Commentary

International Small Cap Strategy

June 30, 2021

THE MARKET ENVIRONMENT

Despite experiencing some volatility in June, major global markets finished largely higher for the second quarter. In April, inflation in the U.S. accelerated at the fastest rate in more than 10 years as the Consumer Price Index rose 4.2% year-over-year and 0.8% month-over-month. Core inflation (stripping out food and energy prices) in May rose at the fastest pace since 1992, up 3.8% versus the year-ago period, while concerns for supply shortages drove national gasoline prices in excess of $3 per gallon for the first time in over five years. In June, oil prices reached their highest point in more than two years, and markets responded unfavorably to the U.S. Federal Reserve’s heightened expectations for inflation in 2021. While the Fed noted that inflationary pressures are “transitory,” it also now foresees two interest rate hikes in 2023. This compares to its forecast in March for zero rate hikes until at least 2024. However, Chairman Jerome Powell made assurances later in June that the Fed would not be coerced into raising interest rates on inflationary fears alone.

On the Covid-19 front, total global cases surpassed 180 million and global deaths approached 4 million. By the end of the second quarter, more than 800 million people reached full vaccination, representing about 10% of the global population. The overall increased distribution of Covid-19 vaccines and the additional stimulus in the U.S. contributed to the International Monetary Fund’s (IMF) decision to increase its outlook for global economic expansion for 2021 from 5.5% to 6.0%. The IMF also now expects 8.4%, 4.4% and 3.3% economic growth in China, the eurozone and Japan, respectively, as well as 6.4% economic expansion in the U.S in 2021.

In our view, there is still value to be had in value investing. We are finding a large gap in valuations when comparing growth and value stocks, and believe value stocks remain attractive on both an absolute and relative basis. Though conditions are ripe for value stocks to recognize upside potential, we also acknowledge that the backdrop of the market could change at any time as evidenced most recently by Covid-19. As such, we aim to invest in companies with strong balance sheets and management teams that can remain successful no matter the macroeconomic backdrop.

THE PORTFOLIO

Top Performers:
ISS released a first-quarter trading update that included revenue of DKK 17.21 billion, which reflected a year-over-year decline of 8.9% as the company continues to feel the effects from the Covid-19 pandemic. However, revenue surpassed market expectations of DKK 16.44 billion, which investors viewed positively. We, too, thought results were good as organic revenue fell 5.6%, which was materially better than organic revenue decreases in previous quarters (second-quarter 2020, -9.9%; third-quarter 2020, -8.8%; and fourth-quarter 2020, -11%). We saw other evidence of sequential improvement. For example, greater demand for above-base work, especially deep cleaning and disinfection, drove organic revenue in this business to grow 20%, which partially offset the 40% revenue decline in the catering business. In addition, ISS renewed some key contracts during the first quarter, including its second largest client relationship with Barclays (which has operations in 30 countries) and its contract with Rolls-Royce (with operations in 8 countries). Lastly, management reaffirmed its full-year outlook and turnaround targets and cancelled its access to EUR 700 million in revolving credit, which was established in 2020 as backup liquidity. We believe ISS can build on this positive momentum and strengthen performance going forward.

LSL Property Services released full-year 2020 results that included earnings (before interest and taxes) on a pre-Covid-19 basis that increased 13% from the prior year and met market expectations. However, including pandemic effects, revenue and earnings declined compared with last year, which the market largely expected. While full-year results generally aligned with our estimates, management’s 2021 guidance was well ahead of our forecasts (and market projections), owing to strong first-quarter performance. Although housing transactions declined 11% year-over-year in 2020, first-quarter 2021 housing transactions were 55% above 2019 levels, and management anticipates 10-18% transaction growth for full-year 2021. In addition, performance of LSL’s other segments positively added to results. The survey business strengthened in the second half of 2020, driven by a recovery in housing transactions and the financial services business signed a partnership agreement with the U.K.’s largest real estate agent TPFG that will expand its mortgage broker coverage area. We think these developments can enhance LSL’s intrinsic value.

ConvaTec Group’s first-quarter trading update included total revenue that reached $500 million, which was nearly a 9% advance from a very strong comparable period last year. Total revenue was also ahead of market forecasts of $474 million. Although organic revenue rose 6.7% and surpassed our full-year estimate, some of this solid progress was due to restocking benefits. All segments realized revenue growth year-over-year with the highest reported increase in the infusion care segment (+13.9%), followed by advanced wound care (+8.8%). Despite this robust first-quarter performance, management maintained its full-year guidance for organic revenue growth of 3-4.5% and for the underlying operating profit margin of 18-19.5% in constant currency. We think this guidance is rather conservative and increased some of our near-term valuation metrics as we are optimistic that ConvaTec can build on this positive momentum.

Bottom Performers:
The share price of Incitec Pivot dropped in the first quarter after management announced a delay in reopening its Waggaman ammonia plant. The facility resumed operations in mid-April as management had expected. However, the company subsequently experienced some unexpected equipment issues and the restart process halted on May 8, which management thinks will additionally decrease full-year earnings by AUD 33-42 million. Later, Incitec released fiscal first-half results that we saw as mixed. Total revenue declined 6.7% from the prior year and earnings fell nearly 31%, both of which also undershot market projections. As we had anticipated, the explosives business suffered from Waggaman and other planned and unplanned facility outages, including the Cheyenne and Louisiana Ammonium Nitrate plants. Consequently, total earnings fell by AUD 49 million from a year ago. Even so, the drop was partially offset by a net benefit of AUD 25 million, mainly from increasing commodity prices. Conversely, the fertilizer business achieved a revenue advance of 1.9%, and first-half earnings reached AUD 20 million, which was a material reversal from the loss of AUD 10 million in the first half of 2020. While Incitec continues to work through these near-term challenges, we believe the company is well positioned to realize stronger fiscal second-half performance.

Wynn Macau’s first-quarter results were particularly weak compared with the prior-year period that included pre-pandemic activity, which was not surprising to us. Although revenue declined 15% from a year earlier, we found it reassuring that revenue improved sequentially and advanced 4% in the first quarter compared with the fourth quarter of 2020. At the same time, adjusted property earnings rose 49% year-over-year (+11% quarter-over-quarter) to $44 million, which slightly outpaced market expectations for $42 million. Management hosted a conference call and exhibited a confident tone owing to strengthening monthly metrics. The Golden Week holiday was quite strong and generated about $3 million of earnings per day, the highest level of earnings since the pandemic began (reaching roughly 80% of 2019 Golden Week levels). Management expressed optimism that the summer months will continue to see improvement based on pent-up demand and new customers visiting Macau. We see evidence that a recovery is underway as gross gaming revenue in Macau has been rising with year-over-year increases in March (+58%), April (+1014%) and May (+492%). We believe Wynn Macau’s management team is taking the right steps to fortify the business, and our investment thesis remains unchanged.

Duerr’s first-quarter results were solid, from our perspective, considering the macroeconomic environment. Revenue largely met market forecasts, while earnings and net income were better than had been projected. In absolute terms, revenue fell 6.3% from the prior year and the earnings margin contracted 20 basis points, mainly as a consequence of low order intake last year. However, first-quarter order intake was up 23% year-over-year and advanced 6% sequentially from the fourth quarter of 2020. Furthermore, the company’s book-to-bill ratio was 1.3, which suggests robust positive momentum to us. The strongest first-quarter performance came from the HOMAG business (a leading revenue generator) where order intake increased 49%, despite continued weakness in the systems business. HOMAG revenue grew by 6.7%, while margins of 4.4% were weaker than in the prior year as was expected. We think this business is poised for growth owing to significant restructuring as well as the order/sales recovery that should lead to significant improvement in future quarters. Duerr’s other divisions are developing largely in line with our expectations. Following the earnings release, we spoke with CFO Dietmar Heinrich and remain confident in his ability to accomplish the newly implemented restructuring goals.

During the quarter, we initiated positions in Nihon Unisys, Nordic Entertainment, SoftwareONE Holding and Talanx. We also received shares of Wickes Group as a result of a spin-off from Travis Perkins. We eliminated Bucher Industries and DSV Panalpina from the portfolio.

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 06/30/21.

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.