Commentary

International Small Cap Strategy

December 31, 2021

THE MARKET ENVIRONMENT

Major global markets finished largely higher in the fourth quarter in spite of a variety of macroeconomic concerns that ranged from inflation fears to supply chain disruptions along with yet another Covid-19 variant that took hold in the final three months of the year. As previously announced, the Federal Reserve slowed its pace of asset purchases in November. The tapering came as the rate of inflation in the U.S. quickened to 6.8% versus the year-ago period. The Fed’s dot plot now calls for three rate hikes each in 2022 and 2023. The Bank of Japan and European Central Bank echoed similar sentiments as they also left interest rates unchanged, while the Bank of England raised its main interest rate from 0.1% to 0.25% following a surge in U.K. inflation to a 10-year high of 5.1% annual growth in November.

Meanwhile, as the world attempted to return to normal from the depths of the global pandemic, energy suppliers rushed to ramp up production to meet growing demand. However, a supply shortage and bottlenecks at major U.S. ports sent U.S. oil prices in excess of $85 per barrel for the first time since 2014. Natural gas prices also spiked around the world, forcing the suspension of operations at factories in Europe and China. A shortage of semiconductors, in particular, significantly impaired worldwide automobile production. Simultaneously, the new and highly contagious Omicron variant of Covid-19 spread in the fourth quarter as countries across Europe implemented restrictions once again to combat the spread of the disease.

Although stock prices surged higher in many places across the globe, we are still finding pockets of value in the market. Once restrictions lift, we think pent-up demand and savings will drive business growth in places like Europe. That said, the world is learning how to live with the ever-changing risk of Covid-19, much like how investors must continuously monitor potential risk, potential return and the quality of the businesses when making investment decisions. We think our long-term investment horizon positions us well to observe and capitalize on these considerations.

THE PORTFOLIO

Top Performers:
Pirelli’s third-quarter earnings results bested expectations as revenues improved 10.5% organically. The company outperformed the market in its tire business by about 4% on volumes with stronger outperformance in high-value tires, which was driven by good pull through and the introduction of new replacement market-focused tires. In addition, price increases have been well tolerated, and we think they should continue flowing through into the fourth quarter and 2022. In our view, Pirelli’s strong price/mix demonstrates the company’s pricing power and the benefits of premium market positioning. This strong performance led management to increase full-year revenue guidance to a range of EUR 5.1–EUR 5.15 billion, up from EUR 5.0–EUR 5.1 billion. We believe Pirelli remains an attractive investment that is trading at a discount to our perception of its intrinsic value.

Autoliv’s third-quarter earnings report revealed suppressed performance, which was in large part due to supply chain and economic headwinds. Despite the lower figures, the company generally outperformed global light vehicle production, which declined 20% year-over-year. In November, the company declared a fourth-quarter dividend of $0.64 per share, an increase from the prior $0.62 per share amount. In addition, Autoliv hosted a capital markets day where it announced a new sustainability agenda, targets for increased efficiency with a 12% adjusted operating margin over the next three years, and a new authorization to repurchase up to $1.5 billion or 17 million common shares over the next three years.

Despite supply chain issues, investors proved relieved with Metso Outotec’s third-quarter earnings report. A 104% year-over-year increase in order intake and a 71% increase in the order backlog compared to the year-ago period exhibited that demand is strong. Though group sales increased just 7%, margins increased 200 basis points to 13.6%. The company offset raw material increases with pricing actions and expects to continue to be able to do so. In December, we spoke with CEO Pekka Vauraumo who believes there is significant room for process improvement and service attachments as well as the opportunity to capitalize on growth areas, like copper and battery metals. That said, the minerals pipeline continues to expand and the company is seeing more and more projects on the table.

Bottom Performers:
Software AG’s share price fell during the quarter after they delivered mixed third-quarter earnings results, in our view. In the digital business platform (DBP), bookings growth came in at 6% for the quarter and 11% year-to-date, tracking light of management’s guidance for 15-25% growth and our estimate for 18% growth. The shortfall is attributable to deal slippage from September to October as well as challenges getting the sales funnel to a stable and predictable cadence of progress. However, management guided to DBP bookings growth of 13-17% for the year, implying strong growth in the fourth quarter. On the positive side, the sales inflection continued with 7% overall product revenue growth and 10% growth in DBP for the second quarter of double-digit topline growth in the segment. In addition, management slightly raised margin guidance to 17-19% and kept the 2023 guidance framework unchanged. Toward the end of the quarter, Silver Lake invested in Software AG with a EUR 344 million convertible via its growth equity private investment in public equity fund, while also acquiring two board seats. The focus of this investment is to accelerate growth and provide capital for attractive use, such as acquisitions. We believe the investment will ultimately be favorable and increase shareholder value.

Babcock International released its first-half earnings report that showed mixed results, in our view. Revenue increased 10% organically, with 600 basis points attributable to marine and nuclear and the rest attributable to Covid-19 interruption versus the prior period. The company broadly achieved growth across its segments, often benefitting from easing headwind pressures stemming from Covid-19. Free cash flow was highly negative as we had expected. Sizeable amounts of the cash outflows can be attributed to management’s move away from period-end management, reversals of deferred creditors, and an unwind of value-added tax deferrals. We spoke with management in December and discussed the restructuring plan, which includes a reduction in the number of organizational layers and turning over the majority of top executives to help drive GBP 40 million in operational savings. Overall, we believe the company’s current valuation remains attractive.

The share price of ISS moved lower throughout the fourth quarter. The company’s third-quarter trading update showed that revenue is tracking below our expectations as clients are slowly returning to the office. The major drag is the catering business, which is still only at 67% of 2019 levels. Although the largest catering business in the U.S. grew just 5% year-over-year in the third quarter, the Americas are the fastest growing region at 8% year-over-year due in part to a large contract win and a larger bounce back in other services. Despite weaker revenue, ISS announced an upgrade to its margin and free cash flow guidance for fiscal-year 2021. We like that ISS is a leading global provider of outsourced facilities management in a very fragmented and growing market and the largest player in cleaning, a vertical whose growth and importance increased due to Covid-19.

During the quarter, we initiated positions in Essentra and TeamViewer. We eliminated medmix 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 12/31/21.

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.