Commentary

International Small Cap Strategy

September 30, 2022

THE MARKET ENVIRONMENT

Major global markets continued to experience pressure and volatility in the third quarter as investors reacted to prevailing challenges facing economies across the world. Efforts by central banks to reign in elevated inflation by tightening financial conditions were at the forefront of financial discourse with investors reducing exposure to assets, such as equities, as interest rates climb at aggressive paces. In the U.S., the Federal Reserve raised its benchmark interest rate by 75 basis points in July and again in August to 3.00–3.25%. Importantly, rhetoric following each decision was noticeably hawkish as Fed Chair Jerome Powell looked to emphasize the Federal Open Market Committee’s commitment to regaining price stability with further rate hikes, even at the expense of economic hardship. The Bank of England, Bank of Canada and European Central Bank all increased their respective benchmark rates in September by 50, 75 and 75 basis points, respectively. China and Japan’s central banks opted for more accommodative policies. Major currencies including the pound, yen, euro, Australian dollar and Swiss franc all depreciated against the dollar throughout the quarter.

Late in the quarter, newly elected U.K. Prime Minister Liz Truss created some volatility in markets when she announced plans for an unfunded tax cut totaling GBP 45 billion per year in hopes of easing citizens financial burdens and spurring economic growth. The 30-year yield for a U.K. government bond jumped nearly 150 basis points in under a week to nearly 5% before settling at around 3.8%. The Bank of England reacted by purchasing gilts to stabilize the market and delayed its planned quantitative tightening program of selling gilts.

While we do not overlook the negative impacts the war in Ukraine, tightening financial conditions, energy crisis and volatile currencies will continue to have, we remain cognizant that a company’s value is derived from its longer term cash flows discounted back to the present day. As share prices fall across the board, we rely on our disciplined approach to identify exceptional businesses overpenalized by share price activity. In our view, risk is not synonymous with owning equities during times of market turmoil. Rather, we believe owning companies that meet our rigorous criteria at discounted levels offers an attractive opportunity on a risk to reward basis.

THE PORTFOLIO

Top Performers:
Vitesco Technologies Group reported results that had exceeded market expectations and maintained guidance for the fiscal year despite increasing inflation, a weaker economic environment and continued supply chain issues. The company is successfully raising prices with OEM customers to offset inflation and now expects to achieve a nearly 100% recovery in the second half. As a result, the profitability of the company’s core portfolio has been relatively resilient. Order intake for Vitesco’s burgeoning electrification products remains robust at EUR 2.3 billion in the second quarter and EUR 5.7 billion year-to-date. The company has also indicated that the order books are already sufficient to deliver the 2025 target of EUR 2 billion of revenue for the electrification technology segment. We are encouraged by the company’s momentum in electrification as well as the strength of its more mature products. We believe Vitesco remains an attractive investment.

Ansell Limited reported fiscal full-year adjusted net profit after tax, earnings and earnings per share that exceeded market expectations by 9%, 6% and 10%, respectively, while total revenue fell short of projections by 2%. Compared with the prior year, total revenue fell 3.7% and earnings declined 23.1% as revenue and earnings were lower across both operational segments. Many factors outside management’s control influenced Ansell’s performance, including negative currency effects and costs related to exiting its business in Russia. Importantly, management successfully delivered on commitments set at mid-year, including second-half growth in four of five business units and improved cash conversion, among others. Ansell’s fiscal 2023 guidance includes earnings per share in the range of AUD 1.15 to 1.35, which matches market predictions, and an improved GPADE margin (gross profit margin including distribution costs). Subsequent to the earnings release, we met via video with CEO Neil Salmon and CFO Zubair Javeed. We discussed some new strategic initiatives and the positive implications these shifts would have for both operational segments. Overall, we are comfortable with management’s approach and our investment thesis for this company remains intact.

In July, we believe EFG International delivered an adequate set of first-half earnings results, particularly when considering the material market headwinds impacting assets under management. On an underlying basis, net income increased 40% year-over-year with a favorable outlook on the back of higher interest rates. In addition, a more normal market performance will help to drive client activity, in our view, which should drive the underlying return on tangible equity above the 14.6% achieved in the first half of the year. The company followed up the report with an announcement for an extension of its share repurchase program by another three million shares. It plans to use the proceeds for funding employee incentive plans. Overall, our underlying thesis for ownership of EFG remains unchanged as its business quality continues to improve.

Bottom Performers:
Software AG released second-quarter results that were softer than we had estimated. Total organic product revenue fell 5%, overall bookings declined 15% and the earnings margin contracted by 600 basis points compared with last year. Weakness in the digital business platform (DBP) segment largely drove the shortfall. DBP bookings growth of 7% year-over-year missed both management’s expected pace for full-year growth and our own projections. DBP renewal activity declined 7%, which we believe may be due to some timing issues. Certain larger deals in the segment shifted into July that otherwise could have closed before quarter end. Even so, bookings for migration and net new business grew 11%. We spoke with CFO Matthias Heiden who acknowledged that execution in the quarter simply did not live up to forecasts largely due to self-inflicted complications as the company migrates from a highly legacy sales structure to a completely new model. Despite these near-term challenges, management reiterated its 2023 guidance, which calls for greater than EUR 1 billion of sales and a 25-30% margin on an organic basis.

Travis Perkins reported relatively healthy first half results, in our view. The core merchanting business (which accounts for 90% of group profitability) grew earnings 9% year-over-year. Toolstation did have a weaker than expected first half as DIY customers that had migrated to Toolstation during Covid-19 lockdowns shifted business back to traditional big box retailers as operating conditions normalized, resulting in excess costs and margin pressure at Toolstation. Even with the challenges at Toolstation, Travis earnings were flat on a year-over-year basis during the first half. Despite the resilience in earnings, Travis’ share price declined 22% in the quarter and has now fallen more than 50% year-to-date. The share price decline seems to be driven by fears that rising inflation/mortgage rates coupled with weakening consumer confidence is likely to lead to a material downturn in the U.K. housing market. While we believe U.K. housing is likely to experience a decline in transactions over the next year, Travis is exposed to RMI (repair, maintenance and improvement), spend which tends to be significantly more stable than housing transactions (if your roof is leaking you tend to fix it regardless of the macro environment). We believe the market is overestimating the sensitivity of Travis’ earnings to downturn in housing transactions. Looking back to the 2008 financial crisis, Travis’ merchanting earnings declined roughly 30% peak to trough in the middle of a housing lead recession. We see far less speculation in the U.K. housing market today than in 2008, but we believe Travis’ current share price implies a similar correction in underlying earnings as seen during the financial crisis. Thus, we believe the stock represents compelling value at current levels, and have been increasing our exposure to the name.

Fiscal first-half results from Azimut Holding were solid, from our perspective. Total revenue reached EUR 666.2 million and rose 18% from a year earlier as fees advanced across categories. However, assets under management declined 3.8% year-to-date and net income of EUR 201.7 million fell 11% below management’s guidance, which the market may have found concerning. Even so, management reiterated its guidance for at least EUR 400 million of net income for the full year. In addition, although assets under management undershot our estimates, we find it encouraging that net inflows are trending ahead of our forecasts through June with an increase of 4.2% (+3.2% organic) and July organic net inflows of EUR 516 million were also strong, in our view. Lastly, Azimut finished the reporting period with EUR 285 million of net cash despite experiencing higher costs than our targets and issuing a EUR 1.30 per share dividend payment in June. We think Azimut is executing well while operating in a difficult market.

During the quarter, we added GN Store Nord to the portfolio. We eliminated our positions in Healius, Incitec Pivot and NOS SGPS.

Past performance is no guarantee of future results.

The MSCI World ex U.S. Small Cap Index (Net) is designed to measure performance of small-cap stocks across 22 of 23 Developed Markets (excluding the United States). The index cover approximately 14% of the free float-adjusted market capitalization in each country. This benchmark calculates reinvested dividends net of withholding taxes. This index is unmanaged and investors cannot invest directly in this index.

The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s International Small Cap Equity composite as of 09/30/2022.

Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.