International Small Cap Strategy

June 2019

Major global markets finished mixed in the second quarter. The reporting period began steadily enough, but fears regarding new tariffs and trade wars caused market volatility mid-quarter before markets rallied in June. Trade talks between the U.S. and China faltered once again and rattled markets in May, despite some forward progress in April. However, following meetings at the G-20 Summit in late June, markets cheered the progression made by U.S. President Donald Trump and Chinese President Xi Jinping, both of whom agreed to reopen trade negotiations and cease additional tariff increases in the hopes of eventually reaching a trade deal. Similarly, after announcing a planned 5% tariff on goods imported from Mexico in May with the goal of deterring illegal immigration from Mexico into the U.S., Mexico’s efforts to mitigate this issue were enough to prompt Trump to suspend his plans to implement new tariffs on the country. Irrespective of the noise, indexes in the U.S. touched record highs during the period. 
Meanwhile, crude oil prices also experienced instability in the second quarter as markets weighed the implications of data and global happenings on supply and demand. In April, the U.S. announced it was ending sanction waivers on Iranian-produced crude oil, sending prices higher. However, continued uncertainty regarding trade tensions sparked demand concerns in May. Ultimately, growing tensions between the U.S. and Iran and subsequent supply uncertainties spurred a boost to crude oil prices late in the second quarter.  
In the U.K., Prime Minister Theresa May announced her resignation, effective June 7, as she was unable to build consensus on a Brexit deal to lead her country out of the European Union (EU). As of the end of the second quarter, May’s replacement had yet to be named. As things stand, the country will leave the EU on October 31 with or without a deal (unless a withdrawal agreement is settled upon prior to that date), leaving room for many possible outcomes and causing continued unease for investors.  
We believe that although a company’s share price may be performing poorly, it is not always indicative that a business is performing poorly. We seek to identify companies with hidden value that feature high-quality business fundamentals and management teams that act in the best interests of shareholders. Often these opportunities unearth themselves during ambiguous times like these when we can take advantage of short-term hindrances to unlock underlying value in underappreciated companies. 

Top Performers:
During the quarter, Azimut Holding announced strong first-quarter results that reflected a 36% increase in fees. We anticipated this fee growth due to the strong market performance and because of the changes that the company made to its fee structure. We do not, however, expect that this pace of growth will continue. That said, Azimut seems well positioned to continue to produce positive results, in our view. Management has successfully controlled costs, which has led to a more than 200% increase in profits this year, compared to the prior year. In addition, the company paid out its previously announced dividend during the quarter, which amounted to approximately a 9% yield. Management also reiterated that it expects to exceed its business plan target of EUR 300 million of net profit in 2019. Our discussions with company executives confirm that they remain focused on profitably growing Azimut’s international business. These investments in international operations should create shareholder value over time, in our view. We continue to remain enthusiastic about the longer term prospects for this holding. 

In April, IWG announced the sale of Regus Japan to TKP for JPY 46.87 billion, which was completed at the end of May. Importantly, IWG will also provide its operating platform to TKP for a fee. While we anticipated the sale of a master franchise agreement, the size of the operation sold and, more importantly, the value received far exceeded our expectations. Notably, management believes IWG can monetize or franchise the majority of the estate within the next two to three years. Later in the second quarter, the company issued a brief earnings statement, which showed that first-quarter constant currency revenue was tracking above our fiscal-year estimate with currency serving as a tailwind. Management also noted it was experiencing strong momentum in the partnering strategy. In the meantime, we like that IWG is the leader in the flexible office space industry and is subsequently best positioned to capitalize on the structural shift that is resulting from the secular growth of the flexible workspace business. 

Element Fleet Management delivered strong first-quarter earnings results as exhibited by earnings per share (CAD 0.21 vs. CAD 0.18) and revenue (CAD 242.2 million vs. CAD 225.1 million) results that bested consensus estimates. These results were due in large part to continued strength in originations (up over 16% year-over-year), low client attrition and CAD 17 million in syndication revenue. In addition, the company is adopting a syndication structure that will 1) more rapidly reduce leverage and risk, 2) enable increased originations and widen unit cost competitive advantage versus peers, and 3) increase reported return on invested capital and earnings per share. Management also believes syndication will reduce client concentration risk. We believe that Element is a solid investment that can reward shareholders into the future

Bottom Performers:
First-quarter results from Ontex were weaker than expected due to a 2% decline in reported revenues. Raw materials and currency headwinds also continue to hurt the company’s profitability. Despite this, Ontex generated 6% organic growth in the Americas, Middle East and Africa regions. After a weak 2018, the company’s management is not sitting idle, in our view. In addition to announcing a significant cost-efficiency plan, Ontex reviewed the entire business and decided to consolidate five business segments into three (Europe, health care and Americas/Middle East/Africa), including making leadership changes within these segments. We believe these changes will better position the company for future growth. Finally, Ontex also has the opportunity to increase its U.S. presence through its affiliation with a large retailer, which could help offset some of its weaker markets in our estimation. 

LSL Property Services’ first-quarter earnings report fell short of market estimates on weaknesses in the end market. We met with CEO Ian Crabb in May who noted a modest improvement in volumes in April and May compared to first-quarter trends, despite the challenging macro backrop in the U.K. In addition, Crabb spoke on the positive revenue development in the restructuring of the Reeds Rains and Your Move businesses. Ultimately, we find that LSL continues to out-execute its peers and make value-enhancing acquisitions. The U.K.’s decision to leave the European Union in and of itself does not change our view on normalized transaction volume, but rather on population growth and household formation, which we think are unlikely to be materially impacted by Brexit. We continue to believe that LSL is undervalued relative to its normalized earnings power. 

In May, Duerr released its first-quarter earnings results, which were mixed, in our view. Sales (+6%) and service revenue (+10%) increased organically, but business mix, higher wages and lower margin orders pressured gross margins. We appreciated that the paint and final assembly segment’s order intake was up 44% year-over-year, driven by large orders in India, the U.S. and Mexico. In addition, free cash flow improved materially year-over-year, but was still decidedly negative in a seasonally difficult quarter. However, Duerr reiterated full-year guidance. In June, we met with CFO Carlo Crosetto who we find to have an excellent grasp on the business. Crosetto spoke on a new robot technology in the paint segment, which eliminates overspray and effectively prints paint on a car. He believes the company is at least five years ahead of its competitors in this space. As a whole, the meeting boosted our confidence in our expectations of Duerr. We believe the company remains significantly undervalued.   

During the quarter, we initiated positions in BBA Aviation, Fluidra, HKBN Ltd. and Loomis. We eliminated Salvatore Ferragamo from the portfolio.

Past performance is no guarantee of future results.


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