Steve Lipper: Could you offer us your perspective on the performance of the Fund in 2022’s first half?

Mark Rayner: It was a very difficult period. Our benchmark, the MSCI ex-USA Small Cap Index, was down 22.9% in the first half while the Fund fared even worse, falling 27%. Underperformance in a down market was especially disappointing, and even surprising, to us, given the Fund’s history over the last 11 years of often outperforming in down periods.

During the first quarter, the market was driven by five large and interrelated themes: inflation, the prospect of rising interest rates, a highly pressured consumer—especially where I am in Europe—supply chain disruptions, and the terrible war in Ukraine. Investors responded to these risks by moving aggressively into stocks with low price to earnings or price to book multiples—which makes sense in terms of risk management. However, investors also bought companies with elevated debt levels and low returns on capital employed—which is precisely our definition of a low-quality company—in areas that we typically avoid such as energy, banks, and metals & mining. Our goal is to invest in companies that can sustain pricing power over the long term. We invest primarily in B2B companies with pricing power, strong balance sheets, and low capital intensity with little direct exposure to the consumer, an approach that should be effective in an environment with inflation and rising interest rates. From that perspective, our underperformance was something of a paradox.

We generally think our disciplined investment philosophy and consistent process are our greatest long-term strengths. We have great faith in the ability of this approach to produce attractive returns over the long run. But I think it’s fair to say that Q1 showed that this long-term strength can be a short-term weakness. We try to invest in companies with high returns on invested capital (ROIC) that compound shareholder value over the long term. If the market prefers headline inflation hedges such as energy or other commodity-based companies over shorter-term periods, we’re not likely to participate.

In Q2, these same five concerns remained, along with the additional theme of recession. In a recession, you really don’t want to invest in highly levered, low-quality companies. You want resilient businesses. You want pricing power and strong balance sheets. These factors were in favor during Q2, so from roughly early May through the end of June and into July, our Strategy started performing relatively better.

I would make one last point. Our returns are U.S. dollar based. We don’t hedge foreign currencies. And the dollar was quite strong in the first half—up 15% versus the yen, for example, which was its highest in several decades. Just shy of 20% of the Fund’s assets were invested in Japanese companies at the end of June. Currency lost us around about 700 basis points of performance in the first half, meaning that roughly 25% of the Fund’s first-half decline came from the strong dollar.

SL: I understand it was a difficult market environment for your investment process, but what could you as a team have done better?

Mark Fischer: It’s a very fair question. We have a lot of faith in our long-run investment process. Of course, in a portfolio of nearly 60 names, there are always going to be some companies that disappoint operationally. We try to learn from our mistakes so that we can improve our stock selection. First, then, we think investors should know that in all the mayhem, volatility, and uncertainty, we stuck to our discipline. Our conviction really remains ironclad that, in the long term, value creation and share prices correlate. So, we’re sticking to our knitting of finding quality businesses.

We’ve also further enhanced our risk management systems in relation to valuation. We’re always seeking ways to make incremental improvements in how we execute our process. And specifically, we've worked in recent years to build an intelligent research management system that improves our documentation and workflows so that we can be nimbler and more responsive to risks and opportunities. At the beginning of 2022, we enhanced the system further by adding an element that gives us timely information about each company’s cap rate relative to U.S. Treasury yields. We think that monitoring cap rate relative to a risk-free rate makes us better equipped to judge the extent to which a company’s valuation is reasonable. We also believe that this has helped us improve the cap rate of the portfolio relative both to our benchmark and to Treasury yields so far in 2022.

Having said all that, we should’ve implemented the system sooner. Based on our valuation discipline, we did trim many positions in 2021’s market run-up. In the final few months of the year, we exited three names based purely on valuation. However, we think that we’re now even better placed to respond to high valuation markets in the future.

SL: What opportunities did this historic market decline create for you?

MR: We have a large database of what we think are investable companies that we’ve built up over the last decade or more. Perhaps surprisingly, and despite the significant market declines, we added only one new name to the portfolio in the first quarter. We didn’t find any other companies where we felt the combination of quality and valuation would improve the portfolio. However, as prices fell further in 2Q, we did more buying, adding five companies at prices which we think are attractive.

SL: Could you give us a couple of examples?

MR: We sometimes buy what we sometimes refer to as ‘boomerang stocks.’ Benefit One is a good example. After owning it for several years, we sold it because its cap rate had fallen close to parity with the 10-year Treasury yield. However, in 2022’s selloff, and due to the very weak yen, we bought the stock back in May at U.S. dollar prices that were some 70% lower than the prices at which we exited. Benefit One is a Japanese business process outsourcing company. It specializes in providing fringe benefit services to something like 10 million individual users who work for around about 12,000 Japanese corporations. It has great operating metrics and a great growth record. It's grown over the last five years at a compound annualized growth rate of about 8%.

Fringe benefits are a particularly important part of Japanese employees’ compensation packages, much more than you would find, for example, in the U.S. or the U.K. For a fee of no more than $3 a month per employee, Benefit One enables its customers to outsource the administration of these fringe benefit schemes, meaning it really does provide a very critical customer benefit. And because it’s a subscription model, Benefit One generates really sticky customer relationships that generate high margin recurring revenue streams, evidenced by the fact that the annual membership turn is as low as about 3% a year.

MF: Another holding that we added also in the second quarter was Intertek, a U.K.-listed company operating in the testing, inspection, and certification industry—which is one that we’ve long admired. So we were delighted when our systems alerted us to the fact that this Premier wish list company’s market cap had fallen considerably and back into our investable range.

The company traces its origins to a lamp testing center set up by Thomas Edison at the end of the 19th century. Fast forward into today, it’s one of the world’s leading outsource providers of testing, inspection, and certification services. It tests and certifies a wide range of different products, including clothing, food, medicine, and electronic devices. It also supplies a clear and enduring benefit to its customers by safeguarding the integrity of their assets and products. It ensures compliance with laws and regulations. All these services are mission critical, yet they make up less than 2% of the customer’s total product cost. Intertek provides services to 400,000 customers, none of which makes up more than 3% of sales, making for a very diversified customer base. And because its services are interwoven with its customers’ operations and supply chains, customer relationships are sticky.

We were able to buy Intertek at a cap rate of nearly 7%, which was in line with the Fund’s median. Additionally, we think Intertek benefits from several highly attractive secular growth opportunities. The outsourcing rate for Intertek services, for example, is still just 25% globally and rising. The industry is extremely fragmented and ripe for consolidation. All the while, regulatory requirements are rising, supply chains are becoming more complex, and, as we all know, companies are increasingly focusing on corporate social responsibility issues. Its innovation-led, end-to-end Total Quality Assurance (TQA) value proposition not only assures the quality and safety of a customer’s physical components, products and assets, but also the reliability of their operating processes and quality management. Given the company’s industry expertise in certain verticals, it is also often a standard setter, for example providing audits of ethical HR practices and assurances relating to net zero.

SL: We’re always interested in what you’re hearing from companies. What have they been saying in terms of guidance, order books and their own spending plans?

MF: Frankly, we’re not economists, so we hesitate to make predictions of our own. But we do note that there are increasing signals pointing to recession in the markets in which we invest, though we’re not currently seeing this affect demand in the portfolio. We estimate that the majority of our holdings are meeting or even beating consensus expectations. In fact, a number of them are experiencing record order backlogs. Executives are optimistic about the demand outlook. Our companies are also collectively growing sales at more than 8% a year, which is a figure that hasn’t meaningfully changed.

Clearly, there’s a disconnect between economists’ prognostications and, as we've seen, executives’ outlooks. And frankly, we don't yet know who’s right. Ultimately, we fall back on our main value proposition to our clients, which is that at a market multiple our portfolio offers investors exposure to a group of companies that generate much higher returns than the market as a whole and create more value as a result. So, the case to maintain or even add more is that investors now can buy a very robust set of value-creating companies at a lower price with a stronger currency and, we believe, with strong price rebound potential based on historical performance patterns for non-U.S. small-caps.

SL: After a difficult first half, how would you make the case to maintain or even add more to the strategy at this time?

MR: Firstly, full disclosure, I’m obviously biased, but I do generally think that international small-cap is a very interesting asset class with an impressive absolute and relative performance record. For example, if someone had invested in the MSCI ACWI ex USA Small Cap Index at its inception at the end of 1994, they would’ve received positive returns in 82% of the monthly rolling five-year return periods through the end of June 2022. Equally important, the MSCI ACWI ex USA Small Cap Index has beaten the MSCI ACWI ex USA Large Cap Index in 83% of these same monthly rolling five-year periods.

Of course, we’re stock pickers, so for us there’s another layer of interest. International small-cap is an exceptionally large and heterogeneous asset class that’s also pretty inefficient—which makes it great for stock picking. Very importantly, there are some truly outstanding companies in our marketplace. And as we discussed above, there’s the added benefit that the dollar has been incredibly strong of late. I would suggest that U.S. investors might consider taking some of those strong U.S. dollars and think about buying high-quality non-U.S. assets. And we invest primarily in companies with high-quality currencies like the Yen, the Swiss Franc, the Euro, the British Pound.

Finally, valuations throughout the non-U.S. small-cap market have gotten better. The cap rate of the Fund hasn’t been this high since early 2015. We systematically track our large database of what we think are high quality companies, so we’re watching out for share price declines and are very much on the front foot of looking for quality business at attractive valuations.