Commentary

International Small Cap Strategy

March 31, 2022

THE MARKET ENVIRONMENT

Major global markets finished lower for the first quarter as Russia’s invasion of Ukraine prompted unease among investors. In particular, major U.S. stock benchmarks delivered their worst quarterly performance since the onset of the Covid-19 pandemic. Throughout the first quarter, countries responded with sanctions on Russia in a nearly unified condemnation of the invasion. In China, concerns that its ties to Russia could result in sanctions from the U.S. pressured share prices in the country. However, a meeting of China’s State Council late in the first quarter effectively alleviated unease regarding its economic climate given the body’s pledge to support economic growth and stability.

Meanwhile, supply concerns stemming from the conflict sent prices of WTI crude oil in excess of $120 per barrel. In response, U.S. President Joe Biden announced the release of 1 million barrels of oil a day for the next six months from the U.S. Strategic Petroleum Reserves. In addition, OPEC confirmed its intent to increase production by more than 400,000 barrels per day.

As expected, the U.S. Federal Reserve raised interest rates by a quarter point in March for the first time since 2018. The Fed also struck a more hawkish tone than at its previous meeting. It now projects a total of seven rate hikes in 2022, an increase over the three projected rate increases in 2022 from its December meeting. In the following days, Fed Chairman Jerome Powell indicated that inflationary concerns further fueled by the crisis in Ukraine that led to a 7.9% increase in the consumer price index in February could lead to a more than one quarter of a percentage point hike at upcoming meetings. In the U.K., the Bank of England increased interest rates by another 25 basis points for its third rate hike since December. President of the European Central Bank Christine Lagarde pointed to a slower pace of rate hikes, despite a 5.9% inflation reading in February and a 7.5% inflation reading in March in the region.

As we have mentioned in time of previous crises, such as Brexit and the global financial crisis, we do not believe that share price movement reflects the long-term underlying value or quality of the businesses in which we invest. Our focus remains firmly on refining our value assessments as material, fundamental information flows from our companies and not on short-term, sentiment-driven share price movements. In our estimation, volatility is not synonymous with risk. Rather, it is an asset that can be utilized to optimize portfolio positioning for success over the long term.

THE PORTFOLIO

Top Performers:
Incitec Pivot benefited in the first quarter from rising fertilizer prices caused by supply concerns, export bans and rising gas costs. While global markets set Incitec’s realized prices, the company’s input costs are more nuanced and benefit from long-term contracts or low-cost positions as in the case of U.S. natural gas. Ammonia (produced at Incitec’s Waggaman plant in Louisiana) and diammonium phosphate (produced at Incitec’s Phosphate Hill plant in Australia) have soared to extremely high levels, providing near-term earnings upside for the company. Although prices will not remain this high forever and our view of normalized earnings is largely unchanged, the additional cash flow further reduces the company’s debt and can be returned to shareholders. Incitec also announced new CFO Paul Victor who is currently CFO of Sasol and has significant experience spanning oil and gas, gold and coal mining, and chemicals and energy. We believe this new addition will prove beneficial for Incitec.

In the first quarter, ConvaTec Group delivered fiscal year earnings results that largely aligned with consensus estimates. Organic revenue growth reached 5.3%, driven by the advanced wound care segment that grew 9.2%, reflecting a recovery in surgeries, strong commercial execution, a weak comparable figure and strong commercial execution. Continued strong demand also drove a 9.6% organic growth rate in infusion care. Management guided for organic growth of 4-5.5% in 2022 with an underlying operating margin of more than 18%, excluding many of the new products developed from ramping up research and development spend. CEO Karim Bitar also reiterated his belief that short- to medium-term margins should be in the low 20% range, while longer term margins should be in the mid 20% range, driven by reduced selling, general and administrative expenses. We appreciate that the company’s new management team is improving the operational effectiveness of the organization and narrowing the gap versus its peers, which adds to our confidence in the investment.

In our view, NOS SGPS reported a strong end to the year as fourth-quarter revenue improved 8.8% year-over-year driven by good performance in both the telecom (+8.6%) and cinema (+125%) segments. For the full-year period, revenue grew 4.6% and adjusted earnings improved 2.5%. The business continues to see momentum into 2022 with consumer telecom subscriptions increasingly moving toward a converged and higher value offering, business telecom subscriptions endorsing NOS’s various IT services, and cinema recovering as Covid-19 restrictions ebb. The company continues to aggressively roll out fiber to the home to lead the market in 5G rollout, though once NOS hits its target penetration, spending in this area should subside.

Bottom Performers:
Although we believed Duerr’s fiscal-year earnings results were decent, they proved disappointing to investors as net income, revenue and earnings fell short of analysts’ estimates. However, free cash flow generation was strong, order intake set a record and finished up 31% year-over-year, and management’s guidance for 2022 largely aligned with our expectations. We spoke with CFO Dietmar Heinrich in January and new CEO Jochen Weyrauch in March. We believe the company remains well-placed to restore profitability to pre-Covid-19 levels. In our view, Duerr remains a compelling investment with multiple avenues for growth in the core business as well as exciting options in battery coating, medical technology and software.

Konecranes’ fourth-quarter results largely surpassed consensus estimates. Revenue and earnings per share accelerated to EUR 948.9 million and EUR 0.86, respectively. In addition, the company sustained its EUR 0.88 per share dividend from the prior year. Management guided to sustained volatility in demand due to Covid-19, specifically in Asia-Pacific; however, it believes the demand environments in Europe and North America are at encouraging levels. Guidance for 2022 included expectations for increases in net sales and the adjusted earnings margin compared to 2021. Later in the first quarter, the U.K.’s Competition and Market Authority blocked Konecranes’ merger with Cargotec. In our view, this was the preferred outcome as it reduces complexity and eliminates the value leakage to Cargotec under a merger of equals. Konecranes subsequently delayed its annual general meeting scheduled for the end of March, but restated fiscal year 2022 guidance for higher sales and adjusted earnings margins despite the conflict in Ukraine.

SoftwareONE Holding released a disappointing set of 2021 results, missing guidance for both our own and consensus forecasts. After reiterating expectations for 25% gross profit growth and unchanged operating expenses for the second half of the year in September and October, each metric came in worse than had been expected. Management lowered mid-term guidance from 30% adjusted earnings margins to 25%. We later spoke with management, which offered further insight to the issues relating to poor guidance expectations and deal closures being delayed until 2022, and we believe these issues will not persist. Despite the disappointing results, we think the market has over-penalized SoftwareONE’s share price. The company reported CHF 180 million of earnings, a minimal decline of 3% year-over-year organically. With improvements in performance from management, the company still has a path toward success, in our view. We believe the company can properly navigate the transition from traditional software sales to the cloud by monetizing its maintenance revenue stream, app conversions and other services.

During the quarter, we added Grifols ADR to the portfolio and eliminated Autogrill.

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 03/31/22.

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.