International Small Cap Strategy

September 2019

THE MARKET ENVIRONMENT
Major global markets finished mixed in the third quarter. August served as the most volatile month, bookended by relatively flat performance in July and September. Most recently, trade negotiations between the U.S. and China are providing a positive impact on global markets as the two countries agreed to restart trade negotiations in early October. Ahead of the planned trade talks, the U.S. delayed a planned tariff hike on Chinese goods from October 1 to October 15 in “a gesture of good will.” On the other hand, China exempted soybeans, cancer drugs and pesticides, among others, from tariffs on the U.S.

Despite the tempered situation between the U.S. and China, U.S. President Donald Trump made headlines for another matter late in September as a whistleblower brought to light the leader’s July telephone conversation with Ukrainian President Volodymyr Zelensky. In the call, Trump asked Zelensky to “look into” 2020 U.S. Democratic presidential hopeful Joe Biden and his son, news of which spooked investors. In response, Speaker of the U.S. House of Representatives Nancy Pelosi announced a formal impeachment inquiry on Trump to further delve into the matter. 

Elsewhere, the political crisis in the U.K. carried on as the U.K. Supreme Court ruled Prime Minister Boris Johnson’s suspension of Parliament earlier in the third quarter as unlawful. Once back in session, the body passed a law requiring Johnson to request an extension from the European Union (EU) on the U.K.’s current exit date of October 31, should the country fail to agree on a Brexit deal with the EU prior to the bloc’s summit on October 17-18. These ongoing situations stoked continued uncertainty surrounding global markets. 

Meanwhile, the European Central Bank opted to lower interest rates and ramp up quantitative easing at its September meeting, which prompted the euro to fall to a two-year low. The Federal Reserve also trimmed U.S. interest rates twice in the third quarter, while the Swiss National Bank and the Bank of Japan maintained negative interest rates in September. 

In our estimation, the lingering memory of the Great Recession is causing investors to be much more fearful than they should be at present. We see no signs of excesses in the economy that typically precede a recession. We believe the noise present today will dissipate and trade will ultimately flow more freely in the next several years. In the meantime, we weather the short-term distractions and volatility in pursuit of long-term results.


Top Performers:
Investors responded favorably to Tower Bersama Infrastructure’s first-half earnings report. The company’s full-year guidance also included expectations for a business mix shift toward the more lucrative colocations (when telecommunications companies lease tower space as opposed to owning towers) segment of the business. We like that once a tower is built, additional tenants come with high incremental returns on capital employed. Later, a positive analyst note on the company provided a boost for Tower Bersama’s share price. Overall, we appreciate that management seems to be returns focused, operationally disciplined, financially sophisticated and is invested alongside its shareholders, adding to our confidence in the investment. 

During the third quarter, reports surfaced that Babcock International Group had won a contract with the Royal Navy to deliver five new warships for GBP 1.25 billion. Later, the company issued a trading update and indicated that performance across the company and win rates were tracking in line with expectations, which bodes well for the order book. We like that Babcock is a skilled and personalized engineering services provider with specialized technical and project management experience. The company owns, operates and manages unique, highly regulated and critical infrastructure for the U.K. government. Our investment thesis for Babcock remains intact. 

GrandVision’s share price soared on news that EssilorLuxottica was in talks with HAL Holding to acquire the latter’s 75%+ stake in GrandVision at a price of EUR 28.00 per share. Later, GrandVision preannounced its first-half earnings results to align with the earnings release of EssilorLuxottica and indicated support for the potential acquisition of ownership. From a governance standpoint, GrandVision continued to operate the business as normal until anti-trust approval was granted for EssilorLuxottica to acquire HAL’s shares, which GrandVision’s management team thought was highly likely. In the meantime, we exited our position in GrandVision as the company’s share price ascended to a point near our estimate of its intrinsic value.

Bottom Performers:
Late in July, Duerr pre-released its first half earnings results and issued a profit warning for full year 2019, driven by weakness in HOMAG (maker of wood processing machines) and measuring and process systems businesses. In HOMAG, second-quarter Chinese business was cut in half year-over-year, while sales weakness plagued the measuring and process systems segment. Slower and lower prepayments also negatively impacted working capital and Duerr now expects free cash flow to be lower year-over-year. While we continue to monitor the situation, we believe the company remains significantly undervalued. 

Konecranes’ second-quarter earnings results experienced a deceleration across most metrics. Investors were also displeased to learn the company perceived a slowdown in demand in Europe, particularly in Germany, as well as weakness in orders and sales in the service and industrial equipment segment. However, Konecranes still managed to grow adjusted earnings by 12% and expand margins by 70 basis points year-over-year, supported by the continued realization of synergies from the MHPS acquisition. In fact, Konecranes completed the integration six months early and achieved its targeted savings level of EUR 140 million on a run-rate basis with continued efforts toward cost savings. Despite the macro slowdown, the company reiterated its 2019 guidance for organic sales growth of 5-7% and adjusted earnings to improve year-over-year. We met with CEO Panu Routila later in the third quarter who gave us increased confidence in our forecasts. We think that while Konecranes may face some short-term obstacles, its long-term outlook is promising. 

ISS’s first-half earnings results proved disappointing to investors. However, we believe the market’s reaction was overdone and far exceeded any realistic impact to value. Organic growth amounted to +5.8% in the second quarter and +6% in the first half. Growth remains strongest in the key account space (+8%) as the company won about DKK 500 million worth of incremental business from three global key accounts during the reporting period. We spoke with CEO Jeff Gravenhorst in the third quarter and came away with a reaffirmed investment thesis. We continue to believe the valuation for ISS remains attractive, offering a compelling reason to own.

During the quarter, we initiated a position in oOh!media. We eliminated dormakaba Holding, Grand Vision, Ingenico Group and Panalpina Welttransport from the portfolio.

Past performance is no guarantee of future results.

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