International Small Cap Strategy

March 2019

THE MARKET ENVIRONMENT
Major global markets moved higher in the first quarter, despite contending with a barrage of geopolitical pressures. Following the second rejection of her Brexit deal, Prime Minister Theresa May secured a two-week extension on the U.K.’s departure from the European Union (EU) with the exit date now set at April 12. The EU also offered a later exit date of May 22 should the prime minister ultimately receive approval from British Parliament on her version of Brexit before the end of March. In the meantime, members of parliament brought eight alternative plans to the floor, none of which achieved a majority. A subsequent third vote on May’s deal late in March also failed to pass, leaving Brexit very much in limbo.
 
Meanwhile, trade disputes proved challenging for the Chinese economy as February exports dropped over 20% from the year-ago period. The country’s industrial output growth also experienced its slowest pace of expansion in more than 15 years. In the U.S., even though manufacturing sector job growth at the end of 2018 was the highest it had been in the last 30 years, factory production during the first quarter reached the lowest level since 2017. Contrary to market analysts’ forecasts of gains, manufacturing output fell in January and February due to pressures of trade disputes and slower global growth. Monthly building permits also fell in excess of market projections. In Europe, the IHS Markit’s Purchasing Managers’ Index’s (PMI) March reading decreased to 51.3 from 51.9 the month prior, while the Flash Eurozone Manufacturing PMI sank to a near six-year low.
 
The European Central Bank announced increased stimulus, a decreased economic growth forecast for 2019 and a hiatus on interest rate increases until 2020. The Federal Reserve left key interest rates in the U.S. unchanged and noted it does not foresee raising rates in 2019, stating intent to employ patience and consider market concerns before taking action. Despite this, the reigniting of trade negotiations between the U.S. and China in the final days of March provided a late boost for global markets.
 
That being said, we use these periods of uncertainty in the market as opportunities to invest in temporarily undervalued companies by looking beyond readily available statistics to uncover hidden value. Our differentiated perspective comes from our unusually long time horizon, an unwavering focus on identifying quality businesses and a deep level of engagement with management teams.

THE PORTFOLIO
Top Performers:
In January, Azimut Holding announced a change to its fee structure that will lead to higher recurring fees and lower performance fees. The new calculation of its performance fees will be more consistent with market practice. We view this change favorably as it will reduce the volatility of the business model. In addition, the company reported 2018 financial results that were in line with estimates and management expressed confidence in achieving its business plan target of EUR 300 million of net profit in 2019. This result, if achieved, would be well ahead of market estimates. Along with the release, Azimut announced a EUR 1.50 per share dividend. This significantly exceeded estimates and amounted to a nearly 12% yield at the time of the announcement, which we believe reflects the company’s strong balance sheet and cash flow generation. We continue to be impressed with the shareholder-friendly orientation of management and the fact that management and employees own over 20% of Azimut’s stock.

Early in the quarter, Volaris reported a 13.5% increase in December traffic. Later, a positive analyst note upgrading the company also provided a boost. In our view, Volaris’ fiscal-year results released in March exceeded our expectations thanks to a strong fourth quarter. The outperformance in revenues was driven by ancillary revenues, which increased 42% in the fourth quarter following the implementation of dynamic pricing and strong growth in cobranded credit cards, v.club pass subscriptions and first bag charges on international flights. The company is also launching a new hotels and tours platform that will direct traffic to a 100%-owned subsidiary rather than an online travel agency. We also appreciated that cost control was solid and free cash flow was better than expected. Overall, we believe Volaris is a solid investment that should reward shareholders into the future.

Investors responded favorably to Travis Perkins’ fiscal-year 2018 earnings report. Full-year earnings finished roughly 2% ahead of our forecasts, driven by better performance in the contracts and consumer segments along with slightly higher property gains. The company’s performance improved markedly in the second half of the year, with earnings increasing about 11% year-over-year. Importantly, the Wickes business experienced a significant turnaround in the second half of the year with earnings up 4% year-over-year compared to a 41% decline in the first half of 2018. We appreciate management’s more cost-focused strategy over the last six months to more appropriately deal with the current market backdrop. Travis Perkins also announced the departure of current COO Tony Buffin as part of the earnings release, which we find to be a loss to the company. However, our investment thesis for Travis Perkins remains intact as we find that the stock is trading at a large discount to our estimate of the company’s intrinsic value.

Bottom Performers:
BNK Financial Group issued full-year 2018 results that missed our expectations, reporting a net loss of KRW 37 billion for the fourth quarter of 2018. These results were due to higher loan loss provisions and charges associated with an early retirement program (ERP). We believe a significant portion of these charges were one time in nature given the bank’s relatively stable underlying asset quality coupled with an expected benefit from the ERP. The market was also disappointed that BNK’s transition to a more efficient capital structure is taking longer than expected because of a change in regulatory personnel. The bank now expects the benefits of this transition to flow through in the first or second quarter of fiscal-year 2019. While this is certainly disappointing, management has reiterated its targeted benefit of 60-100 basis points to its capital ratio and indicated that the group will reach a CET1 of nearly 11% by the end of 2019. The stronger capital base should not only help assuage investor concerns but also enable BNK to increase its dividend payout ratio and even potentially consider initiating a share buyback program.

SKY Network Television’s fiscal first-half earnings results fell short of our estimates along with market expectations. Revenue declined 8.4% and net profit fell 19.6% from the prior year. While these results reflect weaker top-line performance, cost-control efficiency improvements met our expectations as SKY’s cash cost base decreased by roughly 4% from a year earlier. Management issued full-year 2019 guidance that trailed analysts’ projections, and subsequently, SKY was the subject of an analyst’s note that downgraded the company. However, we like that the business is cash flow generative and believe management is taking necessary steps to increase shareholder value by making changes to address the competitive environment, investing in content and connectivity, improving its over-the-top offering, and planning initiatives for future growth.

Criteo delivered fourth-quarter results with revenue and adjusted earnings that surpassed market forecasts by over 4% and 16%, respectively. For the full year, revenue (excluding traffic acquisition costs) grew 3%, which exceeded our estimate, and the adjusted earnings margin reached 33%, which was largely in line with our expectations. Management’s full-year 2019 guidance included revenue growth of 3-6% (constant currency), which is ahead of our forecasts, with an earnings margin projection of about 30%, which is short of our projections. While investors took these results in stride, Criteo’s share price fell dramatically in March on news that Google is considering ad-targeting restrictions for third parties. An article in Adweek stated that Google might make changes to its Chrome browser that could limit access to cookies. If implemented, the ability for third-party vendors to collect website visitor information for retargeting advertisements would be limited or eliminated. Consequently, key market analysts downgraded ratings for Criteo, indicating that such a change by Google would prove to be a massive disruption to the company’s business and the digital advertising industry as a whole. Since the analysis by Google is in the beginning stages, we have not changed our valuation estimates for Criteo. However, we are watching the situation closely.

During the quarter, we initiated positions in Autogrill, Autoliv, Bharti Infratel, Dometic Group and DS Smith. We eliminated Cosmo Lady (China) from the portfolio.

Past performance is no guarantee of future results.

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