Nyhavn warmly illuminated beside the sailing ships moored beneath sunset skies in the heart of Copenhagen, Denmark.

Digitalization has been a driving force behind growth in many industries, creating new opportunities and increasing efficiencies. The benefits of a thriving digital society are immense, including improved productivity and cost reduction. Unsurprisingly, the global market for digital transformation is enormous and rapidly growing. In 2022, this market was valued at close to US$750 billion and is projected to experience a compound annual growth rate of 26.7% from 2023 to 2030

The IMD World Digital Competitiveness ranking evaluates the capacity and readiness of 63 countries to adopt and explore digital technologies for societal enhancement using 54 different criteria. Denmark was named the most digitally advanced country in the world by the International Institute for Management Development (IMD) last year, marking the first time a Scandinavian country surpassed the US in this ranking. The US secured a respectable second place, thanks to its large and expanding tech industry and robust digital infrastructure. Denmark’s top position can be attributed to its readiness to embrace digital transformation, business agility and IT integration. The country also excels in delivering online public services and a remarkable 94% of its citizen are connected and considered tech-savvy.

In other parts of Europe, the digital landscape is uneven, with varying levels of digital readiness, infrastructure availability and digital skills among countries. However, efforts are underway to bridge the digital divide and drive transformation across the European Union (EU).

The European Commission has long been working on the “digital single market” and, in 2020, unveiled the Recovery and Resilience Facility (RFF). This €750 billion initiative aims to address the economic and social consequences of the COVID-19 pandemic and will be distributed among member states. At least 20% of the recovery funds must be allocated to projects that digitize economies and societies. 

The initiative’s goal is to expand digital infrastructure, support digital skills and education, promote digital innovation and entrepreneurship, and enhance digital public services. The EU’s vision is to become the most connected continent globally by 2030, ensuring every household has access to high-speed internet coverage by 2025 and gigabit connectivity by 2030. The EU is also committed to supporting the expansion and improvement of 5G infrastructure across its member states. For instance, Greece’s recovery and resilience plan includes €1.3 billion allocated to the digital transformation of the public sector and €500 million for promoting digital transformation in the education and health systems.

We believe that Netcompany, a recent addition to our international portfolios, is well-positioned to benefit from Europe’s digitalization. 

Netcompany, a Scandinavian provider of next-generation IT services for public and private customers, aims to support its clients in gaining competitive advantages and enhancing efficiency through digitalization, customized application development and business process re-engineering. The company has established a highly differentiated business model that is repeatable and scalable, enabling the delivery of projects on time and within budget. In its most recent fiscal year, Netcompany reported revenues of DKK 5,545 million (US$797 million) and an EBIT of DKK 839 million (US$121 million).

Originally based in Denmark, Netcompany has expanded its operations to Norway, the Netherlands and the UK. In 2021, it further expanded into Continental Europe through the acquisition of Intrasoft, gaining access to EU institutions and government tenders. By leveraging the combined platforms, competencies and strengths of both companies, we believe Netcompany is well-equipped to capture market share in Europe’s digitalization journey.

"Small Cap" written on a sticky note on an office desk over some charts.

Here we are, almost halfway through 2023, and we’re seeing many of the same investment themes we saw last year. Large-cap stocks continue to outperform, driven by the usual suspects. The Federal Reserve (the Fed) has continued to raise rates at the fastest pace in history. The US debt ceiling still looms. Meanwhile, weak economic data and a tight lending cycle point towards a recession. Given these factors, it may seem like large-cap investments are a safer choice than small caps. But there’s another side to the story.

What’s really driving the so-called large-cap performance? 

Under the surface, a handful of stocks are responsible for driving most of the S&P 500 Index’s outperformance, which also happen to be the same names driving the Nasdaq Composite Index’s performance. The year-to-date return of an equally weighted S&P 500 stands at a mere 0.57%, nowhere near the 7.28% performance for the S&P 500. As for the Nasdaq, Microsoft, Apple and Meta alone account for approximately 30% of the Index, thus driving its results. We believe large-cap indices currently lack adequate diversification to provide safety in a downturn. Their heavy dependence on a single industry, namely tech, is a vulnerability.

As at May 9, 2023

Large caps seem ready to disappoint 

As of March 8, 2023 (the day before the Silicon Valley Bank failure came to light), the Russell 2000 Index was outperforming the S&P 500 by 274 basis points (bps). Understandably, the bank crisis led to significant outflows from small-cap ETFs into large caps, which seemed safer given the circumstances. Consequently, large caps are currently outperforming. However, it’s crucial to bear in mind two key factors. Firstly, the Russell 2000 is still far more diversified (and therefore safer in our view) than the tech-heavy large-cap index. Secondly, we believe patient investors will be rewarded as valuations normalize. 

In fact, we anticipate that small caps will make a powerful comeback as large caps lose momentum, driven by the following reasons.

  1. De-globalization leading to lower margins for large caps: According to Goldman Sachs research, S&P 500 margins have risen by 700 bps since 1990, with 70% of the increase attributed to cost savings on goods and the balance to lower taxes and interest rates. However, with de-globalization on the horizon, we believe it’s just a matter of time before investors reduce their overweight positions in large-cap stocks as their margins dwindle. Instead, they’ll turn to smaller caps, which are poised to benefit from local economies. 
  1. Historical data shows that periods of high inflation often correlate with stagnant large-cap performance. Take the 1940s and 1970s – two of the worst decades for inflation in the 20th century.

During the post-WWII period, distortions across supply chains and labour markets fueled a 20% spike in US CPI. Large caps went nowhere for the next four years. Similarly, during the stagflation era of the 1970s, large-cap performance remained flat for over five years while quality small-cap stocks emerged as winners.

Large cap equities were flat for >42 months post-WWII

…and for >5 years during the 1970s inflation shock

If we look at recent large-cap performance amidst soaring inflation, we find a similar pattern across three different time periods. As Mark Twain famously said, “History doesn’t repeat itself, but it often rhymes.”

S&P 500 vs. CPI Change Index

  1. Remember the Nifty Fifty stocks of the 1960s? These were the esteemed blue-chip companies of that era – expensive but deemed “safe.” The only problem was, when the tide turned, they plummeted to single-digit multiples almost overnight. Today, the five largest stocks account for 20% of the S&P 500, indicating even worse diversity than the dotcom bubble. It begs the question: where else can they go but down?
  1. Analyst estimates for the S&P 500 call for earnings to increase from $204 to $225 (+10%) in 2024. Sounds impressive, right? Yet historically, large-cap earnings do not jump that high coming out of recessions (see chart below). In reality, it was the billions of dollars in stimulus during COVID that propelled S&P 500 earnings to grow at an unprecedented pace. Can we really rely on this trend continuing? 

S&P 500 TTM positive operating EPS (log scale) with exponential trend
Grey bars are negative y/y% “industrial production contractions” (R2 = 0.9469)

Take advantage of cheap, high-quality small-cap stocks 

For some time now, low-quality stocks have been more expensive than their high-quality counterparts, primarily driven by inexperienced traders. Jefferies reports that lower return on equity (ROE) names are trading at 4.6x sales, a staggering 60% above their long-term average. In contrast, the highest ROE names are trading at 1.2x sales. In our view, this is a clear signal to avoid these low-quality stocks (which are poised to plummet in value) and focus on quality names with strong fundamentals that currently offer attractive buying opportunities. 

So, what exactly makes a quality company? While there may be varying definitions of quality among experts, we can turn to research done by Hsu, Kalesnik and Kose who identified seven metrics used by popular index providers to define quality. These metrics are: profitability, earnings stability, capital structure, growth in profitability, accounting quality, payouts and corporate investment. 

Quality stocks not only exhibit defensive characteristics but are typically less exposed to macroeconomic influences due to lower operational and business risks. Stronger balance sheets and a consistent track record of predictable profits help mitigate downside risk as well.

The secular case for small caps is intact, with a leadership shift to “old economy” stocks, capex beneficiaries and domestic-focused companies from large caps – all of which bode well for small caps. Valuations of small caps versus large caps currently remain near multi-decade lows, suggesting better returns for small caps over the next decade. 

M&A activity is also heating up. While the market overlooks quality small-cap companies, private equity and strategic corporate buyers are capitalizing on the market dislocation to acquire high-quality companies at attractive valuations.

What’s the impact on your portfolio? 

Large-cap and growth stocks have benefitted from the past decade’s zero-rate policy, low inflation and sluggish nominal growth. However, the current macro landscape is ripe for new leadership, which we believe will come from quality small-cap companies. As the chart below shows, large caps seem due to underperform, creating an opportune environment for small-cap leadership. We believe it’s only a matter of time before this transition happens.

Our portfolio consists of market leaders that are outpacing industry growth. These holdings fit the definition of “Quality Small Cap” with strong industry growth, little to no debt and faster earnings growth. Furthermore, they’re trading at a discount compared to their historical valuations.

As the tide turns against large-cap stocks, these companies are poised to benefit. Not to mention, higher interest rates have the potential to benefit our portfolio holdings, enabling them to gain market share and continue to deliver strong and predictable earnings growth.

Large-cap buyers beware; small caps are coming for you.

Financial district in London at dusk with buses driving through.

The UK has historically been a region that attracts significant takeover interest. In this week’s commentary we look at the increase in activity this year, the reasons why and the potential long-term implications for the UK equity market. 

Several factors have contributed to foreign interest in the UK, including its strong presence in the financial and legal sectors, its industrial heritage, a sizeable consumer market and the widespread use of the English language.

Compared to other G7 economies, the UK government has historically been less inclined to intervene on national security grounds when faced with foreign bids for domestic assets. Between 1997 and 2017, despite accounting for only 3% of global GDP, the UK was involved in 25% of global cross-border merger activity. It is estimated that around 50 UK-based firms eligible for the FTSE 100 Index are now under foreign ownership.

For many years, UK equities have been trading at a larger discount compared to their US counterparts. This can be partly attributed to the differing composition of the respective stock markets. The UK has a larger allocation to lower price-to-earnings (PE) valuation sectors, such as energy and materials, which make up around 23% of the FTSE 100 compared to 7% of the S&P 500 Index. Conversely, information technology represents less than 1% of the FSTE 100 but accounts for 26% of the S&P 500. Even considering these factors, the discount had reached approximately 5% leading up to the Brexit referendum in 2016.

Following the momentous decision to leave the European Union, a “Brexit discount” was applied to UK companies to reflect the structural challenges they would face. Furthermore, recent political turmoil, including three prime ministers within a span of fewer than two months towards the end of 2022, has led to an increased risk premium. Consequently, the discount between UK and US stocks has surpassed 40%.

PE discount between UK and US stocks

Source: Bloomberg. S&P 500 Index was used as a proxy for US stocks; FTSE 100 Index was used for UK stocks.

It is evident that as the discount has grown, the frequency of foreign takeovers of UK companies has also increased significantly. According to the Office of National Statistics, the number of takeovers valued at £1 million or more was consistently between 100 and 300 annually for the 30-year period preceding the Brexit referendum. Since then, the number has exploded. 

This was evident in the first quarter of the year when the deal closed for one of our former UK holdings, Biffa plc (BIFF.LN). Another of our UK holdings, global flexible workspace provider IWG (IWG.LN), has previously attracted takeover interest, while Coats Co. (COA.LN), a global leader in threads, was acquired in the past and later delisted before being relisted a decade later.

A thriving stock exchange can benefit the economy and society as a whole. The capital provided by exchanges enables companies to grow which, in turn, means they employ more people and contribute more taxes for wider public services. However, the number of companies listed in London has almost halved from 2,101 in 2003 to 1,097 today. While this still leaves ample attractive opportunities for investment, the increase in takeovers is just one piece of the puzzle. Another factor has been the decline in new listings. Recognizing the need to adapt and attract more listings, the UK’s financial watchdog, the Financial Conduct Authority, has proposed measures aimed at enhancing the country’s appeal for domestic companies. This follows cases such as UK-based microchip giant Arm, owned by Softbank, opting to list in the US. While streamlining the listing process may remove certain barriers and improve competitiveness, it should not compromise shareholder rights.

The persistently low trading multiples of UK equities leave them susceptible to foreign takeovers. While Global Alpha does not base its investment theses solely on potential takeovers, we acknowledge that it has always been a potential tailwind for the small-cap asset class, and we anticipate heightened takeover activity in 2023. 

The capital dome illuminated after dark in Washington DC.

In recent years, the U.S. federal government’s debt and deficit have been hot topics in the news. The term “debt ceiling” has once again made headlines after Treasury Secretary Janet Yellen warned that the U.S. government could run out of money by June 1. It’s important to understand what the debt ceiling is, why it needs to be raised and how it can impact financial markets.

What is the debt ceiling?

The debt ceiling is the maximum amount the U.S. Treasury can borrow from the public and governmental accounts. Governments, like individuals, must borrow money when they spend more than they earn and they do so by issuing bonds.

The U.S. has had a debt ceiling for over 100 years, first established in 1917 at $11.5 billion. Prior to this, Congress authorized the government to borrow a fixed sum of money for a specified term. After the loans were repaid, the government could not borrow again without asking Congress for approval.

The debt ceiling was created in 1917 under the Second Liberty Bond Act to make it easier to finance WWI. It allowed for a continual rollover of debt without congressional approval. However, increasing government obligations have led to rising government debts to make up the shortfall between tax revenue and government spending.

What are the issues with raising the limit?

To issue more bonds, the U.S. Treasury must increase the debt ceiling. This has been done without incident for decades, with policymakers raising the limit 89 times since 1959. Most recently, in December 2021, the debt ceiling was raised by $2.5 trillion to $31.4 trillion, projected to fund obligations through mid-2023.

US debt ceiling raises keep pace with the growing national debt (in billions of US$)

Sources: U.S. Department of the Treasury, U.S. Office of Management and Budget.

Debates surrounding the debt ceiling have become more contentious in recent years. Disagreement has led to two federal government shutdowns in the late 1990s and a 2011 fight that resulted in volatile financial markets and Standard & Poor’s downgrading of the U.S. government’s credit rating for the first time in history. In addition to political reasons, resistance against raising the debt limit has often come from concerns about the sustainability of the massive government debt balance.

The current public debt outstanding is $31.457 trillion, with each U.S. citizen’s share being around $95,000. Economists and government officials often cite the debt-to-GDP ratio, which measures how much of the annual production would be required to pay off the public debt. The U.S. government’s debt-to-GDP ratio of 148% ranks the fourth highest globally, after Japan, Greece and Italy.

What is the likelihood of the U.S. repaying its debt?

In recent decades, the U.S. government has been in deficit almost every year, except for a surplus between 1998 and 2001. It is projected that the government will continue to run deficits until at least 2028, making it unlikely that the government will be able to repay any debt in the foreseeable future. Instead, more debt will likely be added.

US government surplus of deficit, 1993 – 2028 (dollar amounts in billions)

Source: Congressional Budget Office website.

Until recently, the cost of issuing debt to finance federal operations was minimal. However, with rising interest rates, the average interest rate on federal debt has risen to 2.07% in 2022 from 1.6% in 2021. The Congressional Budget Office estimates that interest costs will triple to $1.3 trillion in 2032, becoming the largest federal budget item and surpassing Social Security and Medicare by the middle of the century.

These developments raise concerns that the world’s largest economy may not be able to meet its financial obligations. As a result, the credit default swap (CDS) against a U.S. government default has risen sharply since the beginning of 2023. On May 4, one-year U.S. government CDS reached 152 basis points (bps), up from 10 bps a year earlier and the highest since the 2008 financial crisis. Although the U.S. has never defaulted on its debt, investors are becoming increasingly anxious about the possibility.

What could happen if the U.S. debt ceiling is not raised?

The U.S. government would be unable to borrow money to finance critical obligations, such as Social Security, tax refunds and federal workers and military salaries. This would result in a severe stock market decline and could damage the reputation of the U.S. as a reliable business partner. Interest rates would skyrocket, potentially causing a U.S. or global recession. The dollar may lose its status as the global reserve currency and drop significantly in value.

While the government could resort to temporary financial measures, such as minting a $1 trillion platinum coin, a more sustainable solution is required to address the gap between revenue and spending. This could involve increasing tax rates, reducing expenditures or both.

The debt issue, combined with the tightening credit cycle following the banking crisis, means that borrowing to fuel growth will become increasingly challenging and expensive. Companies with high leverage may face higher interest burdens.

Evaluating financial health to deliver long-term value

We believe investing in companies with strong financial positions, diversified revenue streams, good profitability and no reliance on government subsidies for growth is essential. We take a disciplined approach to investing and carefully evaluate the financial health of the businesses we invest in. Half of the companies in our International Small Cap strategy and a third in our Global Small Cap strategy are in a net cash position. Our portfolios are well positioned to weather economic uncertainties, with a focus on delivering long-term value to our clients.

Earlier this month, we attended a conference in San Francisco that focused on various carbon removal technologies, including direct air capture, land-based carbon removal and enhanced mineralization. The conference had over 650 participants, with 130 of them being corporates from both private and public companies that are working toward reducing carbon emissions. The number of start ups in this space has grown exponentially in the last couple of years and the United States is becoming a leading global carbon capture centre.

The Inflation Reduction Act (IRA), passed in August 2022, has created favourable conditions for carbon capture technology deployment in the U.S. The most notable provision is the 45Q tax credit for CO2 storage, which aims to promote carbon capture utilization and storage (CCUS).Companies providing direct air capture technologies have grown from only three start ups a couple of years ago to over 60 today. One of the reasons for this is the attractive credit of US$130 per tonne of CO2 captured and stored.

We also learned more about the Department of Energy’s Loan Programs Office (LPO), which grants debt capital to companies providing clean energy services and infrastructure. Over the last decade, this office has already issued over US$38 billion, with billions more available for future funding. The LPO is focused on providing capital in three main areas:

  1. Title 17 Clean Energy Loan Program to accelerate the commercial deployment of innovative energy technologies.
  2. Advanced Technology Vehicles Manufacturing Direct Loan Program to promote local manufacturing of more fuel-efficient and clean vehicles.
  3. Tribal Energy Loan Guarantee Program to support the investments into energy projects for federally recognized tribes.

Many companies that will benefit from the IRA are also eligible to receive additional debt financing if they meet any of the LPO’s three programs, unlocking capital to deploy into clean technologies. With the amount of capital pouring into clean energy sectors, it is definitely an exciting time to follow the sector.

Although carbon capture is a difficult area to gain exposure to in public markets, there are a few public companies that have internally incubated such technologies. One such company is Advantage Energy Ltd. (AAV CN), which we currently own and had the opportunity to meet at the conference. Advantage is an Alberta-based natural gas and light oil producer that has started a subsidiary clean-tech company, Entropy, providing modular carbon capture and storage technology. Advantage owns 85% of Entropy, with Brookfield Renewable being the other strategic owner.

Entropy’s carbon capture technology is already in operation at Advantage’s Glacier Gas Plant and has a capture rate of 90% to 95% of post-combustion flue gas. With the addition of the technology, Advantage’s carbon emissions at that specific plant have fallen by about 15%, resulting in a CO2 savings of about 47,000 tonnes annually. This helps make the company one of the lowest emission intense producers compared to its peers.

The carbon capture process involves capturing the CO2 from the flue gas stream emitted by the plant, processing it by scrubbing it with a chemical solvent and then storing the captured CO2 permanently deep underground. The process is illustrated in the figure below.

The post-combustion carbon capture technology is a strategic advantage for Entropy and the company is a key asset for Advantage Energy. Currently, there are only two operating post-combustion carbon capture projects in the world. The post-combustion technology can be retrofitted to existing energy-generating assets, which is the market the company aims to serve through its capital-light licence and support model, in addition to developing, owning and operating carbon capture units. Moreover, Entropy uses its proprietary solvent called Entropy23 that allows for lower input and operating costs due to its superior chemistry developed in-house. 

Currently, Entropy is benefiting from Canada’s investment tax credit of 50% for carbon capture equipment, but it is also expanding its team to focus its commercial efforts in the U.S. to benefit from the IRA. Recently, the company announced a first memorandum of understanding with California Resources Corporation, in which Entropy will provide technology, engineering and development services to decarbonize gas-fired boilers, avoiding about 400,000 tonnes of carbon annually. 

Aurubis AG (NDA GY), Europe’s largest copper producer and the world’s largest copper recycler is worth mentioning for its commitment to reducing its carbon footprint. Copper smelting is a heavy emitting activity but critical for the energy transition as we have highlighted in a previous note. The company has set Science-Based Targets with a goal of 1.5-degree alignment by 2030 and is piloting the use of blue ammonia in its production process for copper rods at its Hamburg facility. The carbon dioxide by-product from blue ammonia production is captured and stored underground. If successful, Aurubis will permanently switch to blue ammonia, potentially saving 4,000 tonnes of CO2 annually.

The opportunities in the carbon capture space are extremely attractive, with both policy and capital driving growth. We are confident that Advantage and Aurubis will benefit from them in the future while providing critical technology in helping it and other companies achieve net-zero goals.

Bamboo forest in Kyoto, Japan.

At Global Alpha we are macro aware but don’t make macro calls. Being macro aware helps us evaluate investment opportunities through the lens of a country’s economic indicators, politics and regulatory landscape. It can also be an important risk management tool, especially in emerging markets.

Macro awareness also comes from understanding a country’s policy choices on its path to success or failure. An exceptionally interesting book called “How Asia Works” by Joe Studwell, provides unique insights into why North Asian countries (Japan, Korea, Taiwan and China) have managed to achieve sustained economic growth while South Asian countries (Thailand, Malaysia, Indonesia and the Philippines) seem to have stalled on their way to economic success. The book answers several questions including:

  • Why successful industrial brands like Haier, TSMC and Hyundai emerged from North Asia and not South Asia.
  • How the Philippines went from being twice as rich as Korea to 11 times poorer in half a century.
  • Lessons that other emerging markets can learn from ones that have experienced growth and success.

The last point is particularly useful to our investment process. If there was a common thread (or formula for success) across North Asian economies, it would be the following.

Step 1 – Small gardens beat large ranches (Land reforms)

This is the crucial initial step, yet also the stage at which most countries falter. Achieving sustained economic growth of 7% to 10% over a significant period requires making tough political decisions, such as redistributing land in a peaceful manner. Following WWII, many North Asian economies were poor and had a surplus of labour in rural areas. However, land ownership was concentrated in the hands of a few wealthy and connected landlords.

The key to unlocking growth in this situation was to peacefully redistribute land from these connected landlords to small rural farmers and peasants. This approach is counterintuitive to what neo-classical economists might recommend, which is to establish massive, mechanized farms to maximize profit per acre. Instead, an intensive gardening approach on a small plot can deliver maximum crop yield.

The effect of this type of reform is that it fully employs the abundant labour available in rural areas. Increased agricultural output leads to sharp increases in purchasing power, waves of consumption and the resources to pay for basic manufacturing technology. Another significant effect of this reform was the social and economic mobility that it enabled, which in turn led to the emergence of a new middle class and a new cohort of entrepreneurs. For instance, the founder of Hyundai (Chung Ju Yung) in Korea and the founder of Formosa Plastics (Wang Yung Ching) in Taiwan were both sons of farmers.

Step 2 – Export or die (Carrot and stick approach to manufacturing)

As agriculture begins to create a new generation of entrepreneurs, returns from agricultural reforms start to taper off after a decade. The challenge then lies in redirecting entrepreneurial energy towards export-oriented manufacturing instead of services. Manufacturing is preferable to services because significant productivity gains can be achieved with low-skilled workers, and manufactured goods are more freely traded across the world.

Where policy differs from the consensus neo-classical approach is in offering protection to domestic manufacturers in the early stages of a country’s development, in the form of subsidies, while keeping international competition out of the domestic market with high tariffs. In exchange for this protection, domestic firms are required to maintain strict “export discipline.” This means that the more a domestic business exports and competes in the international market, the more subsidies and financing it receives.

A positive side effect of this policy is that businesses in North Asia were compelled to rapidly climb the technology learning curve to produce high-quality products. Those that failed to be export competitive were cut off from cheap credit and subsidies and were forced by the government to shut down or merge with successful companies. Instead of picking winners, the government weeded out the losers.

For example, Korea’s government encouraged a dozen conglomerates, including Samsung, Daewoo and Shinjin, to master car manufacturing in a market that was just 30,000 units in size. Vehicle imports were prohibited until 1988 and the import of Japanese cars until 1998, allowing domestic manufacturers to compete for survival. As a result of this policy, a single world-beating colossus in the form of Hyundai-Kia remains.

In contrast, Malaysia decided to master car manufacturing with a single state-owned enterprise (Proton) instead of encouraging private enterprise. With no export discipline or internal development of technology, Proton has mostly found success in the domestic market. In 2022, Proton sold approximately 141,000 cars, while Hyundai Kia sold over 6.8 million.

Step 3 – Targeted finance (Saying no to short-term profits)

The final step is to ensure that domestic financial institutions are fully aligned with the agricultural and industrial policy goals outlined above. Banks are kept under government control via the central bank and “directed” to lend to industrial and agricultural projects that may not necessarily yield the highest short-term returns but have the potential to earn long-term profits by nurturing infant industries. Capital controls are implemented to ensure that citizens’ savings remain in the country to finance national development projects.

The key is to avoid premature deregulation of the financial sector as with what led to the 1997 Asian financial crisis. Deregulation and capital market development as promoted by the World Bank and International Monetary Fund came much later in the industrialization process in Taiwan and Korea. In South Asia, premature deregulation of the financial system led to the issuance of new bank licenses to a cozy group of entrepreneurs who financed their own business activities and short-term speculative investments, like luxury real estate, instead of projects of national importance.

This historic review of North Asian success may seem both contrarian and counterintuitive due to its prescription of financial repression, tariffs and political intervention. However, it helps us at Global Alpha identify countries or sectors that might be on an unconventional path to success. For example, when we were in Vietnam late last year, we couldn’t help but wonder if its combination of an export-driven model and capital controls resembles the Korea or Taiwan of 1970s and 1980s.

Similarly, when Korea announced in 2022 its plans to develop its carbon composite industry as its second steel industry, we saw parallels with how it mastered the art of steelmaking with POSCO, now one of the world’s most efficient steelmakers. In fact, we have exposure to the advanced materials space in Korea through Hansol Chemical (014680 KS), which plans to invest ₩85 billion in silicon anode production as a solution to increasing the energy density of EV batteries while reducing charging time. If history is any guide, we can expect plenty of support from the Korean government to nurture this industry of the future.

Macro awareness can help you succeed

The success of emerging markets isn’t just about individual companies, but also about the broader economic and political context in which they operate. Being macro aware and having a solid understanding of the broader context can help investors make better informed decisions, mitigate potential risks and maximize their returns.

As we approach the second anniversary of our Emerging Markets Small Cap Fund, our team has been actively discussing investment ideas across 24 countries. In Global Alpha, we follow a well-established investment process, similar to our strategies in developed markets. We believe that complementing our analysis with on-the-ground visits to our holdings and prospects, including factories and other sites, is essential. These visits allow us to enhance our investment thesis and validate or revise our perspectives. In this note, we highlight the main takeaways from our recent trip to Asia and provide some examples of how we incorporate our findings into our portfolio.

During our visit to Mumbai, India, we had the privilege of conducting close to 30 one-on-one meetings and attending a local conference. Two things immediately stood out. First, the heavy traffic, cars honking and bustling crowds signaled a high level of activity, with no signs of recession. Despite potential consumption deceleration during a downturn, the sheer size of the population helps ensure that activity continues.

Second, every company we met with signaled strong, double-digit growth for at least the next three years. This common mindset among the companies we met was striking and seemed almost psychological. None of them anticipated a slowdown in fiscal year 2024. When companies share a common optimistic outlook that deviates from consensus, it often becomes a self-fulfilling prophecy. Each company we visited had a medium-term mindset, with growth as their main focus.

India currently comprises approximately 20% of our Index, making it the second most important country after Taiwan. Valuations of India-based companies have been a challenge for us, as many of the quality players are expensive. However, we believe that investing in India is more for long-term structural growth and our recent visit provided confirmation of this perspective. For example, we visited one of the largest real estate projects in India called Thane, developed by the company Oberoi. Seeing the dimensions of the project in person rather than just in a presentation was illuminating and provided us with new perspective. Another example is the Mulund project of Prestige, one of the company’s flagship developments. Prestige (PEPL IN) is a company we currently own in our portfolio. Over the last decade, the Prestige Group has firmly established itself as one of the leading and most successful developers of real estate in India across all asset classes. The company is based in Bangalore and recently entered Mumbai with better than expected results.

Prestige Group development

In India, we also visited one of our most significant portfolio holdings, CreditAccess Grameen (CREDAG: Natl India). CREDAG is the largest non-banking finance company/microfinance institution (NBFC-MFI) in India with consolidated AUM of approximately INR150 billion, indicating an industry market share of over 5% (16.3% within NBFC-MFI) and a recorded 52% assets under management (AUM) CAGR over fiscal year 2014-2022, with a strong presence in Karnataka, Maharashtra and Tamil Nadu.

The company is a market leader in an underpenetrated business with immense, multi-year growth potential. Driven by its strong management and track record, the company is in a privileged position to capture India’s secular trend of the emerging low-middle-class population. Moreover, there is a massive underpenetration of MFIs in rural areas where CREDAG has its largest AUM. CREDAG maintains strong returns on equity driven by a low cost of risk. There was also a spread cap for this business that was recently removed, creating larger opportunities for the company. In this case, we also received confirmation from the management expecting growth. Their expectations are to increase its AUM by at least 20% for the next three years, driven by strong demand from the rural population and underpenetration. It’s different to understand the drivers of that growth in a lengthy face-to-face meeting than just over a Zoom call. We incorporated all the inputs in our model.

As explained in our previous weekly note, we visited Indonesia, where we took advantage of the opportunity to see the willingness of authorities to attract foreign investors. In another recent weekly note, we highlighted our approach to choosing companies and our preference for Mitra Adrapekasa (MAPI), our top pick in Indonesia. We visited MAPI’s top management and got validation about their significant growth potential. It was a reassuring confirmation check for us. As part of our process, we need to know the management of our core holdings and hear their strategy in person. Thus, this meeting was useful to maintain our conviction in this position, as explained in our previous weekly note. Our main takeaway is that the company is poised for strong top-line growth with sound profitability for many years.

These visits are also relevant to challenge the management teams of our holdings. For example, we own Prodia (PRDA: IJ), Indonesia’s biggest independent lab. The company is a market leader in an underpenetrated business with significant growth potential for many years. Current market share is about 40%. Prodia enjoys superior unit economics, strong returns and profitability indicators. Nevertheless, PRDA maintains conservative top-line growth at high single digits.

The company meets all the criteria in our process with the only caveat being its lack of top-line growth. So we challenged its management team, comparing their situation with other lab companies we own (such as Integrated Diagnostics Holdings (IDHC LN) in Egypt). Indonesia is a huge country with 300 million people with a vastly underpenetrated healthcare system. We should expect the company to grow at double digits. We also mentioned the case of Fleury (FLRY3 BZ) when we were in Brazil, where the growth is higher with a similar population. Management was receptive to our comments and we could understand from them more about their reasoning and intention to grow more aggressively (while maintaining profitability) in the future. Its interesting because we’ve never had the chance to go deep into that conversation by Zoom. There is nothing wrong, indeed it adds a lot of value, to question some strategies of our holdings in-person with them. It helps us understand their view and incorporate their decision-making into our process. Its also useful for us as investors to provide our portfolio companies with feedback and identify opportunities for improvement.

Detailed tests in Prodia.
Prodia lab entrance.

We also had the opportunity to visit Thailand and gain insights into the country’s small-cap companies. Many of these companies are known for their conservative approach to growth, which may not always be a bad sign if they manage risks efficiently. Being on the ground allowed us to understand how the culture drives this conservative approach in various aspects, which is something we can only fully appreciate through firsthand experience.

During our visit, we met with eight companies as well as strategists and representatives from non-listed companies. Thailand is experiencing a significant influx of tourists, which contributes to around 20% of its GDP and is relevant for economic recovery across different sectors, such as consumer, banking and industrials.

In our portfolio, we own two stocks in Thailand, with Chularat Hospital PCL (CHG) being one of the highlights. CHG operates a network of nine mid-end hospitals and four clinics throughout Eastern Thailand. Its network consists of three hub hospitals (Chularat 3, 9 and 11) and 10 smaller hospitals and clinics serving nearby provinces with high concentrations of industrial zones and dense populations. CHG is well-known for its expertise in cardiology and microsurgery and is the sole operator of a heart center in the Eastern region. As such, CHG has become the main referral center for both Social Security Office (SSO) and National Health Security Office (NHSO) programs in the area. CHG is one of the leading regional hospital networks catering to the Thai middle class, with a well-balanced patient base consisting of 59% cash and 41% government program patients.

We visited one of its hospitals (Hospital 3) and were impressed with its cleanliness, spaciousness and organization, with specialized centers within the hospital. Notably, there was a dedicated floor for UAE patients. CHG stands out as one of the few companies in the Thai market that is growing faster than the overall market with good margins and a clear growth strategy. Visiting one of its main facilities allowed us to see firsthand how the company treats and manages their speciality centers, which are well developed in the country. In one of the following photos, we captured the amazing work they do in hand and finger recovery at one of their specialty centers.

Chularat Hospital 3 entrance. 
Specialist center.

During our next country visit to Korea, we spent a whole week visiting close to 30 companies. Overall, our impression was positive although it wasn’t easy to find many ideas because Korea’s small-cap market is mostly linked to memory and EV battery materials. We visited companies we already own, such as Hansol Chemical (014680 KS)and Leeno Industrial (058470 KS), but the message wasn’t very positive as inventory levels were still high and demand was weak.

We also visited other companies that we don’t own but are monitoring closely, such as Tokai Carbon Korea (064760 KS) whose CFO explicitly stated that the company expected the memory market to recover in the second half of 2023 but remain complicated throughout the whole year. We understand that we don’t have to get a positive message from every company we visit and our main job is to incorporate the inputs we receive wisely. So, we took a conservative approach in the material memory names we own and postponed the initiation of some prospects based on feedback during the visits. The beauty of being with the companies in person is that we could understand from different sources on the ground what was really happening, which served as confirmation of what we had read and discussed internally.

We also visited some companies related to EV battery materials, particularly silicon anode technology, which is intended to improve battery life cycle (carbon) and energy density (in the form of oxide). Currently, silicon anode is mixed in small percentages (4% to 8%) with graphite as higher percentages (92% to 96%) cause the battery to swell. However, battery cell makers in Korea have been positive about their ongoing technology of increasing the silicon anode composition to around 15% in a couple of years. If this is achievable it could have a strong multiplier effect driven by the increase of EV sales and the higher penetration of silicon anode. Companies like Daejoo Electronic Materials (078600 KS) are aiming to have more than a million cars adopting this technology by the end of 2023, with Porsche Taycan and some models of GM being among the end clients of battery cell maker, LG Chem. There was also news that Hyundai could be starting to adopt this technology. However, it is difficult to estimate the exact number of cars that will adopt silicon anode oxide (with Daejoo) and the penetration rate.

In this regard, we think that the current rally of pure EV battery materials stocks in Korea has gone a little too far, with too much optimism for 2025-2026 onwards, where profits are still uncertain. In our portfolio, we have two companies, SKC (011790) and Hansol Chemical, that are developing (not commercialized yet) silicon anode carbon, so we feel we can indirectly participate in this technology from 2024-2025 onward. Both companies are more diversified and have other businesses, starting with silicon anode (Daejoo started to commercialize it in 2019).

One of the main takeaways from our visit to Korea is that we met a company we were researching before the trip, and got confirmation about our positive view, leading us to invest. This case is quite interesting because the company is only covered by Korean sell-side analysts, most of the information was in Korean and there was not a lot of disclosure. Nevertheless, we always found the company quite interesting and we continued our due diligence because it fit in our investment process, which we confirmed during our in-person visit.

The company is Park Systems (140860 KS), which was established in 1997 as an Atomic Force Microscope (AFM) manufacturer/supplier for academic research labs and corporate clients. AFM can observe ultra-fine structures that cannot be measured with an electron microscope with high resolution and it has future applications in industries such as new materials, energy, environment, biotech and medical diagnosis. There are several things we like about Park Systems, including its technological leadership, innovative technology that remains far ahead in accuracy and precision with IP protection, integration of hardware and easy-to-use software that stores and analyzes results, shortening training time, and its solid balance sheet, growth profile and capital allocation.

The company also has several opportunities to continue growing, such as expansion into the display products industry and launching new products for industrial AFM. We also had a very good impression of its senior management regarding their experience, industry knowledge and intentions to grow the business.

Park Systems building entrance, Seoul.

Lastly, we visited the Philippines, a country with a population of 100 million people and a young demographic. The Philippines also has abundant nickel reserves, which got us excited about potential investment opportunities in the downstream sector.

During our trip, we came across one of the most exciting stories in Indonesia, which is Nickel Asia (NIKL PM). NIKL is positioned as an EV battery play, with equity in net income from investments in two high-pressure acid leach (HPAL) plants, Taganito and Coral Bay. Looking ahead, NIKL will also be the exclusive contractor of the huge Pujada mine with a possible third HPAL plant.[1]

However, considering the young demographics, vast population and emerging middle class, we tend to favour the consumer sector. We only had one holding in the Philippines and a couple of weeks before the trip, there was a corporate event that raised questions for minority shareholders. We didn’t want to make decisions without understanding management’s view, so we took advantage of the trip to ask them directly. We were not satisfied with their response, as they literally said, “if you want to invest in us, you have our assets and these events, it’s all in the soup.” With that answer, our investment process quickly came into place and we decided to sell our position. As we have mentioned in previous examples, these trips are useful not only to confirm positive aspects but also to identify red flags more easily when you have an ongoing in-person relationship with the company.

During our visit to the Philippines we also explored other alternatives in the consumer space and will be keeping an eye on them. The country offers a wide range of opportunities and things are improving compared to previous years.

The Global Alpha emerging markets small-cap team will continue to be on the ground, integrating our on-site views with our investment process and daily analysis of prospective companies that could be included in our portfolio, as well as monitoring those we already have.

[1] Source: CLSA research.

Several banknotes of Mexican & Indonesian currencies.

We are nearing our second year of our Emerging Markets Small Cap Fund and continuously monitoring various sectors across 24 countries. Almost 60% of the MSCI Emerging Markets Small Cap Index is represented by four countries: Taiwan, India, South Korea and China. In our view, these countries have advanced nicely in the emerging markets (EM) small-cap arena. Many of today’s technological developments are driven by companies that have been in the Index, including TSMC from Taiwan (circa 1994-95), Korea-based battery maker, LG Chem (circa 2001), India’s Apollo Hospitals (circa 2021) and consumer names from China.

These countries and companies have also been well represented in the MSCI Emerging Markets Small Cap Index having satisfied regulatory requirements, with some exceeding expectations by innovating such that they get “upgraded” in valuation or become classified as EM large caps. There are also ongoing discussions to elevate Korea from an EM to a developed market (DM).

We nevertheless feel that MSCI classifications can be inefficient. MSCI attempts to select promising EMs in advance using mostly backward-looking data, which can lead to mistakes. Argentina is an example. It was reclassified as an EM in 2018 and then cut in 2021. Vietnam should eventually be included in the Index despite foreign ownership limits, among other issues. It is more indicative of an EM than a FM classification. Saudi Arabia also has foreign ownership issues, yet is included in the EM Index.

Both Mexico and Indonesia make up close to 2% of the Index, but why? Considering their history, this is presumably due to a retrospective bias. From a forward-looking standpoint since 2020, our view is that their Index weightings are underestimated.

Mexico rising

Mexico comprises 2.1% of the MSCI EM SC Index (as of January 31, 2023). Although it has similar domestic issues as its peers, we believe it offers outstanding investment opportunities. Mexico is becoming increasingly relevant on the global stage considering its proximity to the U.S. and that many companies from Asia and beyond are setting up there. U.S.-based companies are following suit, including Tesla that will invest US$10 billion in a new plant in Nuevo Leon. Many of our Taiwan- and Korea-based companies are also expanding to Mexico. This nearshoring trend creates attractive investment opportunities across all sectors. According to the Inter-American Development Bank and Coldwell Banker Richard Ellis, nearshoring could represent a US$35.3 billion opportunity for Mexico, positioning the country as having the highest exports growth potential worldwide.[1] The share of Mexico’s nearshoring demand (based on % of net absorption) has increased from 10% in 2019 to 25% in Q2 2022.[2]

It’s worth mentioning that January 2023 was the strongest start of any year for Mexico’s stock exchange since 1996, despite the U.S. slowdown. We believe Mexico stands to benefit from the U.S. – Mexico – Canada Agreement for the next few years. The country’s fiscal accounts are well managed, it has low debt (50% of GDP) and its central bank will be one of the first globally to lower interest rates (currently at 11.25%). Moreover, the Mexican peso has outperformed other currencies, explained by more remittances and new foreign investments. As of Q3 2022, foreign direct investment already surpassed 2021 inflows, mostly concentrated in manufacturing and logistics.

All sectors seem robust and are expanding nicely. For example, the banking sector is one of the best capitalized in Latin America (together with Chile’s), net interest margin securities (NIMS) and cost of funding are healthy and the system as a standalone has ample liquidity and capital. Mexico is not immune to global banking events, but the main point is that its system remains strong. Why then is Mexico such a low weight in the Index? Its economics are changing, trends are evolving and global conditions for Mexico are rapidly improving. The following chart compares the returns of the MSCI Mexico Small Cap Index to its EM and World small-cap counterparts, with Mexico outperforming since 2020. Besides the factors already mentioned and that Mexico is the U.S.’s second-largest trade partner, other positive tailwinds for the country include its pension reforms and the rising possibility of a favourable outcome in its presidential elections next year. It wouldn’t surprise us if the MSCI increased its Mexico weighting in the interim.

Graph showing Mexico outperforming both its emerging market and global peers between March 2020 and April 2023.
Source: Bloomberg.

Indonesia rising

We just attended Indonesia’s largest conference – its most important of the year – where President Joko Widodo made the opening speech. At how many private conferences (especially in EMs) would a country’s president be so involved in promoting the country as a viable and attractive environment for investment? This is uncommon and means a lot. The event was exceptionally investor-friendly, with the government keen to attract capital. We also enjoyed intimate dinners with top Indonesian officials including Luhut Binsar, Coordinating Minister of Maritime and Investment Affairs who shared knowledgeable insights on the future of the country with us.

Prior to 2020, Indonesia had many restrictions that made enticing foreign capital tedious, costly and time consuming. Then the government passed its Omnibus Law, simplifying many processes and clarifying regulations to help foreign investors better understand them.

Over 500 investors from around the world attended the conference. When asked to compare Indonesia’s current investment climate to five years ago, 94% of attendees said it had improved. Despite global turmoil, Indonesia’s macroeconomic indicators in 2022 were among the best in the G20. We remain confident in the country’s economic resilience in 2023.

As the world’s fourth-largest country with a population close to 300 million, Indonesia enjoys sound demographics and is commodity rich. Its government is focused on capitalizing on trends such as nickel downstreaming where the country can be a key player in the electric vehicle market and substantially increase its country exports. We believe the downstream industry has the potential to be a transformational pillar in Indonesia’s economy and contribute to strong growth and employment. The target pipeline investment for battery chain development according to government officials at the conference is US$31.9 billion. 

In terms of fiscal discipline, the country has carried a surplus trade balance for 32 consecutive months supported by the strong performance of its downstream exports. During her presentation at the conference, Finance Minister Dr. Sri Mulyani Indrawati highlighted that as of Q3 2020, Indonesia’s GDP growth has been 5.7% year over year, one of the best in the G20, while inflation has sat at 5.5% and gross debt to GDP has averaged 41%, which are some of the lowest figures in the G20.

Sector-wise, the country’s recovery has been relatively even with mining and manufacturing surpassing pre-pandemic levels by 2022. And structural tailwinds that we also favour include Indonesia’s emerging middle class and its increasing purchasing power. Consumption benefits the most from this trend, but so do other sectors.

So, why theses low Index weights? We understand that the MSCI follows certain criteria to arrive at this outcome; however, with a forward-looking perspective we believe there’s a high probability that both Indonesia’s and Mexico’s weights will be revised. Relative to the Index, we are overweight in both countries.

Graph showing Indonesia outperforming both its emerging market and global peers between March 2020 and April 2023.
Source: Bloomberg.

This is the result of our strong bottom-up ideas that we think we have identified correctly against Indonesia’s and Mexico’s favourable investment backdrop and disciplined fiscal policies that are especially important during uncertain times.

Our approach in action

The following holdings in our view are quality companies with the balance sheets, cash flows and management team to prove it.

In Mexico, we own Grupo Aeroportuario del Centro (OMA MM). The company has a 50-year monopoly on developing, operating and maintaining 13 airports across northern and central Mexico. OMA enjoys strong margins (63% EBITDA Margin 2023E[3]), generates plenty of cash and has improved profitability on an ongoing basis even with 80% of its costs being fixed. As it relates to nearshoring, OMA is developing airports near the U.S. border and close to 65% of its traffic is associated with manufacturing and exports.

We are also positive regarding the experience of its new shareholder, Vinci Group, which builds and operates airports worldwide (on July 31 2022, Fintech informed OMA that it had entered into a share purchase agreement with a subsidiary of VINCI Airports SAS to indirectly sell 29.9% of its capital stock). OMA has maintained strong year-over-year passenger growth of +30% as of Q1 2023 and we expect its business traffic to continue recovering, where the company has larger exposure than the other two listed Mexican airports and which also reflects positively on profitability.

In Indonesia, we own Sido Muncul (SIDO IJ), the country’s largest herbal medicine company with some 300 herbal and supplement, food and beverage and pharmaceutical products. Since its IPO in 2013, Sido has grown its revenue per share and operating profit (OP) per share at c5% and c12% CAGR, respectively. In most quarters it has delivered on expectations, supported by a strong balance sheet with superior OP margins and return on invested capital, high cash flow generation and low capital intensity. As people become more health conscious, they are adopting the “back to-nature” secular trend with herbal medicines, the fastest-growing category within consumer health. Sido’s leading product portfolio, proprietary formulations and strong brand equity (it’s a household name in traditional herbal products) allow it to maintain its dominant position despite its premium pricing model. The company has a strong distribution network and vertical integration and its new extraction facilities provide superior yields and raw materials efficiencies.

Sino products on store shelves, Jakarta, January 2023.

[1] Source: Actinver Institutional Research.

[2] Ibid.

[3] Source: Bloomberg Consensus.

Magnifier focusing on a financial & technical data analysis graph.

During times of volatility and uncertainty, quality investing can be a common buzzword among investment managers and the media alike. But what is it exactly? This commentary discusses what quality investing means and how Global Alpha incorporates its quality bias into its portfolios.

Novice investors often confuse defensive characteristics for quality, as the quality factor falls under the defensive category. However, defensive stocks are defined by their non-cyclicality, which means their financial performance isn’t significantly affected by the state of the economy. These stocks, such as household products, utilities, food suppliers and discount retailers, tend to outperform cyclicals during recessions and also on an absolute basis.

In contrast, quality investing is unrelated to market cycles or sectors. Instead, it’s defined by certain fundamental characteristics that distinguish a company from its peers. These include factors that give a business a more durable and sustainable competitive advantage, as well as profit and cash flow stability. Key variables that define the quality factor include:

  • Moat: This term, popularized by Warren Buffett, refers to the factors that allow a company to maintain its long-term competitive advantage over its peers (e.g., economies of scale, intangible assets, switching cost, etc.).
  • Business model: A durable corporate structure and business strategy can enable a company to remain nimble and competitive, unlike many Japan-based companies with bloated corporate structures operating in multiple unrelated lines of business.
  • Corporate governance: This criterion examines management strength and the quality of the rules of governance. Strong governance practices are now widely accepted within the investment community as beneficial (given the rise of ESG investing).
  • Balance sheet: A company with a quality bias tends to have a high return on equity, low and sustainable debt, low earnings growth variance and strong cash flow generation.

Quality is a well-documented source of alpha. Eugene Fama and Kenneth French, who won the 2013 Nobel prize in Economics for their three-factor model (size, value, market risk) have updated their model to include two factors related to quality: profitability and asset growth. This is backed up by other research that has also shown how profitability and stability are as useful as size, value and market risk at explaining returns.

So why don’t all managers have a quality bias? Although many studies illustrate that quality tends to outperform over long periods, there will be times when it does poorly relative to other factors. Most notably, quality companies tend to underperform in momentum-based environments wherein investors disregard fundamentals and valuation and stock winners keep on winning. The last decade has seen many momentum-driven cycles, including the COVID-19 rebound in 2020 during which tech stocks were in vogue and names like Zoom, Robinhood and Peloton were trading at multiples that implied they would become the next Apple or Microsoft.

Quality-biased fund managers can encounter several challenges in such environments, including avoiding speculative names and selling their winners too soon. Quality strategies often incorporate GARP (Growth at a Reasonable Price) even though discussions of quality as a factor do not technically address valuation. However, their bottom-up approach and consistent growth of their companies make these investment managers more aware of the cost they are paying for that growth. Quality strategies can offer superior downside protection and steadier returns than peers despite not experiencing the same highs as momentum strategies.

An example of a quality holding in our portfolios is CVS Group (CVSG LN), one of the U.K.’s largest veterinary practice operators and consolidators. The company’s complete service offering includes laboratories, surgeries and crematoria. CVS is known for hiring new graduates and providing them with training and development, creating a consistent pool of veterinarians in a talent-scarce and competitive industry.

The company satisfies most of our quality criteria, including:

  • Economies of scales as a moat: The company’s management has a strong track record of growth through disciplined M&A and sustained organic growth. With over 25% market share in the U.K. and a differentiator as a higher-end veterinary care business, CVS has comfortable pricing power, and generates steady and predictable earnings per share (EPS) and cash flow growth.
  • Balance sheet and financials: Despite its M&A activity, the company’s net debt is well below 1x earnings before interest, taxes, depreciation and amortization (EBITDA). Management’s ambitious plan to double EBITDA over the next five years is expected to bring that ratio to a manageable 1.2x EBITDA, demonstrating their intent to maintain a nimble and flexible balance sheet.
  • Corporate structure and governance: In 2022, the company made governance structure adjustments to align with the UK Corporate Governance Code, despite not being obligated to comply with the code given its AIM listing. CVS’s governance framework is clear and transparent, with board activity and accomplishments provided to investors in the company’s annual reports.

At Global Alpha, we prioritize quality names like CVS in our investment strategy. The company provides downside protection while capturing above-market rates of sustained EPS and cash flow growth, allowing us to continue to build portfolios from the ground up.

Global economic sentiment has improved on the back of China’s reopening and a collapse in the European gas price but monetary indicators continue to signal a negative outlook. The “excess” money backdrop remains unfavourable for equity markets, with prospective developments suggesting overweighting non-energy defensive sectors and expecting a further relative recovery in quality / growth. 

Revisions to US seasonal adjustments have slightly altered the recent profile of global (i.e. G7 plus E7) six-month real narrow money momentum – the key leading indicator in the money / cycles forecasting approach used here. On the new numbers, momentum bottomed in June 2022, recovering modestly into December before falling back in January / February – see chart 1. 

Chart 1

Chart 1 showing Global Manufacturing PMI New Orders & G7 + E7 Real Narrow Money (% 6m)

The June turning point has been followed – with a lag within the normal range – by a recovery in global manufacturing PMI new orders from a low in December, with the revival driven by a sharp rise in the Chinese component. 

The PMI recovery is expected to fizzle out and reverse into H2, for both monetary and cycle reasons. Six-month real narrow money momentum, as noted, fell back in January / February and remains in negative territory – a sustained economic / PMI recovery has never occurred historically against such a monetary backdrop. 

From a cycles perspective, major PMI lows occur around troughs in the stockbuilding cycle but the current downswing phase was only starting when PMI new orders bottomed in December. With the last cycle trough in Q2 2020, the average historical cycle length of 3 1/3 years suggests another low in H2 2023. 

The marginal recovery in global six-month real narrow money momentum since June 2022 has been driven entirely by China and several other E7 economies. US / European momentum has slid deeper into negative territory as already restrictive monetary policy settings have been tightened further – chart 2. 

Chart 2

Chart 2 showing Real Narrow Money (% 6m)

The Chinese pick-up suggests economic acceleration through 2023 but a recovery will be held back by – and won’t offset – global weakness. Current Chinese real money strength, moreover, could fade: higher short-term rates / yield curve flattening since late 2022 suggest a slowdown in nominal money growth while unusually low inflation may revive as the economy normalises. 

The assessment of market prospects relies on two indicators of global “excess” money – the gap between six-month real narrow money and industrial output momentum, and the deviation of year-on-year real money momentum from a long-term moving average. The signs of the two indicators define four investment quadrants describing different market environments – see table 1. (This presentation echoes Hedgeye’s investment “quads”, in their case defined by the directions of economic growth and inflation – the approach here offers an alternative “monetarist” perspective.) 

Table 1

Table 1 showing “Excess” Money Quadrants Real Narrow Money % yoy minus Slow MA

The two indicators were negative from January 2022 (allowing for reporting lags) through year-end but the last quarterly commentary suggested that the first measure would turn positive in early 2023 as weakening industrial output momentum crossed below stable or rising real money momentum. Based on historical patterns, the implied shift from the bottom right to top right quadrant might be associated with less negative equity markets and a reversal of some of last year’s sector / style moves, including relative recoveries in quality / growth and tech – table 2. 

Table 2

Table 2 showing “Excess” Money Quadrants Real Narrow Money % yoy minus Slow MA

The suggested sign switch of the first indicator had not occurred by January – chart 3 – but markets appeared to front run the quadrant shift in Q1, with tech / growth outperforming strongly and energy / financials weak. A cross-over of six-month industrial output momentum below real money momentum is still expected here, although timing is uncertain – Chinese reopening has delayed industrial weakness. Some Q1 moves were extreme so it may be advisable to await confirmation before adding to favoured themes. 

Chart 3

Chart 3 showing G7 + E7 Industrial Output & Real Narrow Money (% 6m)

A common characteristic of the right hand quadrants of the table is a trend of non-energy defensive sectors outperforming non-tech cyclical sectors. The reverse occurred during Q1, although much of the cyclical relative gain unwound later in the quarter as financials were pummelled by banking crises. With no early move to the left hand of the table in prospect, an overweighting of non-energy defensive sectors – along with quality, which also usually outperforms in both right hand quadrants – is suggested. 

The stark contrast between positive and rising E7 six-month real narrow money momentum and faster contraction in the G7 raises the question of whether investors should overweight EM equities. Over 1990-2022, EM equities outperformed developed markets by 3.2% pa on average when the E7 / G7 real money momentum gap was positive, underperforming by 6.1% when it was negative. 

Further investigation, however, indicates that a positive gap is a necessary but not sufficient condition for EM outperformance – the global “excess” money backdrop, in addition, needs to be taken into account. Table 3 shows that, since 1990, EM equities have outperformed on average only when both the E7 / G7 gap and the first global excess money indicator were positive. Confirmation of a sign change in the latter indicator would strengthen the case for overweighting EM. 

Table 3

Table 3 showing Average Excess Return on MSCI EM vs MSCI World 1990-2022, % pa E7 minus G7 Real Narrow Money % 6m

Historically, periods of sustained EM outperformance coincided with trend declines in the US dollar. The dollar reached major peaks in 1969, 1985 and 2002. These peaks occurred 6-7 years before housing cycle lows (in 1975, 1991 and 2009). Assuming a normal (i.e. c.18 year) cycle length, another cycle low is scheduled for the late 2020s. A dollar peak in October 2022, therefore, may turn out to be a major top, preceding a trend decline into or beyond the housing cycle trough.