International Small Cap Strategy

June 30, 2023


Major global markets generally finished the second quarter higher, continuing the relief for the year-to-date period following a challenging 2022. In the U.S., the Russell 1000 Growth Index gained 12.81% versus the Russell 1000 Value Index, which gained 4.07% as technology and AI-related companies led the advances. While the U.S. and Europe equity markets showed strength on the back of better than expected economic data, Asian markets were mixed with China equities finishing lower and Japanese equities reaching 30-year highs.

Central banks continued to focus on reining in inflation, which remains elevated across most regions. The U.S. Federal Reserve increased its benchmark interest rate by 25 basis points in May before pausing at its June meeting. Comments from members of the Federal Open Market Committee pointed to further hikes in the future and interest rates remaining elevated for some time. The European Central Bank and Bank of England both increased their respective interest rates in May and June, reaching 4.00% and 5.00%, respectively, while Japan and China opted for more accommodative monetary policies. In the face of tightening financial conditions, inflation fell from prior year levels during the quarter throughout most of the world.

Regardless of the economic backdrop and central bank activity, our disciplined investment process continues to revolve around bottom-up, fundamental research. As long-term investors, we value our companies through the economic cycle and focus portfolio construction on optimizing what we believe are our best investment opportunities. We attempt to identify growing businesses that are managed to benefit their shareholders and invest in those businesses only when priced substantially below our estimate of intrinsic value, then patiently wait for the gap between share price and our estimate of intrinsic value to converge. We believe this approach best serves our goal of growing our clients’ capital over the long term.


Top Performers:
On April 21, Silver Lake announced a deal to acquire a 25% shareholding in Software AG from the Software AG foundation for EUR 30 per share and announced a tender offer at the same price for all remaining shares. This was accepted by the board and eventually increased to EUR 32 per share. Silver Lake now owns more than 60% of the company’s voting shares. While the EUR 32 per share price represented an over 60% premium relative to the share price before the announcement and a significant return for investors, the price is well below our estimate of intrinsic value and was consequently a disappointment to us. Unfortunately, the supervisory and management boards of Software AG declined to allow a competitive bid process that might have benefitted shareholders more and allowed Silver Lake to succeed with an opportunistic offer.

Applus Services released a trading statement during May that included double digit growth in the energy and industry, labs, and IDIADA (design, testing, engineering, and homologation services for the global automotive industry) segments, in-line with our expectations. The automotive business contracted 5% due to the loss of Cosa Rica and Alicante concessions but is expected to return to growth by 2024 with material renewals returning in 2027. Adjusted earnings margins of 10% were down 40 basis points year-over-year pro-forma for the disposals due to negative mix from the automotive division decline. Cash generation was healthy at EUR 34 million, and Applus continues to actively buy back stock with 3.8% of shares outstanding repurchased since November of 2022. In addition, three private equity firms expressed interest during the quarter, and all were granted diligence rights. Ultimately, Apollo offered EUR 9.50 per share, which we believe undervalues Applus. Applus shares traded above Apollo’s offer price because one of the other interested firms engaged in diligence could respond with a higher offer. We appreciate the Applus board’s willingness to allow a competitive bid process to develop.

SoftwareOne reported first-quarter earnings in May that were in line with prior guidance. Earnings are expected to accelerate in the second half of this year since Microsoft price increases started taking effect in April and the company’s cost savings program is weighted toward later in the year. Revenue grew 8.7% which was in line with our expectations, and we appreciate that SoftwareOne continues to outperform some of its pure play software peers. SoftwareOne received an unsolicited offer of CHF 18.50 per share from Bain Capital in June, which the board rejected. We believe Bain’s offer materially undervalued SoftwareOne and supported the board’s rejection of it. We were impressed by the independence displayed by SoftwareOne’s board as Bain’s offer had support of SoftwareOne’s founders who control just under 30% of the outstanding equity. The founders that supported the offer would have been able to rollover their investment in SoftwareOne—an opportunity not available to other shareholders.

Bottom Performers:
Viaplay issued a profit warning in June and replaced its CEO with immediate effect. We believe this is attributable to the convergence of a tough macro environment and a growth-minded former CEO that has been slow to adapt, leading the board to opt for a course correction. We still find that Viaplay is a good business and believe quick and commercial action should be able to strengthen the company. Despite the disappointing guidance revisions, we still appreciate its Nordic business which has a 30-year track record of profitability, strong engagement metrics, and position as a leader in local and sports content. We look forward to the new plan and financial targets from CEO Jorgen Lindemann, the former CEO of MTG that previously housed Viaplay.

oOh!media released a trading update during the quarter that caused a subsequent drop in share price, as it revealed lower-than-expected growth. After stating in February that first-quarter revenue was on pace for 8% growth year-over-year, the actual figure came in at 3%, attributable to the street furniture business which was pressured by a decrease in advertising and government spending. The company also faced market share loss to a competitor who recently won government approval for a larger number of digital screens than management expected to be approved. In our meeting following the release, management said it is inquiring about the approval and believes the market share loss is temporary. While March and April in the business were weak, management believes May and June look better based on order activity.

We believe Travis Perkins released first-quarter results that reflected the challenging macro backdrop in the U.K. The core merchanting business declined 12% year-over-year in volume, and management indicated the rate of volume declines is likely to slow materially in the upcoming quarters. The Toolstation business reported revenue growth of 8.5%, slightly ahead of our expectations. Pricing was up 9% year-over-year with management estimating that two-thirds of the increase came from the roll forward of legacy prices. In June, Travis Perkins lowered its full-year adjusted operating profit guidance to GBP 240 million and reported a 9% decrease in volume growth due to weakened demand in the merchanting sector. Management remains optimistic for a better second half of 2023 given strong performance with large customers, despite losing some share with the smaller repair, maintenance and improvement customers to independent competitors. Despite cyclical near-term weakness, we continue to believe Travis Perkins is an attractive long-term investment at its current valuation.

During the quarter, we initiated positions in Adecco, Euronext and Sapiens International (US Shs). We eliminated Abrdn and Element Fleet Management 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 06/30/2023.

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.