Portfolio Manager David Nadel explores the positioning and outlook for his high-quality international small-cap portfolio and discusses some of the companies that fit his approach.
What's the current positioning and outlook for the portfolio?
Well, the outlook is positive. We really like the healthcare sector. It's much broader and really cheaper outside the U.S .than it is in the U.S. We like industrials. They tend to be asset light industrials in our strategy.
We like IT companies, mostly software companies. So, that's where some of the positioning is in the portfolio. In terms of country, our biggest overweight is in Switzerland.
I think Switzerland may be the highest quality market in the world, bar none. Certainly, if you run into an international small-cap manager and they don't invest in Switzerland, that’s probably not a high-quality strategy, at least in my opinion.
How are you positioned to participate in an expanding global economy?
Well, I think we're positioned to participate in an expanding global company or a not so robust global economy. We, as I mentioned earlier, tend to eschew deeply cyclical businesses but small-caps, in general tend to outperform in expanding economies. They also tend to outperform, so our whitepaper shows, quite nicely in rising rate environments.
In fact, international small-cap, the whitepaper shows, has provided a return of about 380 basis points per year over international large-cap in rising rate environments. The German Bund is at 25 basis points. We like that finding.
How do current profit margins look for international small-caps?
I think the margin recovery story for international stocks is another reason to be optimistic about potential cyclical recovery. Operating margins for non-U.S. stocks, ex-financials, excluding financials, are about 400 basis points lower than U.S. stocks.
You've had tremendous productivity gains in the U.S. since the global economic crisis, really, which I think are going to be translated into some of our businesses. We're seeing evidence of that quarter after quarter with our holdings.
What is the investment thesis for some current International Premier Fund holdings?
Mark and I, Mark Rayner, the co-manager, visited Australia in June. A country which has not had a recession in 25 years. And one of the businesses we really like from Australia, which we've owned in the past, in International Premier, but added relatively recently again, is a company called Cochlear. Cochlear is the global number one in cochlear implants, they have about a 60 percent market share in cochlear implants.
It's a business market that's growing about eight percent a year. These are surgically implanted devices for people that suffer from severe hearing loss, beyond the scope of a hearing aid. The market for these people is only about two percent penetrated.
What we love about this business model is many things, not only the growth, but also this is literally an installed base of products. I mean surgically installed in the customer and there is a lot of aftermarket support of these products.
So whereas this company's portion of recurring revenue was pretty much zero about 15 years ago, now it's close to 25 percent, and that is actually higher margin revenue than the products themselves; that's things like software updates, etc. And so you've probably got 30 percent of profits coming from that. And so the company does what we do as well, is a discounted cash flow on what their installed base can produce over time.
We've also recently added a Swiss company called Burkhalter. Burkhalter is in the business of providing electricians for residential and for commercial property. This is a nice high barrier to entry business. You have to be highly skilled and certified as an electrician, the stakes are high.
They’re able to buy kind of mom-and-pop businesses and roll those businesses up and so long as they're able to source electricians at a favorable cost, this is a nice kind of a compounder type of business. Again, Burkhalter being an example of something that we owned in the past, sold the stock, kind of traded sideways for a couple of years, and we've reentered it.
I think what got us interested in Burkhalter was it had stayed in our premier wish list, which is a group of about 250 companies that we track carefully, where valuation might not have a enough of a margin of safety for us. But because the shares had traded sideways and the earnings had grown a little bit, the valuation had actually come much more into our zone, and so we have reentered that position.
Why do you think now is a good time for this portfolio?
Well, I think we're in the early innings of a kind of reversion to the mean, in terms of what the asset class and the portfolio can do. If you look at longer term statistics, you know, again, that rolling ten-year return, going back 20 years of data, average return for this asset class is 8.5 percent, but the trailing, the simple trailing 10-year return, is less than three percent.
So, it gives you a sense of how depressed international has been for many, many years, really for seven or eight years preceding 2017. This is a strategic asset class that deserves to us, a permanent allocation.
Article by David Nadel, The Royce Funds
