Commentary

International Small Cap Strategy

June 30, 2020

THE MARKET ENVIRONMENT
Major global markets finished higher for the second quarter, despite pockets of volatility dispersed throughout the reporting period. Businesses continued to grapple with the effects of the coronavirus pandemic on economic activity in the second quarter. In the U.K., gross domestic product sank 20.4% in April following a 5.8% decline in March. In Germany, industrial output dropped a record 17.9% in April after an 8.9% descent in March. In June, the International Monetary Fund (IMF) lowered its previous forecast for a 3.0% global economic contraction to a 4.9% global economic contraction for full-year 2020. The IMF also anticipates that the Japanese economy will shrink 5.8% in 2020, which is in excess of the 5.4% contraction the country experienced in 2009.

By the end of June, confirmed global coronavirus cases topped 10 million and global deaths from the virus surpassed the grim 500,000 mark. The U.S. accounted for over 25% of both global cases and deaths, with more than 35 states experiencing an increase in new cases by the end of June. Daily cases in the country eclipsed the 40,000 mark multiple times during the second quarter. Brazil trailed only the U.S. in both cases and deaths at more than 1.3 million and 55,000, respectively.

Meanwhile, heightened recognition of racial inequities and injustices prompted large-scale protests (and, in several cases, riots) to break out around the world. Surging protest activity that lasted weeks interrupted newly reopened businesses just emerging from pandemic-induced shutdowns, which led to further market volatility. The widespread call for change caused many organizations to publicly implement practices to fight racism, emphasize diversity, and eliminate offensive images, symbols and product brand names.

As is the case in any period of volatility, we find that the price of a business is an important aspect of what makes a stock attractive. Investing in a business at a fraction of what we think its underlying value is presents an opportunity to create value for our shareholders. In times like these, we look for high-quality companies with over-penalized share prices as investors disregard strong balance sheets and free cash flow and instead base investment decisions on market sentiment.

THE PORTFOLIO
Top Performers:
Early in the second quarter, Konecranes announced it had reached an agreement with a German customer for the delivery of 39 reach stackers, its largest ever such order. Later, the company released its first-quarter earnings report. We were pleased to see that group revenues held up better than we had expected, declining only 1.6% organically, while the order book was just 1.7% lower year-over-year on an organic basis. In the service segment, the service agreement base grew over 8% organically from the year-ago period and about 2% quarter-over-quarter. While Konecranes expects second-quarter sales and order intake will be lower across all divisions, the company believes cost cutting will drive earnings margins higher quarter-over-quarter. Konecranes’ operations are considered essential and technicians have been making a significant majority of planned customer maintenance visits throughout the pandemic. At the same time, some customers have asked the company to perform significant maintenance overhauls while their plants are closed, providing further support for the performance of the business during a very difficult economic environment. Our investment thesis for Konecranes remains intact.

Fiscal first-half results from Healius were strong, by our standards, and included year-over-year increases in revenue and earnings of 7.5% and 4.1%, respectively. Revenues advanced across segments and earnings rose in pathology (+10.4%) and imaging (+16.4%), while earnings fell in the medical centers (-8.9%) segment. The day prior to the earnings release, private equity firm Partners Group launched a bid for Healius at AUD 3.40 per share. We spoke with Chairman Rob Hubbard regarding the bid, which management rejected because they did not believe it reflected the fair value of the company, and we believe the decision was ultimately the correct one. We also reviewed the Sustainable Improvement Program cost-cutting initiative with CEO Malcolm Parmenter. The program saved AUD 20 million in the fiscal first half with the largest savings coming from technology and labor, and Parmenter sees ample opportunities to reduce expenses further. Lastly, late in the quarter, Healius sold its medical centers business to BGH Capital for AUD 500 million. While the price was not optimal, in our view, the sale removes a hefty level of execution risk. Therefore, we are glad management moved forward with the transaction.

Duerr participated in the German market rally in the second quarter and finished higher for the reporting period as a result. The company delivered first-quarter earnings results in May, which proved disappointing to investors as the current operating environment translated to delayed orders. However, we appreciated that gross margins continued to rise, despite the service decline. In our view, the two non-auto businesses, HOMAG (woodworking machinery) and clean technology, performed well considering the circumstances. Moreover, Duerr was free cash flow positive in the first quarter for the first time in a number of years. We spoke with CEO Ralf Dieter following the report and learned that Chinese HOMAG and paint segment orders actually increased. We appreciate Duerr’s strong balance sheet, which allows it to continue to fund research and development as well as pursue small bolt-on mergers and acquisitions. While the near-term industry outlook is weak, we believe the company is trading at a large discount to our estimate of the company’s intrinsic value.

Bottom Performers:
Babcock International’s share price fell late in the second quarter after management announced it would defer its final dividend and that its fiscal-year earnings were lower than expected. The company’s primary weakness has been its oil and gas aviation business. The global oil and gas market has become even more competitive and the significant fall in the price of oil, coupled with coronavirus-related restrictions, has made transport to offshore oil rigs more challenging and has hurt demand. Babcock recently announced that David Lockwood would become its new CEO in September, replacing Archie Bethel, who announced his retirement earlier this year. Lockwood was previously CEO of another large U.K. defense company, and we look forward to speaking with him in the coming months. Despite the company’s recent stock price weakness, we believe it is well positioned and trading at a large discount to our estimate of its underlying value.

Early in April, Dignity announced CEO Mark McCollum would step down immediately and Clive Whiley, who had been a non-executive chairman at the company since September 2019, would become executive chairman while the search for a permanent CEO is underway. Dignity also stated expectations that the coronavirus would likely have a significant impact on near-term revenues as the moratorium against social gatherings would affect conducting in-person memorial services. Considering these factors, we decided to exit our position in the company and redeployed the proceeds to holdings that we believe possess better risk/reward profiles.

We initiated a position in Equiniti Group in the second half of June, and the company’s share price declined for our short holding period in the second quarter. We like that Equiniti holds the leading market position in an oligopolistic share registry sector. In our view, share registry is a sticky, stable and critical part of any listed company. Furthermore, we find that the company’s management team is forward thinking as evidenced by share gains in most areas and aggressive management of the cost base. We believe that Equiniti is a solid investment that can reward shareholders into the future.

During the quarter, we initiated positions in ALS Limited, Elekta, Equiniti Group and St. James Place. We eliminated Dignity from the portfolio.

Past performance is no guarantee of future results.