Commentary

International Small Cap Strategy

March 31, 2020

THE MARKET ENVIRONMENT
At the start of 2020, it appeared market activity would continue in familiar fashion and would largely support global benchmark levels achieved from prior bull market advances. However, by mid-January, developments concerning the coronavirus came to light. What began in late 2019 as an outbreak localized to China spread swiftly and by mid-March, the World Health Organization officially deemed the coronavirus a global pandemic. Equity markets declined precipitously in conjunction with increasingly dire news about the accelerating rate of illness.

The virus quickly disrupted economic activity across geographies and sectors from large global enterprises to Main Street businesses. Significant travel restrictions, the shutdown of typical group gathering activities and orders by officials in many countries for citizens to stay home upended daily life. Even the 2020 Olympic Games were postponed. Unemployment began to rise, with the U.S. seeing a record three million jobless claims filed in a one-week period and the United Nations estimated that virus-prompted job losses could exceed 25 million worldwide. To stem the economic impact, policymakers around the world enacted significant economic stimulus measures and leaders of industrial nations vowed to work in tandem to support the global economy. Though some funding levels have already reached trillions, economists expect that even more stimulus may be necessary.

Over our decades of experience, we have witnessed other market-rattling crises, each uniquely different from each other. No one knows how this particular issue will be resolved as there is not enough data today to reach specific conclusions. Yet please be assured that our framework for dealing with exogenous risks like this is to attempt to determine the impact on business value rather than extrapolate near-term costs in perpetuity. In our assessment, equity share price declines have reached levels that are in excess of the actual value declines of businesses we hold. One proactive action we adopt under adverse circumstances is to rebalance our client portfolios. We take advantage of lower equity prices to increase share weightings of companies that, according to our estimates, have become even more undervalued. Although the current situation is changing rapidly, as long-term investors, we focus on rational decision-making and avoid making emotionally driven investing choices. Our investment team remains on vigilant watch for appropriate opportunities today that we believe can yield shareholder rewards over our typical five- to seven-year holding timeframe.

THE PORTFOLIO
Top Performers:
oOh!media conducted a rights offering and the price of these shares increased after the issuance. Trading was halted for the company’s ordinary shares in March after the price declined over 18% in one day from investor fears that the coronavirus pandemic would have an outsized impact on oOh!media’s business. Management subsequently decided to issue the rights to raise capital and avoid breaching its debt covenants. The company also released full-year results in the quarter that included a revenue increase of 1% from the prior year, while underlying earnings and underlying after-tax net profit declined. Later, management withdrew full-year 2020 earnings guidance and temporarily suspended future dividend payments. Although we initially disliked the decision to offer rights shares, we think this action was ultimately necessary. After conducting some additional in-depth analysis, we assessed that oOh!media is equipped to withstand a much worse short-term scenario than we had originally projected. Importantly, once this extremely difficult environment subsides, we believe the company should be in a strong position to grow ahead of the media market and expand profitability.

Sugi Holdings’ share price climbed higher following the release of its February 2020 sales bulletin. Sugi Holdings operates drugstores in Japan through stand-alone pharmacy facilities, discount stores and nursing homes. The company’s two segments, Sugi Pharmacy and Sugi Medical, together have a presence in nearly 1,200 locations. Sugi Holdings reported opening 116 new stores in the fiscal year-to-date period with the Kanto region reporting the most growth thus far with 50 new stores through February. The company also reported that Sugi Pharmacy’s February total sales increased 20.9% on an existing-store basis and 28.6% on an all-store basis. We continue to believe the valuation for the drugstore company remains attractive, offering a compelling reason to own.

Software AG was added to the portfolio in the latter part of the first quarter and its share price rose for the holding period. The company provides business infrastructure software solutions through three divisions. Its digital business platform segment is growing and produces the majority of Software AG’s revenue. This segment consists of integration/automation software, analytics, in-memory data and Internet of Things applications. Application development and maintenance for mainframe-related systems are conducted in the company’s Adabas & Natural segment and the global consulting services segment includes implementation and strategy/design services. We think Software AG is a solid investment that can reward shareholders over the long term.

Bottom Performers:
Konecranes’ fourth-quarter results largely aligned with market expectations and management’s 2020 guidance was better than had been projected, which positively surprised investors. For the full year, total revenue increased 5.4% from a year earlier and advanced across segments. Total earnings rose 7%, mainly driven by increases in the port solutions and service segments. However, Konecranes’ business was impacted in the quarter by fallout from the coronavirus pandemic. Management subsequently withdrew original guidance, citing concerns over demand levels in the first half of the year. During the quarter, we spoke with CEO Rob Smith who officially became CEO on February 1. Smith joined Konecranes because of his familiarity with the company’s equipment (from a background in manufacturing industries) along with its leadership position in service and industrial equipment and global footprint. Smith believes that his background matches up well with what Konecranes needs to strengthen going forward, such as an improved customer-centric approach and a focus on profitable growth. While Smith is new to the leadership role, we agree with his priorities at present.

Duerr issued fourth-quarter results with total revenue and net income that were weaker than the market had expected. However, earnings and orders were better than forecasts by 9% and 5%, respectively. We were pleased that full-year adjusted earnings rose 6.7% compared with a year ago, which beat the company’s revised 2019 growth range target of 6.0%-6.5%. Adjusted earnings outperformance was driven by the paint and assembly and clean tech divisions along with HOMAG, a producer of woodworking machines. We remain impressed with Duerr’s leadership team, including CEO Ralf Dieter and the team’s vision for restructuring initiatives. We believe management will continue to build value for shareholders and have already seen success with prior initiatives, such as the Focus 2.0 restructuring program.

BNK Financial Group’s share price fell in conjunction with share prices across the banking sector in South Korea owing to coronavirus fallout. We recently met with the company’s Chairman and CEO Ji-Wan Kim and CFO Hyung-Guk Myoung. Kim indicated the company is now more focused on expanding the net interest margin and increasing the dividend payout and he attributed the recent net interest margin decline to both lower base rates and a change in loan mix. Kim indicated a full-year net income target of KRW 600 billion and a common equity Tier 1 (CET1) ratio of at least 12% by 2023. BNK also plans to increase the shareholder dividend by 20% in fiscal 2020. Overall, we think the dividend increase and continued improvement to the CET1 ratio are steps in the right direction, which adds to our confidence in the investment.

During the quarter, we initiated positions in dormakaba Holding, Software AG and Wynn Macau. We eliminated Criteo ADR, Ontex Group and Wajax from the portfolio.

Past performance is no guarantee of future results.