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Equity Perspectives

Why certain sectors in Japan, India, Australia, and Europe look particularly attractive. 

 

In Brief:

  • The Lord Abbett International Opportunities Fund looks for well-managed small- to medium-sized foreign companies with improving industry and company fundamentals.
  • The team believes that global sector research is the most effective way to uncover companies that are selling at a substantial discount to our bottom-up, fair-value assessment.
  • The European economic cycle—boosted by quantitative easing—is in an upturn, or recovery phase, that favors small caps over large. Given this trend, the team prefers more cyclical small caps in Europe.
  • Small- and medium-sized companies in Europe have been outperforming on earnings revisions during the first half of 2015, with money supply growth providing further upside potential.
  • A number of sectors in Japan also look attractive given the combination of monetary stimulus, corporate governance reforms and improving fundamentals.

 

Todd Jacobson, Lord Abbett Partner & Portfolio Manager, and Edward Allinson, Portfolio Manager, seek under-researched and undervalued international small caps—an asset class that has become increasingly popular in recent years with both retail and institutional investors.

With a unique combination of skills, company, and country knowledge that averages more than 28 years, they know that a good investment theme in one region may be viable in other parts of the world.

Take Europe, for example, where the European Central Bank (ECB), following in the footsteps of the Federal Reserve and Bank of Japan, is taking quantitative easing to new heights, and interest rates to historic lows.

Like the Fed’s monetary stimulus since the financial crisis, the ECB policy has not only boosted the European economy, but also piqued investment interest in some of the hardest-hit countries that stood to benefit from any recovery, added liquidity, lower oil prices, and (in some cases) negative interest rates.

After investing aggressively in German real estate companies, Jacobson and Allinson found similar opportunities in Spain, one of the cheaper rental markets for commercial space in Europe.

With Spain's economy expected to grow 2.8% this year, according to the Bank of Spain, and global private equity firms picking up heavily discounted properties already, Jacobson and Allinson focused on real estate investment trusts (REITS) yielding nearly 5%.  

“We think we’ve seen a bottoming in the marketplace, and opportunities for experienced local players to acquire (and upgrade) assets, particularly defaulted ones held by the financial sector, as well as ‘Sareb,’ the government’s ‘bad bank’ for real estate,” Allinson said.

Mentions of “bad banks” may remind some readers of the U.S. savings & loan (S&L) crisis of the 1980s.  Back then, Congress set up the Resolution Trust Corp. to liquidate assets, primarily real estate-related assets, such as mortgage loans, that had been assets of S&Ls declared insolvent. In November 2012, Spain set up Sareb, a management company where troubled banks could transfer distressed real estate assets to facilitate an orderly divestment of such properties. 

Sareb received almost 200,000 assets, which were valued at 50.781 billion euros, in two phases. The main tranche (36.567 billion euros) was contributed by four nationalized banks. The second transfer (14.086 billion euros) was contributed by four banks that received State funding. Out of all of the assets, 80% are loans and 20% are properties.1

While new construction dried up, many of those Sareb properties lay vacant for five to seven years. As a result, prime center-city properties lost substantial value. Suburban properties did even worse. 

“Madrid and Barcelona is where the recovery is happening fastest,” said Allinson. “So the challenge for REITs is to increase occupancy rates and rental rates, then reposition and renovate properties.”

In Italy, the team took a substantial position in an asset manager that appeared well positioned to capitalize on savers’ long-simmering frustration with paltry government bond yields and greater willingness to invest in alternatives such as equities. After all, Italy, like most major equity markets worldwide, sports current dividend yields in excess of its 10-year government bond yields. As a result, the company has attracted a huge amount of capital in the last several months, which in turn has driven up its stock price.  

Finding Opportunities and Recognizing Value
If Jacobson and Allinson like a company's leadership, industry position, and fundamentals, the key thing they look for is a catalyst that will unlock the perceived intrinsic value of the stock.

"We look at a variety of companies in small cap," said Jacobson. "They may be best-of-breed, with a long track record, quality management, and strong niches that they dominate. They may be younger companies with true growth potential or simply overlooked companies, whose intrinsic value may have been underestimated by the market."

Take Australia, where the Australian dollar has trended lower against the U.S. dollar over the past year and stimulated tourism in the country. As a result, hotel companies, with yields that are typically higher than more traditional investments, have become more attractive.

Lately the team has focused a lot on Japan, where post-QE currency weakness has created some opportunities for exporters, real estate and financial companies. As a result, the team is overweight Japan relative to the S&P Developed ex-U.S. SmallCap Index2 as of May 31, 2015. Significant positions have included a Japanese hotel, a commercial and residential real estate company, as well as a Japanese construction firm. Travel and luxury goods companies have also benefitted, thanks in part to a huge influx of Chinese tourists keen to scoop up bargain luxury goods.

Against that backdrop, Jacobson is closely watching opportunities created by “Abenomics”—the term coined to describe Japan Prime Minister Shinzo Abe’s current economic plan. The final component was a commitment to long-term reform of the notoriously rigid and inefficient economic, regulatory, labor, and financial system in Japan.

That has resulted in sweeping changes in corporate governance and stewardship standards for the JPX-Nikkei 4002 Index, which was started last year in order to identify Japan’s most appealing companies for investors and revitalize the Japanese stock market. The JPX-Nikkei 400 index weights companies by operating profits and return on equity in addition to market capitalization, which encourages management to reduce their large cash piles and return more cash to shareholders.3

Companies with accounting irregularities or cozy board arrangements have already been excluded from the index. Under a stewardship code which takes effect June 2015, each company in the index must have independent directors, but like a previously instituted framework in the United Kingdom, the Japanese code will be run on a “comply or explain” basis.

“Companies will need to have an ROE [return on equity] of at least 5% to be included,” said Allinson. “So if they’re not in it, consultants and rating agencies will be increasingly likely to advise investors to vote against current management unless they manage their businesses more efficiently.”

While it may be too early to gauge how small cap companies in Japan will step up efforts to keep shareholders happy, a stronger consensus on stewardship could help systems integrators as the government, banks and industry boost investment in technology to improve efficiency.

Another potential beneficiary identified by the team is the staffing sector given a tightening labor market for specialized skills and a secular trend of companies outsourcing the search for such specialists. 

“There is a lot of trapped talent in Japan, in some cases underutilized in sclerotic corporate bureaucracies,” said Allinson. “Temp agencies can help workers with underutilized skills find better opportunities elsewhere.”

Passage to India  
Imagine a politically dysfunctional country that imports 80% of the oil it consumes. If world oil prices hit $100 or more, double-digit inflation is likely to ensue. Factor in a new pro-market government; widespread reforms; and lower commodity prices, including oil, and that country is likely to attract considerable amounts of international investment.

That country is India, the world’s largest democracy, which is now growing faster than China and poised for continued growth. With lower interest rates and huge pent-up demand, both the real estate market and lending have shown significant improvement. All of which explains why the team is now overweight the country in the portfolio.  

The team tracked a microfinance company in India, which had experienced significant regional political headwinds, for several years before believing that those obstacles had diminished. They then added the stock to the portfolio as it had little to no research coverage and they felt they had a knowledge advantage on the company.

Given the improving real estate market, the small cap team invested in an Indian home loan company, which was one of the largest positions in the portfolio as of April 30, 2015. Transactional activity at the lender has grown and policy rates have been cut, which have supported the mortgage business and housing development and infrastructure—two industries to which the portfolio also has exposure.

Headhunters of the World—Unite!  
When it comes to deep-value plays, Allinson harkens back to the international small cap team’s first foray into the global staffing arena shortly after the 2008–09 financial crisis. Two of the largest firms had shrunk from large cap stocks to small cap stocks, but because they were industry leaders, their long-term upside potential still seemed attractive. As the global economy recovered from recession, that investment thesis proved correct, and those two headhunters became large caps again.

Since then, Jacobson and Allinson have been interested in three distinctly different staffing companies, assuming more and more corporations will outsource their recruiting functions and increasingly rely on temporary workers to lower their overhead. One of those staffing companies focuses on engineering and energy jobs, and has built a strong reputation for staffing large and small projects all over the globe. The second is a broad-based staffing firm. The third specializes in executive recruiting. The common denominator is a deep reservoir of industry contacts, logistical expertise, and country knowledge—exactly what major multinationals need to deploy skilled workers in remote locations when timing is critical.  

Recruitment and staffing firms in Europe have been in focus for the team, as confidence in the labor market has improved this year. These types of companies are high beta plays on the economy and profitability has tended to increase as the economic cycle improves. The team has exposure to recruitment firms in the U.K. and the Netherlands in particular.

“These three firms are all global; they’re all gaining market share; and they’re all enjoying a secular growth trend,” said Allinson.

The Bottom Line
Amid growing interest in international small caps as an asset class, retail and institutional investors have come to rely on active managers with extensive experi­ence in navigating volatility as investment opportunities and competitive advantages cycle around the world.

One key reason for the growing interest in international small caps is the return differential versus U.S. and international large caps, and emerging markets over the more than 20-year period ended February 28, 2015. Then there’s the combination of: attractive valuations; strong and improving cash flows; a larger opportunity set with relatively sparse research coverage; and a burgeoning middle class in developing markets, particularly in the Asia-Pacific region.

The team believes its global sector approach is critical to analyzing companies in this space. Lately that approach has led to attractive opportunities in Europe (where the economic cycle has been boosted by quantitative easing), India, Japan, and Australia.

 

1 www.sareb.es
2The S&P Developed Ex-U.S. SmallCap Index captures the bottom 15% of companies domiciled in the developed markets excluding the United States within the S&P Global BMI with a float-adjusted market capitalization of at least US$100 million and a value traded of at least US$50 million for the past 12 months at the time of the annual reconstitution. Stocks are excluded if their market capitalization falls below US$75 million, or if the value traded is less than US$35 million at the time of reconstitution.
The new JPX-Nikkei 400 index is composed of companies with high appeal for investors, which meet requirements of global investment standards, such as efficient use of capital and investor-focused management perspectives. The new index will promote the appeal of Japanese corporations domestically and abroad, while encouraging continued improvement of corporate value, thereby aiming to revitalize the Japanese stock market.
4 Madison Marriage, “Shareholder-friendly Japan Inc. is a Slow Business,” Financial Times, May 10, 2015.

 

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