Portfolio Manager and Director of International Research David Nadel discusses our attraction to international small-caps, how our investment approach translates into the international small-cap universe, how we try to avoid value traps, the effect monetary policy has had on our approach and performance, and more.
Over the past several years, international markets have lagged their domestic peers. Why is now the right time for investors to add international small-caps to their portfolio?
Investors should consider international small-caps for a number of reasons. First, investing in international small-caps increases your exposure to many unique businesses that are unavailable as pure plays in the U.S.
Some examples of unique non-U.S. businesses include Virbac, the leading pure play in animal pharmaceuticals; Fresnillo, the leading primary silver producer; Ashmore Group, the global number one pure-play manager of emerging market fixed income; and Victrex, the leading pure play in the production of “PEEK” plastics. In short, international small-cap is home to many world-class companies.
Additionally, there were more than 20,000 small-caps traded outside the U.S. at the end of 2013.1
Royce’s International Funds
- Flagship international fund
- Diversified portfolio of currently more than 100 stocks.
- Concentrated portfolio of currently approximately 50 companies
- International counterpart to Royce Premier Fund
A second reason investors should consider international small-caps is valuation. The prolonged outperformance of U.S. equities over international equities has created some very compelling values in the international small-cap space.
Relative to the stock-market highs achieved before the global economic crisis in 2008, European equities, for example, are trading at roughly 30% below those highs. In contrast, U.S. equities are making new highs and are now trading about 40% above pre-global economic crisis highs.
The valuation appeal is arguably even more striking when we move to emerging markets. Emerging market equities have underperformed global equities for three consecutive years now, a very unusual streak.
With most attention being focused on the macro headwinds facing the international markets, I think it’s easy for a lot of investors to overlook the underlying fundamentals that make international small-caps so compelling for us at Royce.
This mainstream de-emphasis on individual companies, as well as a lack of institutional focus, often creates mispricing. For long-term investors such as ourselves, we believe it represents an attractive stock-picker’s market.
Furthermore, the profit margins of international companies on average are still depressed (and in many cases recovering), whereas U.S. corporate profit margins are now at all-time highs. In essence, in international small-caps we see the possibility of both margin expansion and multiple expansion, a combination that could set the stage for powerful returns over the next two to three years.
How does Royce’s investment philosophy translate into the international small-cap universe?
Royce’s investment philosophy is built on risk management. We believe that preserving capital is just as critical as growing it, and that an investment approach that focuses on shedding less value during downturns—while remaining competitive in more bullish periods—can provide very strong absolute returns over long-term time periods.
This is baked into our approach and stock-selection process for international small-caps. We look to target companies that are globally structured and that have the wherewithal to withstand divergent market conditions or out-of-left-field events. Once we’ve run our proprietary quantitative screens and have done our qualitative due diligence, we begin looking at valuations.
In terms of valuation, we target a 15% cap rate at entry and a 7-8% cap rate at exit, meaning that we seek an intended cap-rate return of 100%. We calculate cap rate—the inverse of a multiple—by dividing earnings before interest and taxes (EBIT) by Enterprise Value, which equates to a company’s earnings yield before taxes.
Our 15% cap rate at entry approximates 7x operating income, or roughly 10x post-tax earnings, and our 7-8% cap rate at exit approximates 14-15x operating income, or roughly 20x post-tax earnings.
Our international team consists of six portfolio managers and analysts—including London-based Royce portfolio manager Mark Rayner —who travel extensively around the globe to source and analyze investments.
How do you try to avoid value traps?
It’s very easy to find cheap companies, but many of them are inexpensive for a very good reason.
Qualitative research is a big part of our company analysis. We’re more than willing to leave our chairs, ignore the headlines, and go beyond traditional research methods.
This is especially important in the international small-cap space, where research coverage is limited, and information is disseminated less efficiently.
Traveling abroad to meet with company management often reinforces our conviction in a business or reveals something that quantitative analysis cannot show.
We try to visit 300 non-U.S. companies per year. In addition to interviewing company management, we also talk with suppliers, competitors, and key customers.
One key way we try to avoid value traps is by focusing first on company quality before looking at valuation. Rather than screening for statistically cheap companies—many of which have flawed business models, making them deserving of their depressed valuation—we search for the highest quality companies we can find and then wait for their valuation to be attractive enough for us to invest with confidence. Learn more about our international investment process.
What effect has monetary policy—be it Japan, Europe, or the U.S.—had on your approach and the performance of your Funds?
We’re disciplined, bottom-up stock pickers, so the actions of the Fed, ECB, and the BOJ haven’t had a dramatic effect on our approach, which is something that has not changed since Chuck Royce founded the firm more than 40 years ago.
The repercussions of monetary policy, however, have hurt the shorter-term relative performance of some of our Funds.
In essence, in international small-caps we see the possibility of both margin expansion and multiple expansion, a combination which could set the stage for powerful returns over the next two to three years.
In an effort to support economic recovery and to avoid deflation, major central banks have implemented fiscal policies using unprecedented—and unorthodox—stimulus measures.
Amidst this zero interest rate policy (ZIRP), financially levered companies and industries have been driving benchmark index performance. Arguably, it’s been a “low-quality rally” over the last 18-20 months, a rally of speculative, highly levered companies that have benefited from access to cheap capital and the ability to restructure debt.
We haven’t changed our approach to chase speculative companies. At Royce, we want to own self-funding companies with strong, unlevered balance sheets, strong market shares, high ROIC, an established record of profitability, and the ability to generate free cash flow—in essence, quality companies with competitive “moats” that do not need to rely on easy money to survive tepid economic climates. While our approach may be temporarily out of favor, we believe quality will persevere, especially as interest rates rise—and they most likely will—and the economy begins to grow at a more normalized pace.
Do international small-caps pay dividends?
The dividend story abroad is quite interesting. Not only are dividends more prevalent among non-U.S. small companies, but their yields are often more generous than those in the U.S. (There is no guarantee that companies that pay a dividend will continue to do so