Commentary

International Small Cap Strategy

September 30, 2020

THE MARKET ENVIRONMENT

During the third quarter, global markets continued to contend with the economic ramifications of Covid-19 as worldwide fatalities surpassed the grim 1 million mark. In August, the U.S. Federal Reserve announced a policy change that indicated it would not necessarily increase interest rates upon an improvement in unemployment figures, even if inflation is above the group’s traditional 2% target. At its September meeting, the Fed maintained near zero interest rates and publicized intentions to keep them at this level through 2023. Meanwhile, both the S&P 500 Index and the NASDAQ Index closed near peak levels in the quarter. Ultimately, the Fed raised its forecast for full-year 2020 gross domestic product (GDP) from a 6.5% contraction to a 3.7% contraction.

Similarly, both the European Central Bank and the Bank of Japan opted to keep interest rates steady in September. In Japan, the Nikkei 500 Index reached a record high, while industrial profits in China increased 20% in July and 19% in August. Conversely, the U.K. moved into a technical recession following a roughly 20% contraction in GDP in the second quarter, the largest on record, which followed an approximately 3% contraction in the first quarter. As of the end of the third quarter, the country had yet to secure a Brexit trade deal with the European Union. Furthermore, continued Covid-19 concerns and Saudi Arabia’s plans to cut oil prices translated to a decline in both West Texas Intermediate crude and Brent crude to less than $40 per barrel.

On the vaccine front, China indicated a Covid-19 vaccine may be ready for public consumption as early as November. Meanwhile, a leading vaccine candidate from the University of Oxford and AstraZeneca was halted again in September when a participant in its trial became ill. On the other hand, Johnson & Johnson’s vaccine candidate moved into Phase 3 of its clinical trials, the first single-dose vaccine in the U.S. to do so.

In our view, there is a lot of value in the market today. Though the near-term macro outlook may be mixed, positive vaccine developments or further signs of economic recovery from the initial shock of Covid-19 could improve market sentiment. In the meantime, we are finding good opportunities from a valuation perspective and think it is a ripe environment to be picking stocks.

THE PORTFOLIO

Top Performers:
During the quarter, Konecranes announced second-quarter earnings results that exceeded market expectations. Despite the significant impact of Covid-19 on the demand environment for the company’s products and services that resulted in revenue declining by 14.2% organically, all three divisions reported improved margins over the previous quarter. This result was driven by significant cost reduction efforts by management with additional cost reductions and restructuring activities announced to improve Konecranes’ profitability. The second-quarter results also showed solid free cash flow generation, driven by the resilient margins and significant working capital release, in our view. We believe the company remains an attractive investment and is well positioned for long-term growth and profitability improvement. Furthermore, after the close of the quarter, Konecranes and Cargotec, a Finnish cargo handling machinery maker, announced plans to merge. The companies expect the merger to increase scale and produce at least EUR 100 million of synergies. News of the merger sent the share price of Konecranes sharply higher.

Metso Outotec released a positive profit warning in July that exhibited the company’s resiliency in the second quarter as revenue and adjusted earnings estimates at both Metso Minerals and legacy Outotec were ahead of both market estimates and our own. The company’s official first-half report in August showed that revenue (EUR 751 million vs. EUR 735 million) and adjusted earnings (EUR 121 million vs. EUR 94 million) bested analysts’ expectations. At Metso Minerals, orders were up 3% organically, driven by strong demand in mining. Aggressive cost-saving actions paved the way for strong margins as well. In the legacy Outotec business, the minerals processing segment grew sales by 16% organically in the second quarter. Moreover, management increased its outlook for synergies from the combined company from EUR 100 million to EUR 120 million, with expectations to realize EUR 50 million in synergies by the end of this year. Overall, we continue to believe the combination of attractive industry fundamentals, the logic of the merger and a solid management team should result in positive outcomes for Metso Outotec into the future.

Considering the challenging operating environment, we think Atea delivered a strong second-quarter earnings report, highlighted by record sales and earnings results. Revenue growth amounted to 11.7%, adjusted earnings increased 51.3% and the adjusted earnings margin improved 54 basis points to 2.08%. Following the report’s release, we spoke with CFO Robert Giori, who believes the business is extremely strong outside of Denmark. We discussed the company’s deal with Lenovo in which it will implement AppXite on a global basis across its 60,000 partners and distributors worldwide. Giori noted that this is a “strike of lightning” in the development of the business. In our view, a sale of this non-core asset could unlock value.

Bottom Performers:
Before the pandemic began, ISS suffered from a massive IT malware attack in early 2020 that disrupted operations and resulted in excess costs. Due to Covid-19, revenue declined by nearly 10% organically in the second quarter. The business segments most significantly impacted by the virus were catering and above-base (work in excess of contract) and this revenue is falling away at a slightly higher margin than anticipated. Despite improving conditions, the near-term outlook remains uncertain and the company issued a rather wide guidance range for the 2020 fiscal year. That said, Covid-19 significantly increased demand for the company’s deep cleaning and disinfection services, which could support revenues in the medium term. ISS has a rather indebted balance sheet, but thanks to the lack of financial covenants and high liquidity, we believe the company should be able to navigate this difficult environment successfully. Although the operating environment is more challenging than expected, we are optimistic that the appointment of new CEO Jacob Aarup-Andersen, who started in September 2020, will provide the company with the fresh perspective it needs to improve its results. We believe ISS remains an attractive investment.

Investors were disappointed with EFG International’s first-half earnings report, challenged by a difficult market environment and currency headwinds. However, net new money grew at a 5.5% annualized pace in the first half, driven by a strong second quarter, and management is confident that current strength will continue. We spoke with CEO Giorgio Pradelli and CFO Dimitris Politis following the release of the report. We appreciate that a more systematic and structured pipeline analysis is translating to greater accountability, as well as an emphasis on properly identifying prospects while also improving the conversion rate. Though the hiring of relationship managers (RMs) slowed in the first half due to Covid-19, the pipeline to hire RMs remains strong, in our view, with 24 having been added in the month of July. Management also noted it has been easier to bring on higher caliber talent now that the integration with BSI is complete, which contributed to a steady increase in assets under management per RM. To offset interest rate headwinds, management intends to be more aggressive in re-pricing deposits and increasing its standardized fees. In addition, the company sees significant scope for further cost savings, noting incremental actions on general and administrative costs now that the integration is complete. Late in the third quarter, EFG entered into an agreement to “transfer its Ticino-based retail business, including individual clients and corporate clients who do not make use of its private banking business” to BancaStato. Our investment thesis for this company is intact as we believe its management team is working to enhance shareholder value.

Babcock International issued a fiscal first-quarter trading statement that reflected the material impact Covid-19 had on the company’s performance. Underlying revenue declined 11% compared with a year earlier and underlying operating profit was down 40%. Half of these reductions were related to lower levels of productivity in the core business. Safety constraints that are now necessary for close proximity working, such as reduced numbers of onsite staff and restricted access to customer sites, have had a significant impact on revenues as well as on costs and efficiency. Although the company did not provide forward guidance, management did note expectations for improvement in subsequent quarters and, as in previous years, performance should accelerate in the second half of the fiscal year. Management also stated progress with collecting outstanding accounts and the working capital position has strengthened. Lastly, Babcock installed a new CEO, David Lockwood, in September and we look forward to meeting him and learning about his strategic initiatives.

During the quarter, we initiated a position in Link Group. We eliminated ASL Limited, Neles and Signature Aviation from the portfolio.

Past performance is no guarantee of future results.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.

The NASDAQ Composite Index is a broad-based market-capitalization weighted index of all common type stocks on the NASDAQ Stock Market, including common stocks, American depositary receipts, ordinary shares, shares of beneficial interest or limited partnership interests, and tracking stocks. The index includes all NASDAQ listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures. This index is unmanaged and investors cannot invest directly in this index.

The Nikkei 500 Stock Average is a price-weighted average of 500 Japanese companies listed in the First Section of the Tokyo Stock Exchange. Constituents are selected based on liquidity and industry representation. 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 09/30/20.

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.