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Deep Dive: You may be overlooking high-quality stocks in this part of the market

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With interest rates rising, a possible recession looming and stock valuations already having tumbled, this may be a good time for long-term investors to increase diversification for better times ahead.

An overlooked area is small-cap stocks outside the U.S. Surprised? According to Mark Fischer of Royce Investment Partners, higher-quality companies in this category have been among the world stock market’s steadiest performers over long periods.

Fischer co-manages the Royce International Premier Fund, which has $755 million in assets under management and typically invests in companies with market capitalizations of up to $5 billion. In an interview, he explained the fund’s approach to selecting quality companies and named two examples.

Selecting ‘quality’ small-cap stocks

Royce Investment Partners is based in New York and has about $10.5 billion in assets under management, with a focus on small-cap stocks.

Fischer said small-cap stocks outside the U.S. are an asset class that favors active management because of its diversity and inefficiency. “There are whole swaths of the market where it is not uncommon to find billion-dollar-market-cap companies with no analysts covering them,” he said.

When referring to analysts that cover companies, Fischer meant analysts working for brokerage firms — those whose estimates are used for the consensus numbers cited when earnings results are reported in the financial media.

He said most investors will place themselves in “growth” or “value” camps, but that both of those broad categories might serve them poorly over time. A company characterized as a value play might be earning less than its cost of capital, setting up long-term declines. A company in the growth camp might be increasing sales very quickly while generating low returns on invested capital (ROIC).

“Our companies grow the topline at least 8% a year,” he said, adding that the starting point for any company he considers for investment must show a return on invested capital of at least 20% per year over the previous five years.

A final test is the amount of leverage, or a company’s borrowing. “We require our companies to have at least a third of their balance sheets in equity,” Fischer said, referring to the ratio of total equity capital to total assets.

This way of looking at balance-sheet strength is conservative, because it counts all debt, not only long-term debt. “If it is not equity, it is debt. Even if it is not interest-bearing bank debt, if it is accounts payable, it is not our money. It is money we owe somebody else. We treat it as debt,” Fischer said.

“If we add up all the debt and cash of our companies, our portfolio is net cash. We have more cash than debt,” he added.

Customer screens

Fischer said it was easy to screen for companies with high returns on invested capital and low debt. But then there needs to be screening that is more subjective, which he calls “the customer test,” consisting of three questions.

What is the customer benefit? Fischer and his colleagues need to understand the benefit to a company’s customers. This would exclude biotech companies, for example, with products in development that are still being tested. He also said he would not invest in tobacco companies because he could not see a benefit to the customer.

Does the customer have an incentive to look for a new supplier? It is important to look at what a company’s customers do with what it provides. “We want to invest only in companies that have customers with no ability or incentive to be price-aggressive,” Fischer said. In other words, the ideal company being considered for investment provides a low-cost component or service to its customers. These items should make up small portion of the customer’s operating budget or be critically important, so that the customer is less likely to shop around for a new supplier. “So out would go auto suppliers, for example, because they service professional buyers,” Fischer said, to name a commodity business with low margins.

Is the customer base inherently loyal? “We only want to invest in companies for which the customer doesn’t have incentive to leave,” Fischer said. For example, a company might be providing a component that was specifically designed for its customer’s product — a process that might take years. “If my product is only a single-digit cost for the customer’s product, the incentive to switch is very low,” Fischer said. There might be only a minimal benefit for the customer to switch to another supplier, and the process could take a long time. If you are providing a mission-critical product or service to a business, then that customer relationship is stickie,” he said.

Summing up the customer test, Fischer emphasized the importance of companies’ ability to pass rising costs to their customers through price increases. This is one reason his strategy generally steers clear of companies providing products directly to consumers.

Addressing investors’ fear of a recession, he said that “when you invest  in companies that sell mission-critical products, it means when customers slash budgets, our companies tend to stay out of the line of fire.”

Examples of companies the fund buys

Fischer named two companies held by the Royce International Premier Fund as examples with strong balance sheets, mission-critical products and sticky relationships with customers.

Carel Industries SpA
CRL,
-1.00%

is an Italian company that provides components and software for air-conditioning and refrigeration systems worldwide. According to Fischer, the company has grown its sales by double digits over the past five years. He said Carel has about 10,000 customers, with the largest making up about 4% of sales. He added that the typical product Carel sells to air-conditioning-system manufacturers costs less than 5% of the full product cost.

“Customers are not motivated primarily by price. The company has pushed through high single-digit price increases this year without much of an effect on customer retention. This is a very lengthy sales and co-development process for customers, making it difficult to switch,” Fischer said.

For the long term, he sees a benefit for the company that is “decoupled from from the recession” because of the need for building operators to increase the efficiency of their air conditioning systems.

Another example Fischer cited is New Work SE
NWO,
+0.65%
,
which provides employee recruitment and branding services to companies in German-speaking countries. The company provides services similar to LinkedIn and Glassdoor, combined.

Fischer described New Work as running an asset-sensitive model, because most of its services are run across its software platform. The company has no debt. “So it has a strong balance sheet, is very cash generative and has grown its sales by 15% a year over the past five years, on average,” he said.

He described “an acute demographic opportunity” with over 1.9 job vacancies in Germany — a number he expects to rise to 5 million by 2030 as the German population ages.

Fischer said New Work’s platform has about 20 million users and that it has about “1 million paying customers, none of which is financially material to the company.”

“Almost 90% of profits come from business-to-business customers who pay for recruiting tools,” he said.

Largest fund holdings

At the end of the third quarter, the Royce International Premier Fund’s regional investment breakdown was as follows:

Region

Royce International Premier Fund

MSCI ACWI ex USA Small Cap Index

Western Europe

49.1%

31.3%

Asia Pacific (Developed)

36.0%

42.5%

North America

4.2%

8.3%

Latin America & Caribbean

3.4%

2.7%

Eastern Europe

1.9%

0.6%

Asia Pacific (Emerging)

0.4%

10.1%

Middle East & Africa

0.0%

4.5%

Royce Investment Partners

And this was the breakdown of investments in countries that made up at least 3% of the fund’s portfolio, based on where companies are headquartered:

Country

Royce International Premier Fund

MSCI ACWI ex USA Small Cap Index

Japan

23.5%

21.2%

U.K.

17.7%

9.7%

Sweden

9.9%

3.4%

Australia

7.4%

7.0%

Germany

6.9%

2.7%

Switzerland

5.1%

3.1%

Canada

4.2%

7.6%

Italy

3.8%

1.9%

South Korea

2.5%

3.4%

Brazil

3.4%

1.9%

Source: Royce Investment Partners

The fund had no investments in Chinas as of Sept. 30.

Here are the top 10 holdings (of 58) of the Royce International Premier Fund as of Sept. 30:

Company

Ticker

Country

% of portfolio

TKC Corp.

9746,
-0.28%

Japan

3.4%

IPH Ltd.

IPH,
-0.80%

Australia

3.3%

OBIC Business Consultants Co. Ltd.

4733,
-1.36%

Japan

3.2%

Loomis AB

LOOMIS,
-4.56%

Sweden

3.2%

Hansen Technologies Ltd.

HSN,

Australia

3.1%

BML Inc.

4694,
+0.30%

Japan

2.8%

Marlowe PLC

MRL,
-1.15%

United Kingdom

2.7%

Meitec Corp.

9744,
+1.05%

Japan

2.4%

Restore PLC

RST,
-1.41%

United Kingdom

2.4%

Learning Technologies Group PLC

LTG,
-2.60%

United Kingdom

2.3%

Sources: Royce Investment Partners. FactSet

Click on the tickers to begin your own research about any of the companies.

Click here for Tomi Kilgore’s detailed guide to the wealth of information for free on the MarketWatch quote page.

A tough year for “quality”

The Royce International Premier Fund has several share classes with different expense ratios, some of which may have redemption fees for shares sold within 30 days. If you are interested in the fund, the institutional shares
RIPIX,
+0.62%

have the lowest expenses and no redemption fee, and might be available to you through your broker.

Royce Investment Partners provided these figures comparing the fund’s Investment shares
RIPNX,
+0.70%

with the fund’s benchmark, the MSCI ACWI ex USA Small Cap Index:

 

Total return – 1 year through Dec. 9

Average return – 3 years

Average return – 5 years

Average return – 10 years

Royce International Premier Fund Investment Class

-26.6%

-2.9%

1.5%

6.6%

MSCI ACWI ex USA Small Cap Index

-17.9%

2.6%

1.7%

5.6%

Source: Royce Investment Partners, FactSet

When asked about this year’s underperformance, Fischer said that within the benchmark index, “companies with the highest leverage have outperformed companies with the best balance sheets” this year, and that the last time high-quality companies had lagged the index to this degree was 10 years ago.

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