Nuclear power is a low-carbon, reliable source of energy. Yet, over the past decade, it has struggled to play a strong role in energy transition. Nuclear power generation has been around since the 1960s, and saw massive growth from the 1970s to 1990s. Since then, however, its share of global electricity production has declined from 17% in the 1990s to the current 10%, largely due to safety concerns following the tragic accidents in Chernobyl in 1986 and Fukushima in 2011.

Today, nuclear energy’s role in the energy system varies by country. In 2021, for example, nuclear accounted for 69% of total domestic electricity generation in France, 51% in Belgium, 28% in South Korea, 20% in the United States, 12% in Germany, 7% in Japan, and 5% in China.

Amid the global energy crisis following the war in Ukraine, many nations have prioritized efforts to reduce their reliance on imported fossil fuels. Add the backdrop of the global climate crisis, and the search for other sources takes on increased importance. Renewable energy sources have experienced remarkable growth in recent years, yet renewables alone are not sufficient to fully decarbonize the energy grid. This opens the door to an increased role for nuclear power.

According to the International Energy Agency (IEA), global nuclear capacity needs to expand by about 10 gigawatts (GW) per year to be on track with the Net Zero Emissions by 2050 Scenario. In 2022, nuclear energy had an operational capacity of 413 GW in 32 countries, thereby helping reduce reliance on fossil fuels while also avoiding 1.5 gigatonnes (Gt) of global emissions and 180 billion cubic metres of global gas demand a year. Emerging countries accounted for almost all new nuclear capacity added in recent years, while developed economies are catching up.

The UK currently has 5.88 GW of nuclear capacity, accounting for 15.5% of energy generated in 2022. It has set a goal to reach 24 GW by 2050, about 25% of UK’s predicted energy demand.

In the U.S., meanwhile, nuclear energy has consistently provided about 20% of total electricity generated over the past 30 years, and that country’s 93 operating nuclear reactors had a combined capacity of 95 GW at the end of 2021. However, as most of the American nuclear plants are approaching their 40-year design life, capacity will need to be extended or added to achieve the 2050 net zero goal.

Before the Fukushima disaster, Japan sourced about a third of its electricity from 54 nuclear reactors, but only nine are still operational. Following the war in Ukraine and the subsequent energy crisis, Japanese citizens’ sentiment toward nuclear reactors has shifted positively. In December 2022, the Japanese government announced a new nuclear energy policy aimed at maximizing the use of existing nuclear power plants and building next-generation reactors. Nuclear currently accounts for 7% of total power generation in Japan, and their goal is to increase the percentage to 20-22% by 2030. But getting there will require about 26 to 33 operational nuclear reactors.

Two major barriers hindering the growth of nuclear power are safety concerns, and elevated construction and operating costs. However, advancing technologies can help to overcome those barriers. Small Modular Reactor (SMR), for example, can be made in factories and installed on site, reducing both initial costs and construction times. The smaller size also makes economic sense for small electric grids. It is also believed to have enhanced safety characteristics.

Most recently, scientists have achieved a breakthrough by successfully producing a nuclear fusion reaction resulting in a net energy gain, instead of just breaking even as past experiments have done. Nuclear fusion provides carbon-free energy, without the highly radioactive, long lived nuclear waste created by current nuclear reactors. The process is inherently safe as fusion is a self-limiting process, the reaction could come to a halt within seconds. However, it will take years if not decades before fusion can meaningfully contribute to energy transition. The next step is to figure out how to produce more energy from nuclear fusion on a much larger scale, and at a lower cost.

Global Alpha has some holdings in the nuclear power sector that we believe offer good investment value.

For example:

Curtiss-Wright (CW US) supports the global nuclear power industry by providing precision components and highly engineered products and services. The company has an installed base of products at all nuclear plants operating in the U.S., and many operating internationally. Curtiss-Wright designed the world’s most advanced reactor coolant pump for Westinghouse’s AP1000 reactor, one of the safest and most economical nuclear plant designs available worldwide and has been approved or planned at many nuclear plant projects globally, notably in China, India, U.S., and UK. Curtiss-Wright also works with SMR and Advanced Reactors designers to ensure its presence in the future growth of this market. It has the opportunity to secure $10 million to $100 million in content per location.

Horiba (6856 JP) manufactures measurement equipment, specializing in the analytics and measurement of small particles in the field of environment, health, safety, and energy. Among its extensive product lineups, Horiba offers a wide range of measuring instruments and sensors to measure the pH of secondary water in nuclear power plants. For example, measurement of silica is paramount in preventing the problem of scaling, which reduces the efficiency of power generation. Horiba provides silica analyzers to allow for quick and automatic measurement for boiler water, and trace amount of silica present in pure water. 

For fans of Seinfeld, the line “What’s the deal with…” reminds us of a particular brand of observational comedy from the 90’s. Well, turns out 90’s humor is still a big deal, as Netflix paid half a billion dollars in 2021 for the streaming rights of Seinfeld. Not bad for a show about nothing. As we kick off a brand-new year, we thought it’s the perfect time to ask ourselves “What’s the deal with EM small cap…?”

For most investors, emerging markets (EM) as an asset class is high on the risk spectrum. They could be forgiven for thinking of small caps within EM to be a step too far. The EM small cap universe (EM SC) for the most part is ignored or misunderstood. We hope to change a few perceptions along the way by shining a light on EM SC as potential ground for adding alpha.

Added value

Before we begin to answer “What’s the deal with EM small caps…” let’s look at how MSCI EM SC has performed compared to its all-cap counterpart, MSCI EM. As seen below, whether on a three year, five year, 10 year or 20 year period, the MSCI EM SC index adds value compared to its all-cap counterpart. At the start of 2023, as we possibly enter a prolonged period of higher inflation and interest rates, we expect small caps to outperform by leveraging the flexibility and nimbleness that comes with smaller size and lower bureaucracy.

% Annualized USD Returns

	3 yr	5 yr	10 yr	20 yr
MSCI EM SC	5.38%	1.32%	3.45%	9.60%
MSCI EM	-2.42%	-1.10%	1.77%	9.04%

A big stage

The reasons for its relative outperformance are many. Let’s start off with the fact that the EM SC universe is vast, with plenty of space to find the next big compounder among 11,000 companies, 24 countries and 11 sectors. The benchmark index – MSCI EM SC (MXEFSC) – is constructed with no index weight bias. Also, except for Taiwan, there is no sector bias among the big countries that constitute the index. This size and diversity mean that the EM SC universe offers plenty of scope for portfolio diversification and alpha generation.

Low to no coverage

With big size comes lack of proper coverage. This universe’s vastness, combined with liquidity constraints, means this asset class doesn’t get extensive coverage, despite the value it has added historically. We see under coverage from both the buy side and sell side. This lends perfectly to our process at Global Alpha where we put in the hard yards to travel, meet management in person, and understand local business customs to stay on top of the story.

Analyst Coverage Comparison

Less sino-centric

China dominates the large cap index – making up over 30% of the benchmark – while making up just around 10% of the small cap index,as seen in the graph below. The more balanced construction of the EM SC index helps investors avoid the policy and geopolitical risk that comes with concentrated exposure to a single market. At the same time, this differentiated exposure is a good complement in terms of total portfolio diversification.

EM Index Composition

Tailwinds

After decades of globalization, the pandemic exposed the fragility of the global supply chain system. De- globalization, near shoring and a greater reliance on domestic consumption as an engine of growth could come to define the next decade. EM small caps have greater exposure to consumer-facing sectors like healthcare, industrials, and discretionary and lesser exposure to global cyclicals like IT and energy compared to its all-cap peer.

MSCI EM

Source – Bloomberg. As on 30 Dec 2022

MSCI EM SC

Source – Bloomberg. As on 30 Dec 2022

SOE’s are minor actors

The EM SC benchmark has a lower allocation to State-Owned Enterprises (SOEs) than its large cap counterpart. Our experience informs us that SOEs are the same regardless of the country in which they are domiciled. They suffer from:

• poor capital allocation,
• lack of alignment of incentives,
• slow pace of decision making, and
• a track record of poor shareholder returns.

On the flip side, many of our small cap names need to be nimble and innovative to survive. Experience has shown that first generation entrepreneurs with skin in the game and properly aligned incentives tend to create shareholder value in the long run.

Being active

Emerging markets is a space where portfolios can look different from benchmarks. Research confirms that the average active share in this space has historically been close to 70%* and that there is a positive and significant relationship between active share and fund performance. Further, being consistently active is a strong predictor of fund performance. In other words, managers who back themselves on their ability to outperform by maintaining a high level of active share do well in the long run.

As we travel around the world, we are also seeing a generational shift in thinking among many of our family-owned companies. There is an openness among them to hire professional management. We also see a willingness to enhance corporate governance standards, and a better appreciation of what constitutes good capital allocation. While we don’t underestimate the challenge of finding the next HDFC Bank or TSMC, we feel the EM SC space offers the best playing field to generate value for our clients in the long run. And in our mind, that’s a big deal.

*Based on 67 emerging market funds that use MSCI Emerging Market Index as their benchmark. Active share is defined as percentage of holdings in a portfolio that differs from its benchmark.

Anyone who’s kept an eye on the markets is aware that the energy sector had a blowout performance in 2022. It started with the war between Russia and Ukraine in February that spiked oil and gas prices, the discussion then shifted to European LNG supply for the following winter, including which countries would be able to absorb Russia’s excess oil supply. Clearly, the energy resurgence in 2022 was a European-driven one.

With that in mind, what is the situation going into 2023? It appears that the worst-case scenario for this European winter has been avoided. Natural gas prices are now back at the pre-Ukraine invasion level, EU gas storage is sitting a comfortable 5% above its five-year trend, and winter weather has been lenient so far.

European Union gas storage levels, 2017 – November 2022

Governments are now focusing on planning for next winter, and the data points are more mixed. In 2022, Europe benefitted strongly from having Russian LNG flow for most of the summer and from lower LNG demand from China. Both things are unlikely to repeat in 2023. Indeed, a worst-case scenario, where Russian pipelines stop flowing completely for 2023, would represent a gap of nearly 50% of total gas storage requirements for the winter of 2023/24. And there are not many options for Europe to fill this gap elsewhere. Indeed, China’s 2023 LNG imports are expected to reach 2021 levels, which would capture over 85% of the estimated increase in 2023 LNG global supply, with much of that increase already contracted by China.

The market however does not appear to be discounting this. December 2023 futures contract for LNG is sitting around €70 per MWh, three times pre-2021 levels but well below the peak of €345 seen in August. There are certainly some indicators that support this optimism. Between August and November 2022, EU natural gas consumption dropped 20.1%, well above the government self-imposed target of 15% for the period between August 2022 and March 2023. Finland reduced its consumption by as much as 52%. Many countries capped the price for consumers and businesses. These lower prices should help alleviate the size of deficits generated from these programs, allowing those countries to face next winter with a healthier balance sheet. Furthermore, the weather for the rest of the winter will be a key driver of the requirements for next year, as estimates for gas storage levels at the end of the heating season vary between 5 and 35% of full capacity. Clearly it is too soon to predict a worst-case scenario, and Global Alpha does not expect a worst-case scenario to materialize. But the pain is likely to be felt more than markets currently discount.

At Global Alpha we have historically underweighted energy in our portfolios, not because of any macro views, but instead because the team consistently found better stock picking opportunities elsewhere. Indeed, pure oil and gas stocks are often at odds with Global Alpha’s investment philosophy: the quality of their balance sheet is volatile, they depend on macroeconomic factors to outperform, and as such tend to be more momentum based.

So how does Global Alpha get its energy exposure? An example of a name we have owned for many years is Schoeller Bleckmann Oilfield Equipment AG (SBO VIE). The company is the global market leader for high precision drilling components, providing nonmagnetic drill string components to directional drilling oil field service companies. Headquartered in Austria, more than 80% of its business is done in the U.S. and Europe, with high profile clients such as Schlumberger, Halliburton, and Baker Hughes.

With a healthy balance sheet and key market positioning backed by proprietary technologies, Schoeller-Bleckmann provides an attractive exposure to energy prices without being dependent on a few oil and gas projects. Indeed, its stock price has benefited from the pick-up in rig counts since mid-2021, with the firm boasting a book-to-bill ratio consistently above 1x, while at the same time showing its ability to pass on cost inflation to clients. There have also been discussions of green energy diversification, though the strategy remains unclear for now.

SWOT analysis

Strengths

• +50% market share in most of its products
• Strong balance sheet supported by low net debt

Weaknesses

• Dependence on the big three oil services companies

Opportunities

• Increased geographical diversification
• Opportunistic M&A

Threats

• Technological competition in their key plug market
• Loss of market share in the U.S.

Schoeller-Bleckmann is a perfect example of the type of quality names Global Alpha is looking for in its portfolios: a niche, market leader with global exposure and a clean balance sheet that allows for sustained growth.

In mid-October 2022, after more than 2.5 years of strict border control measures, Taiwan lifted all its COVID entry restrictions and allowed foreigners free access. As countries returned to their pre-pandemic routine, Taiwan was among the laggards (along with China and Hong Kong) in loosening requirements for visitors to complete a mandatory lengthy quarantine. That is why we welcomed (to say the least) the announcement of easing travel restrictions. And after two weeks of preparation, we landed in Taoyuan International Airport at the beginning of November.

Except for the requirement to wear a mask in all public places including outdoors, lifted only on December 1, life in Taipei looked normal. There was strong traffic in malls, convenience stores, hotels and restaurants. Over the span of a week, we met with 28 corporates engaged in the information technology, consumer, healthcare and industrial sectors.

Our general impression was mixed, with more optimism around healthcare and consumer-oriented companies balanced by a more cautious outlook provided by the technology operators. Overall, most corporates noted quite low visibility going into 2023, with only a handful of companies ready to provide guidance for the next year.

Key takeaways from our meetings:

• Strong domestic consumption recovery after the reopening in Taiwan.
• Most of the semiconductor companies are in the midst of weak momentum due to slow demand for consumer electronics and inventory corrections. PC and handset unit sales are expected to decline in 2023.
• Data servers, automotive and industrial remain the only bright spots for now. The U.S. hyperscaler server market is expected to continue growing at a double-digit rate in 2023, although global enterprise and China server demand are expected to remain weak. Demand for ASIC (application-specific integrated circuit) design remains strong, as does demand for the ABF (Ajinomoto build-up film) substrate despite a correction in the PC market.
• The impacts so far of U.S. sanctions on the Chinese semiconductor space are limited on Taiwan semiconductor companies because the new rules target only the most advanced technology, and most Chinese IC (integrated circuit) designers are making changes to fall within key thresholds of those sanctions. Moreover, some companies aim to reap benefits on lower competition with Chinese peers in the long term. However, there is a risk of further escalation in U.S.-China relationships, which could disrupt global technology supply chains and impact demand in 2023.
• Many technology companies pointed out an increased need to de-risk their production facility locations following their customers’ requests for production capacities outside of both China and Taiwan.
• General supply chain normalization, with remaining tightness in the supply of some key components.

Taiwan is the second largest market for our Emerging Markets strategy (behind India), with about 20% weight in the MSCI EM Small Cap index. It is the only country in the EM universe with a clear sector bias, as information technology accounts for more than half of the country weight in the benchmark. In the first 10 months of the year, Taiwan Small Cap underperformed the EM benchmark by more than 10%, a result mostly driven by derating of the technology sector. However, its performance in November looks like the beginning of a year-end rally on the expectations of semiconductor inventory correction bottoming. Likewise, moderating geopolitical risk may ease following the results of local mayoral elections on November 26, in which the Kuomintang, a party taking a more moderate stance on China, scored a big win over the incumbent Democratic Progressive Party.

Although we remain cautious on the technology inventory correction cycle, as there are multiple risks that might delay the sector recovery (e.g., deep recession in the U.S. and Europe, and broader geopolitical escalation), we acknowledge that some of the corporates in Taiwan are progressing well ahead of their peers. Most of market participants expect that a cyclical bottom in semiconductor demand might occur in the first half of 2023, with sequential improvement starting in the second half of 2023. This could drive a strong recovery in technology stocks. The importance of understanding inventory cycles was discussed in our note published on March 13, 2009. We see similar patterns here and remain alert to understanding where we are in the cycle.

Our EM portfolio is currently in a market-neutral position in Taiwan. We have a balanced roster of technology leaders, dominant operators catering to domestic markets, and exporters benefiting from secular tailwinds.

Here is a description of a sample of our holdings in Taiwan.

Chroma ATE Inc. (2360 TT) is a power and semiconductor testing equipment provider enjoying a leading position among the top-five global IC testers. For instance, NVIDIA uses Chroma testing equipment for all its products. Chroma also enjoys strong growth momentum in the electric vehicle (“EV”) industry. The company is one of the few operators in the technology sector that is less susceptible to industry cyclicality, and it has better visibility into the longer-term growth trajectory of the semiconductor industry.

Universal Vision Biotechnology Co., Ltd. (3218 TT) is the largest ophthalmology chain in Taiwan. The firm offers various eye treatments and related medical services such as laser vision correction and cataract surgeries. It is the leading brand in Taiwan, backed by a 30-year track record of high-quality services and innovation, with a dominant position in advanced eye surgeries such as SMILE (Small Incision Lenticule Extraction) and FLAC (Femtosecond Laser Assisted Cataract Surgery). The company also sells optometry products such as eyeglasses, contact lenses, and orthokeratology lenses at its self-operated eyewear stores. Benefiting from structural demographic tailwinds in Taiwan – due to high prevalence of myopia in the population – UVB is also a beneficiary of China’s COVID reopening, where it derives 25% of revenue. Following the recent easing of COVID restrictions, the company is looking to accelerate clinic openings in China.

Makalot Industrial Co., Ltd. (1477 TT) is one of the major global apparel manufacturing companies with industry- leading design flexibility, lead times, product offering and scale. We believe it is one of the main beneficiaries of the supply chain consolidation trend due to its diversified production sites, aggressive expansion in Indonesia and Bangladesh, and ability to deliver rush orders.

With recession risk concerning many developed countries, it seems there is nowhere to hide. But actually, there is. Japan’s GDP is expected to grow 1.6% this year and 1.8% next year, according to the latest forecast of the Organization for Economic Co-operation and Development (OECD). In contrast, 2023 GDP growth in both the U.S. and the eurozone is expected to be only 0.5%.

We think the following reasons could explain such differences.

• Extremely loose monetary policy. The Bank of Japan maintained its key short-term interest rate at 0.1% and the 10-year bond yield around 0%.

• Supportive fiscal policy. An extra economic package of ¥29 trillion (US$208 billion) was recently announced, worth around 5% of GDP. The package aims to bring down inflation by 1.2% between January and September next year.

• Low inflation. Although Japan’s core CPI hit a 40-year high of 3.6% year over year in October, the pace of change was far slower than in the U.S. or Europe. Wage increases in September 2022 were up by only 2.1% on a year-over-year basis, contributing to Japan’s comparatively low rate of inflation.

• Reopening catch-up. Japan has lagged the U.S. and Europe in easing COVID policies. Face-to-face services resumed in March 2022, accelerating private consumption. Another boost for consumption came on October 11, 2022, when Japan lifted its border restrictions. In 2019, about 32 million foreign tourists visited Japan and spent a record high of ¥4.81 trillion. Pent-up demand should carry over into 2023.

• Automotive industry recovery. The manufacturing sector accounts for 20% of Japan’s total GDP, and automotive and ancillary manufacturing remain a substantial segment of that overall sector. As supply chain disruptions subside, automakers are expected to enhance production to fulfill record backlogs.

• Weak yen. The yen (JPY) has declined this year by more than 20% against the U.S. dollar, to a 32-year-low. In October, Japan’s exports were up 25.3% year over year, led by shipments of chips, electronic parts, and cars. For foreigners, a weak yen and low inflation mean that Japan is a relatively cheap shopping destination.

The Nikkei 225 Index has been whipsawed so far in 2022 and is currently -3% compared to January 1, 2022. Yet there are many positive stories to be found when you dig a little further into the numbers. Based on the September quarterly results of over 1,800 companies on the Tokyo Stock Exchange Prime Market, sales on aggregate are up by 21.9% year over year, operating profits are up by 9.2%, and net profit by 31.6%. Likewise, 64% of companies have reported sales higher than consensus estimates, according to Mizuho Securities.

We invest in a total of 20 Japanese companies in Global and EAFE Small Cap strategies. Below are some common themes from the management of these firms.

• All companies have benefited from the weak yen and/or reopening of the economy. Sales have been notably robust.

• Six of our holdings reported very strong results and raised their full-year sales guidance. These are:
  • ASICS (7936.JP): a global sports goods maker best known for its performance running shoes.
  • HORIBA (6856.JP): a global measurement equipment maker specializing in the analysis of small particles in the fields of semiconductors, environment, health and safety.
  • Iwatani (8088.JP): a leading distributor of industrial and household gases in Japan.
  • DMG MORI (6141.JP): the largest machine tool maker in the world.
  • Seiren (3569.JP): a global leader in car seat materials.
  • Kurita (6370.JP): the largest industrial water treatment company in Japan.

• Margin pressure remains a challenge: cost pass-on might be easier with time, but investment and spending are also rising.

• Supply chain issues are improving. Compared with western peers, our Japanese holdings have been more conservative in inventory management. They have kept a high raw material inventory to ease supply chain disruption. Long-term relationships with diversified suppliers also contribute to these supply chain improvements.

• Product prices continue to increase, though domestic increases are more difficult to impose than in overseas market.

• To our surprise, leaders of our Japanese holdings do not see pressure on wage increases from employees or the Japanese government. Nor are they experiencing a labour shortage issue.

• Reshoring is on the rise. Back in April 2020, Japan set aside a ¥243.5 billion fund to help manufacturers shift production out of China to avoid supply chain disruption. Recent U.S. restrictions on China to cripple its semiconductor industry should also help Japan attract more investment.

The MSCI Japan Small Cap Index is currently trading at a very attractive level, at 13x P/E. It is not only its lowest level in the past decade, but also lower than U.S. peers at 23x and European peers at 16x. We believe the fundamentals of the Japanese economy are still solid, with low inflation risk.