Commentary

International Small Cap Strategy

December 31, 2023

THE MARKET ENVIRONMENT

Major global markets generally showed strength during the fourth quarter, despite pressure in October when Hamas, an Islamist political and military organization, orchestrated an attack against Israel, shaking markets and the geopolitical landscape. The U.S. reported its strongest quarter of gross domestic product growth in nearly two years at 4.3% annualized, while economic data throughout Europe and China was mixed and provided reasons for both pessimism and optimism.
 
The U.S. 10-year yield reached as high as 5% in the quarter before declining and ending the period around 3.86% as investors continue to digest economic data and expectations on interest rates. In November and December, the U.S. Federal Reserve met and held its benchmark interest rate steady at 5.50%. Similarly, the Bank of England held its benchmark interest rate at 5.25%, and the European Central Bank held rates steady at 4.50% at its most recent meeting. Headline inflation in the U.S. and the U.K. declined during the quarter and ended at 3.1% and 3.9% in the most recent release, respectively. The Bank of Japan continued its accommodative monetary policy stance, although it took a step toward reversing the policy when it announced that the 1% cap on its 10-year government bonds would be considered a reference rate going forward. The yen reversed its recent trend and gained value during the quarter, ending the period at approximately 141 USD/JPY.

We believe our intensive research process and focus on the long term help us find opportunities despite the pervasive theme of the time. When the market does not separate the macro from the micro, there is an exploitable opportunity for long-term investors, such as ourselves. We use times of uncertainty and volatility to strategically position our portfolios for long-term success and believe this approach best positions us for achieving the protection and appreciation of our investors’ capital over the long term.

THE PORTFOLIO

Top Performers:
Konecranes, an engineering company that specializes in lifting equipment and associated services, ranked as a top contributor for the quarter. The company released nine-month earnings in October that showed strong operational execution. The service business grew its agreement base by 1.6% versus the prior quarter and revenue by 11.5% versus the prior year in local currency, and EBITA margins expanded by 130 basis points to a record 20.9%. We believe the service business has the potential for both substantial growth and continued margin improvement. Industrial equipment, which has endured challenged profitability in recent years, demonstrated significant margin progress. Finally, the company’s port solutions segment delivered a 48% increase in EBITA compared to the prior year. We believe Konecranes remains an attractive investment and that it is well-positioned for long-term growth and profitability.

Dometic Group was a contributor during the fourth quarter. The Sweden-headquartered manufacturer of products for land vehicles and boats reported third-quarter results that we view as encouraging amidst a challenging external environment. In particular, aftermarket demand showed signs of stabilizing, margins increased year-over-year despite a decrease in organic growth, and strong cash generation drove deleveraging. We found Dometic Group’s operating cash flow of SEK 2.1 billion to be encouraging as the company posted the second biggest cash inflow in its history as still-elevated inventories continued to normalize. We view this as a strong result overall and continue to appreciate Dometic Group delivering on margin and cash generation. In our view, the company remains a very compelling investment.

Nexi was a contributor during the fourth quarter. The Italian financial company’s share price rose following multiple headlines of private equity buyers expressing interest in the company. Nexi also reported third-quarter results during the month that were generally in line with our estimates. Organic revenue grew 5% year-over-year and has grown 7% so far this fiscal year, on pace for management’s prior guidance. Adjusted earnings grew 8% organically in the third quarter and margins expanded by 160 basis points organically to 56.9%. Regarding the recent private equity headlines, CEO Paolo Bertoluzzo said he is “quite impressed by such a long list of high-quality private equity” suitors and that he views it as “a sign that qualified investors think that the price is low enough compared to the quality of the assets and their potential.” We believe payment processing businesses in Europe are well-positioned due to the region’s significant use of cash payments and its relatively low levels of bank payment outsourcing. As such, we appreciate Nexi’s more than 75% revenue exposure to attractive, fast-growth European payment markets, including Italy, Germany and Poland, as well as its ongoing ability to consolidate the European market. We believe the company remains undervalued today relative to our estimate of its intrinsic value.

Bottom Performers:
Duerr, a global mechanical and plant engineering firm for the automotive industry, was the top detractor for the quarter. In October, the company issued a 2024 profit warning while reaffirming its 2023 guidance. The profit warning was centered entirely around Homag, the furniture-making machinery and solid-wood construction business. The company deemed the warning necessary after order intake failed to improve in the third quarter. As such, Duerr expects Homag’s full-year 2024 revenue to decline around 15%, significantly detracting from the company’s profitability. Further, due to the expected decline, Duerr is no longer able to achieve its 8% group-adjusted earnings margin target in 2024, and management indicated a new range of 4.5-6%, implying that Homag margins could be as low as 2% compared to the prior target of 9%. Despite the setback, management indicated that Homag is still core to the business and that its long-term profit potential remains unchanged. Although we were disappointed by the news of Duerr’s 2024 profit warning and reduced our view of intrinsic value as a result, we believe the company remains a compelling investment with multiple avenues for profitable growth in its core business as well as exciting options in its battery coating, medical technology and software segments.

St. James’s Place was a detractor during the quarter. The U.K.-based investment management firm’s stock price fell following its announcement of a new revenue model, which eliminates early withdrawal charges to clients. The change will pressure both short-term and medium-term profitability and comes on the heels of the company’s August decision to reduce fees ahead of new U.K. regulation. We believe the updated revenue model is positive in the long term as it removes complexity, increases stability and aligns with regulatory requirements. While we lowered our estimate of intrinsic value, we continue to believe St. James’s Place represents an attractive risk-reward opportunity.

Julius Baer Group was a detractor during the quarter. In November, the Swiss private bank released a trading update that showed material deterioration in the profitability of its business over the past four months. We believe recent weakness is due to market volatility and upfront investment in hiring new relationship managers, which was confirmed through conversations with CFO Evie Kostakis. In our view, Julius Baer is an excellent business due to its strong competitive position in growing emerging markets and a new CEO who has taken steps to improve operating efficiency.

During the quarter, we initiated positions in LANXESS and Valmet. We eliminated Kansai Paint and Talanx from the portfolio.

Past performance is no guarantee of future results.

EBITA refers to Earnings Before the deduction of payments for Interest, Taxes and Amortization which is a measure of operating income.

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 12/31/2023.

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.