Commentary

International Small Cap Strategy

December 31, 2020

THE MARKET ENVIRONMENT

Similar to the year 2016, 2020 was a year of extremes driven by exogenous factors ranging from the Covid-19 pandemic to Brexit negotiations with elections in between. Most recently, markets reacted favorably to events in the fourth quarter, particularly the approval and emergency use authorization of multiple vaccines aimed at preventing the spread of Covid-19.

Meanwhile, the U.K. and European Union negotiated arduously in the quarter, finally accomplishing an agreement that eliminated the possibility of a hard Brexit outcome. In the U.S., the four-year presidential election cycle produced a more balanced outcome than many had expected. The market proved relieved at both the elimination of uncertainty and the lower probability of big changes. Later in the fourth quarter, President Trump signed the country’s long-debated second economic relief bill into law, sending direct payments to some individuals and families as well as further extending unemployment benefits.

These events propelled equity prices higher across the globe for a strong finish to a year that had earlier experienced a bear market. Ultimately, the Nikkei 225 Index soared to a 30-year high in Japan, the German DAX Index surged to a record figure, and both the Dow Jones Industrial Average and S&P 500 Index closed out the year at record levels.

This year amounted to a volatile 12 months for investors. Though traumatic and difficult to tolerate, we recognize that market instability can unearth investment opportunities for those who are patient and willing to weather the storm. In times when others chase performance or lose conviction based on news headlines and irrational reactions, we remain alert to subsequent opportunities caused by short-term investors to build positions in quality companies that are trading at large discounts to our perception of their intrinsic value. This discipline is deeply embedded in our philosophy and process.

THE PORTFOLIO

Top Performers:
We thought Volaris’ nine-month earnings release was acceptable. Revenue trends were largely in line with expectations, but costs tracked higher than had been expected. For the third quarter, capacity reached 75% vs. 2019, with October bookings exhibiting a further acceleration. Management believes its domestic market share increased from 30% pre-Covid-19 to 45% today. We spoke with management following the release where we learned that short-term trends are positive surrounding capacity growth, load factors and pricing. In addition, cash burn is improving on an operating basis. As we had anticipated, Volaris entered into an equity raise later in the fourth quarter. The company will now issue 13.4 million shares while raising about MXN 3 billion, though the strong share price made the raise less dilutive than we had expected. In our view, Volaris’ strategy remains sound and our investment thesis for the company remains intact.

Julius Baer Group provided a positive nine-month trading update in October as nearly all of its key operating metrics finished higher than our estimates. Annualized net new money growth of 4% accelerated from the 2.3% growth achieved in the fiscal first half. In November, the company benefited from the European financials rally, and CEO Philipp Rickenbacher expressed confidence in Julius Baer’s ability to execute acquisitions in the next few years. Later, the company settled with the U.S. Department of Justice regarding the investigation surrounding corrupt behavior related to FIFA (governing body of international soccer) to the tune of a $79.7 million provision. Investors responded favorably to the resolution on the matter. We appreciate that Julius Baer continues to benefit from its 2019 cost reduction program and the initial impact of cost measures taken in the first half of 2020, which resulted in a year-over-year decline in the absolute level of operating expenditures. The company’s CET1 ratio of 14.3% exceeds both the regulatory minimum (7.9%) and management’s internal floor (11%). We continue to believe Julius Baer is a solid investment and our thesis for this company remains unchanged.

BlackBerry’s share price surged early in December on news that management signed a multi-year agreement with Amazon to develop and market an intelligent vehicle data software platform called IVY. Cloud-connected IVY enables auto manufacturers to securely and consistently collect standardized data from vehicle sensors to improve performance and develop new value-enhancing features and services for drivers. This product will not be available in vehicles before 2023, but we believe IVY has the long-term potential to buttress BlackBerry’s strong position in automotive software with a potentially dominant data platform. The company’s core operations continue to progress in line with our turnaround expectations as it firms its new product lineup and realigns its sales force. Recent quarter results were slightly ahead of market forecasts, but continue to be negatively impacted by Covid-19 with year-to-date sales down 13%. The company is delivering on cost control, driving a 177% rise in EBITDA and year-to-date cash flow in positive territory. CEO John Chen anticipates the sales force restructuring and new product launches will translate to strong growth in the coming year. We believe that the return to growth as well as the longer term opportunities of IVY continue to make BlackBerry an attractively valued holding.

Bottom Performers:
In October, Software AG reported a ransomware attack conducted by Clop, a malware organization that claimed it took possession of corporate files and employee information. Clop demanded a ransom payment of $23 million to prevent the release of highly sensitive and confidential data. Later, management disclosed that some of the data was released, though stated that there were no indications that any services to customers were disrupted. News of the situation unnerved investors and pressured Software AG’s share price. Subsequently, the company reported preliminary third-quarter revenue and earnings that were lower than market expectations by roughly 6% and 23%, respectively, which prompted a further selloff of shares. The circumstance is the result of an accelerated shift toward a subscription-based business model, which depresses near-term revenue and earnings while materially improving long-term customer value. We are in favor of this transition and believe that it is positive for per share value, but it does create near-term fluctuations in reported results. We were pleased that the key new business bookings metric performed in line with expectations and that results overall largely met our estimates, driven by healthy delivery in the IoT (Internet of things) and Adabas & Natural (A&N) businesses. In addition, management increased full-year bookings growth guidance across segments. We believe Software AG remains a solid business that is well equipped to overcome the near-term challenges it has faced.

Despite no fundamental changes, Sugi Holdings finished lower in the fourth quarter. The company posted solid nine-month results in December, in our view, as margins exceeded both management’s guidance and consensus expectations. Third-quarter topline grew 7% and same-store-sales (SSS) growth reached 4.7%, driven by a 7% increase in prescription drugs on an SSS basis. In addition, over-the-counter drugs, food and homewares sales were up 11%, 9% and 11%, respectively. Gross profit margins expanded 130 basis points in the third quarter, though selling, general and administrative costs were up nearly 12% for the nine-month period due to the aggressive hiring of pharmacists, opening new stores and rental increases. Moreover, Covid-19 accelerated the shift to Sugi’s local neighborhood stores in lieu of others located near hospitals, resulting in new customers, higher traffic numbers and higher prescription drug sales. Sugi opened 84 net new stores year-to-date, putting the company on pace to meet its full-year target for about 100 new stores. We believe the company is a solid investment that will reward shareholders into the future.

Fiscal nine-month results from NOS SGPS were acceptable, by our measure, as both revenue and profitability improved sequentially from the fiscal first half to the third quarter. Although year-over-year revenue fell 14% and earnings dropped 6.7% in the third quarter, revenue and earnings roughly met market forecasts, and net income of EUR 44.1 million surpassed projections of EUR 35.2 million. Even though revenue in the key telecom segment declined 1.4%, revenue generating unit (RGU) growth has been solid across all service offerings and rose 2.4% from the prior year. Management expects RGU growth will persist as the company continues its network swapping agreement with Vodafone, which should expand fiber-to-the-home penetration across its network. Concurrently, third-quarter revenue and earnings both declined 67% in the cinema business due to postponements of movie releases and Covid-19 impacts. Furthermore, free cash generation for the nine-month period fell 10.7% from the prior year period in part owing to increased capital spending related to the fiber network rollout and higher taxes, which the company can recoup in 2021. We think that while NOS will likely face ongoing near-term challenges related to Covid-19, its leading market position as a pay-TV and broadband provider remains secure.

During the quarter, we initiated a position in TIS Inc. We eliminated Fluidra and Freightways from the portfolio.

Past performance is no guarantee of future results.

The Nikkei Stock Average (Nikkei 225) is a price-weighted average of 225 Japanese companies listed in the First Section of the Tokyo Stock Exchange. Constituents are selected based on liquidity and industry representation. This index is unmanaged and investors cannot invest directly in this index.

The Deutsche Boerse AG German Stock index is an equity index that measures the share performance of the 30 largest German companies in terms of exchange turnover and market capitalization, and is thus an established indicator for the performance of the German economy as a whole. This index is unmanaged and investors cannot invest directly in this index.

The Dow Jones Industrial Average is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities. This index is unmanaged and investors cannot invest directly in this index.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. 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 12/31/20.

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.