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.

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 can find situations where companies find ways to overcome challenges that a weakened economy might pose.

Dilip: I do want to re-emphasize Jim’s earlier point, which is really the mandate we follow at Royce. In addition to this play on export-driven businesses, within each of these two markets are individual companies that are growing within their respective economies. Just because an economy might be growing only 1-2% instead of 5-7%, there still can be lots of small companies that are taking share. So while we may at times veer towards companies that are export focused, it’s not the primary criteria.

Are there any themes unique to Europe that you are currently exploring?

Dilip: Within both countries we are finding, for example, that share is shifting from traditional media to the internet space. This, of course, is not particularly unique to Europe—but the interesting thing here is that we’ve been able to find companies within the internet sector both trading at valuations that you don’t typically see in the U.S. and valued at prices that meet our investment criteria.

Tomorrow Focus is a Munich-listed digital media content company—it’s effectively the Trip Advisor of Germany. As is the case in the U.S. where travel agents and traditional travel publications are having a tough time competing with online platforms, services like Trip Advisor are growing solidly. Tomorrow Focus is the largest online travel portal in Germany, and, again, we’re able to buy it at a valuation level we wouldn’t typically see in the U.S. for a similar business.

Additionally, Tomorrow Focus operates two other businesses: an online dating service and a medical ratings service. The latter allows users to rate their experiences with physicians so users can better gauge their options.

These types of businesses in the U.S. tend to trade at much higher valuations. In Europe, we haven’t seen venture capital funding come in at the same level that you see in the U.S., so that’s why we’ve been able to buy these businesses at a relative discount.

Jim: Another business we own is XING, which is essentially the LinkedIn of the D-A-CH countries: Germany, Austria, and Switzerland. Investors might ask themselves, “Why would anyone compete with LinkedIn?” XING is unique because it is a business-oriented social networking service which caters to people working in this part of the world, where it has a higher market share than LinkedIn. In fact, XING has double the amount of users in Germany and these other countries than LinkedIn, with around 90% of page views coming from the D-A-CH regions. It’s really become the place to be for business networking and, increasingly, if you want to find a job in this region of Europe.

While the natural assumption in terms of the endgame for XING may be that it gets acquired by LinkedIn, we believe the company can really stand on its own. The business generates cash, is profitable, is growing, and pays a dividend. Here, we feel we can participate in a LinkedIn-type of business in a small-cap stock in a part of the world where LinkedIn is less relevant.

Small-cap internet and new media companies—the types of things we see here at home that trade at these stratospheric valuations—outside the U.S. give investors the opportunity to participate or own a piece of this rapidly growing industry with companies that can actually be valued on earnings, on operating income. Again, this is not always the case in the U.S.

Dilip: XING is taking share from traditional employment services companies. So although the overall German economy might not be growing right now, employment services is still a big market. XING saves employers money, so it’s a great value proposition for the employer. Additionally, this is a classic network-effect type of company, which makes it very difficult for it to get displaced. If the German economy does begin to really grow again, we believe we will see quite a bit of operating leverage in the business. But if the economy remains anemic, we still feel XING will be able to grow.

What does the employment level in Germany look like relative to the economic conditions there?

Dilip: That is one way Germany and France are in stark contrast. Unemployment is actually pretty high in France—I think it’s close to 10%—whereas in Germany it’s about 5%. That’s a big disparity, especially for young people looking for work.

What other investment themes unique to Europe are you looking at?

Dilip: The last name I want to mention on the technology theme is French-based aufeminin.com, an internet portal that focuses on women’s interests. It’s a dominant player in the market and it’s still growing. As in most developed societies, people are increasingly getting their information online.

Digital content is still a new industry, and businesses are trying to figure out how to generate the right mechanism for pricing ads and/or subscription services. But even as the industry develops, aufeminin.com is still making money. The stock is cheap in our view; it trades at around 12x earnings. Again, it would be hard to find a business like this in the U.S. with that kind of growth rate and multiple.

Jim: Investors just aren’t paying attention, and in this case it could be due to liquidity because there is a large owner. But here you have a web property that is one of the largest providers of women’s content in the world—not just in France. It has sites operating throughout Europe, Canada, and even a little bit in the U.S., and you can get its shares at an affordable price.

Dilip: Mutares and Aurelius are small private equity firms that are unique to Europe. The latter is based in Munich with additional office locations in London, Stockholm, and Madrid. While we do not own Aurelius in International Micro-Cap’s portfolio, as a firm we’ve owned it for about three years now. We met Mutares, also located in Munich, on this trip.

Because of how the labor laws in Europe are structured, it’s difficult for companies to shut down a business division or subsidiary. Both Mutares and Aurelius serve large conglomerates by acquiring those divisions that they are looking to phase out. Often, Mutares and Aurelius will receive an up-front payment to take on ownership of these subsidiaries, and once they are acquired, will work to restructure the business and return it back to profitability in order to avoid having to lay off employees. We believe these small private equity firms are great little compounding machines.

While it may be natural to conclude that these types of “sweetheart” deals would attract many competitors, the fact of the matter is there’s a lot of labor intensity and expertise required to take part in this type of business. For example, with one of the acquisitions Mutares made recently, one of the partners made 47 visits to France within a three-month period. For large private equity firms, these types of small deals just don’t make sense.

Jim: This business model is unique to these European markets because of the social contract that these large companies have with their employees, which makes it very difficult for management to lay people off. The nice thing about Aurelius is that it has a reputation for handling acquisitions properly. Once these big companies decide to relinquish an asset, they don’t want negative press associated with it: they want to avoid any lingering effects from a PR standpoint, so they must trust that the acquirers will handle the transaction appropriately.

Dilip: The ideal outcome is these acquired subsidiaries get turned around while the majority of workers remain employed.

Jim: It’s exciting to operate in this small end of the market. As Dilip mentioned, the real beauty about this business is that these small private equity firms often get paid to take these operations off the hands of larger companies, even if it’s just funding the working capital required to get things moving in the right direction. So this typically results in returns on capital that are quite high—often eight or more times the amount of capital employed. Once the acquired businesses are turned around, Mutares and Aurelius can do a number of things: they can sell it, keep it as part of their operating entity and enjoy the operating income that the underlying business generates, or they can IPO it.

Dilip: I think a common misconception some investors might have about this kind of business is that when the economy is bad, business picks up. We don’t make those kinds of predictions or rely on macro events to inform our investment decisions at Royce. We’ve known Aurelius for a long time now, and through frequent communication with management we’ve learned that its business has been fairly consistent regardless of how the economy might be doing.

What are some questions you typically ask management teams?

Jim: Generally, it starts with wanting to know how the company came about, how long it’s been around, and who’s been in charge along the way. We want to understand what they do, and that will typically lead to a whole host of questions about their operations. We will then ask questions based on criteria that are important to us. What’s the growth profile? How does the company generate returns?

As far as how we come upon some of these companies, it’s generally the same across the board. We want to see certain levels of return on capital, and we want to see companies that exhibit some type of operating leverage where operating income is preferably growing at a faster pace than sales over time. That alone will very often lead us to companies that are doing something right, whether it comes from pricing power, highly efficient operations, or scale. It’s a great validation of our overall process when the numbers lead us to the right kinds of stories.

Dilip: When we’re on the road we want to meet as many companies as possible because you never really know what types of opportunities are out there until you meet management teams face to face. Listening to management teams describe their companies in a live setting is a much different intellectual exercise than simply reading written research or news headlines. So we try to keep a full schedule of meetings in order to fully take advantage of our time on the road.

Jim: It’s important to keep in mind that we could be in a soft patch again in Europe. We don’t know how long it’s going to last, and we don’t know how things are eventually going to turn around. Europe is at a fragile moment again—you have leaders talking and disagreeing in a lot of cases as to what the right growth path is. Germany and France have been debating with each other as to whether it is austerity or stimulus that will pull them out of this.

Again, despite all the issues, we have confidence in the companies we’ve aligned ourselves with. We just have to wait until the market starts cooperating again. Given the unique attributes and growth profiles of these companies, our expectation is that they will hold up just fine.

At the end of the day it’s satisfying that we’re building a fairly unique database of knowledge on these small- and micro-cap companies around the world. When we are out on the road we often come across companies that are underfollowed and misunderstood. That’s important because it creates interesting opportunities. I’ve been researching companies and managing portfolios for more than 15 years and I can say with confidence that this is truly one of the most inefficient parts of the equity markets I’ve ever seen.  That’s what really makes this an enjoyable effort.