

Germany and France: Looking for Quality In Small-Caps

Concerns about slower growth in Europe and Asia appear to once again be escalating, making investors with international exposure anxious. What were your observations during your recent visit to continental Europe?

Dilip Badlani: In early October, Jim and I visited Germany and France. In Munich, we attended a conference where we had the opportunity to meet with companies from throughout the continent, making a total of 15 one-on-one meetings in Germany and five meetings in Paris.

Despite what’s been happening in the eurozone, we find that quality is abundant in the French and German markets. Germany and France are the world’s fourth- and fifth-largest economies, respectively, and combined the two countries have a GDP of approximately $6 trillion. In addition, both are export powerhouses. Following China and the U.S., Germany is the largest exporter in the world, while France ranks in the top six.

Germany and France both face different challenges today despite being a part of the same economic region. Our job is to analyze these challenges to uncover unique opportunities within each market.

Jim Harvey: While we were in Europe, early signs of recent weakness started to emerge. People were talking about Europe possibly rolling over again. In fact, Germany’s Purchasing Manager’s Index (PMI) really started to decline during the summer, dipping into negative territory in September. I think France currently has a bit more on its plate, and we are at that point again in Europe where people are starting to question growth and whether further stimulus measures may be necessary.

What types of businesses or areas of the market might help mitigate the risks of investing in Europe?

Jim: I think it’s worth mentioning that in Germany you are going to find world-class smaller companies. If investors are willing to take that deep dive and really look closely, they’re often going to see best practices among some of them and find very well-run companies.

At Royce we begin by looking at companies with a quality orientation. Quality to us is a company with a strong, unlevered balance sheet that has the ability to generate high returns on invested capital and free cash flow, take market share, and remain profitable during unfavorable economic climates. As long-term investors, we’re looking for reasonable growth and plans by management to create shareholder value.

Dilip: Even though Germany is a large economy which would provide ample opportunities for a small company, a lot of the micro-cap and small-cap companies that we tend to follow are driven by the same export-oriented mentality as the larger companies. So when they look at their market, they are targeting the high-quality spectrum with a value-added global component.

Our primary function when meeting with management is to understand the culture of the company. We want to know how management teams are thinking about their business and how they plan to generate returns for shareholders. So we like to get on the road to understand the elements of those plans, whether it’s a turnaround or something going on internally where these companies can grow despite what’s going on around them in the macro economy.

Today, the popularity of French President Francois Hollande is pretty much at an all-time low since he was elected in 2012. But the fact remains that France is a $2.5 trillion economy and a critical area for any global investor. Again, similar to Germany, we have found there are a lot of high-quality businesses that are headquartered in France but have a majority of their revenues coming from overseas. Many French smaller companies are also able to find ways to effectively manage their businesses despite the macro and socioeconomic headwinds.

Jim: We came across Lectra, an export-driven company headquartered in France, when we were in Paris. Lectra is a global leader in equipment used to automate the design and cutting of fabrics. It has carved out a pretty good business with high-end brands, many of which are based in France and Italy.

The company is a trusted source for providing equipment and software that allow its clients to design and manufacture their own apparel and accessories. These high-demanding customers have to maintain their brand image, so having a trusted and reliable supplier is very important. Lectra has been serving their needs for quite some time, investing heavily in R&D during the recent downturn and positioning itself to get back into growth mode.

Lectra also has a dominant position in the automotive sector, which is something we like to see. It took its expertise in manufacturing clothing and other kinds of fabrics and applied it to automotive products such as car seats and airbags. The increasingly diversified nature of the business is something we’re highly attracted to.

Dilip: Management made a decision four years ago to spend money to move the business overseas, and while this has caused some near-term pain in the financial results, ultimately it is the right decision for the long term. Management saw that its customers—the global fashion houses and global automotive companies—were moving away from Europe, and in order to serve them better, it needed to move its manufacturing and its staff away from Europe to Mexico and China. That cost the company in the near term from a margin perspective, but management expects margins to start ticking back up because the costs have now been largely baked in.

Jim: The market wants to wait and see if Lectra’s plans come to fruition. That, coupled with the fact that the French stock market is down, gave us, in our view, a solid entry point. The nice thing about going on the road and meeting with management teams is being able to gauge honesty, commitment, passion, and the mindset of management that you wouldn’t necessarily be able to read from a financial statement.

Our primary function when meeting with management is to understand the culture of the company. We want to know how management teams are thinking about their business and how they plan to generate returns for shareholders. So we like to get on the road to understand the elements of those plans, whether it’s a turnaround or something going on internally where these companies can grow despite what’s going on around them in the macro economy.

Dilip: This is a company where the stock has been hit hard because of the weakness in the European equity markets and lower confidence in the euro. However, the business actually benefits from a weakening euro. Even though France might not be doing well, the company operates a global business.

Jim: In general, the companies we met with in Paris all acknowledge the structural challenges that the economy is facing. Most of the management teams we met with in France generally don’t agree with how the country is being run. But again, if you look hard enough, you