In times of market challenges, companies are taking steps to reduce their cost structure. Over the past weeks, we have seen several layoff announcements. As companies review and adopt their operating budgets for next year, other non-personnel costs could be at risk.

With many economies on the brink of recession, executives could be inclined to decrease their marketing expenditures. As shown in the latest International Business Barometer, more than half of corporations expect to reduce marketing expenditures over the next year in fear of recession.

As seen in previous downturns, companies maintaining their marketing expenditures increase their likelihood of emerging from recessions in a better position than competitors. As the competitive landscape becomes less intense, companies maintaining these expenditures could differentiate themselves and gain market share.

Market research is vital in finding new customers or launching new products. Market research expenditures represent a small proportion of the total marketing expenditures. For that reason, they tend to be more resilient compared to advertising expenditures. For example, P&G spent $7.9 billion on advertising during its fiscal year 2022, as opposed to $2 billion for research and development costs. In our view, market research expenditures could be one of the most strategic expenditures inside marketing budgets. Market research is the starting point for the launch of new projects, and it drives commercialization.

Ipsos, a company we own in our International Small Cap strategy, is one of the largest market research companies globally. The company is active in 90 different markets and employs more than 18,000 people. We believe that Ipsos benefits from secular growth driven by strong demand for reliable information to solve more complex issues. Corporations need to access that information to position themselves in a fast-changing world. The new 2025 plan unveiled by Ipsos aims to have the company grow faster than the market research industry, notably through market share gains and the development of digital and tech-based services.

Market size

• The global market research services industry is expected to reach $90.8 billion by 2025. That industry is expected to grow 5.3% per annum.

Growth strategy

• Expanding its client base or grabbing more share of wallet from their existing customers.
• Adding new tech-based services, such as: SaaS offering, advisory, DIY research, social intelligence.
• Bolt-on acquisition.

Strengths

• Recognized as one of the most innovative market research companies, as published in a recent GreenBook Research Industry Trends report.
• Thanks to its global reach, Ipsos is one of few companies with capacity to manage worldwide market research programs.
• Well-diversified geographically and by client types. Its exposure to defensive sectors like the pharma and public sectors represents close to 30% of revenues.
• Long-term client contracts with high recurrency.
• Strong balance sheet with a low leverage ratio of 0.4x net debt to EBITDA.

Opportunities

• Fragmented market with lots of opportunities to conduct M&A, especially in DIY research.
• Digitization trend in the market research industry. Digitization helps bring down costs associated with data collection while providing new source of revenue.
• Its revenue from new services has grown rapidly over the years. Through these new services, Ipsos has met corporates’ needs in term of data collection in real time, quickly analyzing large amounts of information, leveraging measurement of social media, and providing advice for clients. The company can build on that expertise and experience to increase market share. 
• With 32% of its revenue being generated in the U.S., Ipsos has room to gain more market share in the biggest market research industry globally. 
• Emerging markets are expected to outpace the growth in developed markets.

Risks

• The industry is somewhat exposed to the cyclicality of its clients’ marketing budgets.
• Failure to develop new services or falling behind on technology would negatively impact its revenue.

According to research by the Bank of America, global risk assets have lost over $35T since November 21, 2021¹. This should come as no surprise as we are seeing: the co-dependency of Wall Street and the Fed, stop-go economic policies, zero COVID policy in China, headline inflation, political instability, war, oil and food shocks, fiscal excess, and industrial unrest.

Given all this volatility, recession is a common topic of conversation among investors and companies. The general consensus? Avoid small cap stocks and stick to the so-called safer large cap companies.

In today’s weekly, we’re busting this myth by explaining why small cap is back and why exposure to this asset class is your best bet during a recession. We’ll begin with a brief trip down memory lane.

1970s – Small caps shine amid economic volatility

Investors assume that for small cap to outperform, we need economic certainty, lower rates and better credit conditions. But history proves otherwise. The 1970s were one of the best decades for small cap, and yet this era was plagued with a wide variety of economic volatility.

Throughout the 70s, inflation averaged 7.1% with a high of 13.3%. Fed rates peaked at 14% in 1979 from 3.5% in 1971. The economy faced oil shocks, embargoes, and taxes were high. Real economic growth was below the previous decade by 1%, and productivity was even lower. Meanwhile, President Richard Nixon became the first U.S. president to resign, and the dollar abandoned the gold standard and devalued.

Incredibly, in the midst of all this uncertainty, small cap outperformed large. Why?

Why small cap succeeds during unexpected inflation

What really helped small cap outperform during the 70s was the unexpected inflation. According to Aswath Damodaran, a finance professor at NYU Stern, there are two reasons why unexpected inflation benefits small cap companies.

1. Nimbleness in price adjustments – Large cap stocks, with their layers of management, have very entrenched pricing models. On the contrary, small cap can quickly change pricing structures to reflect the new inflationary environment. Hence, small cap reports much better margins.
   
2. Less long-term investment projects – Large cap generally undertakes investment projects, which can have a 10 to 30-year timeline. They need to think much longer term just to maintain their growth rates. The problem is during high inflationary and interest rate environments, the Net Present Values for the projects drop drastically as cost and revenue inputs change. By contrast, small cap companies are in growth ramp-up mode and have a long runway for potential expansion.

Why is now the time to buy small cap?

With inflation at 8.3%, the probability of a recession in the U.S. is almost certain. Earning season is already indicating lower earnings growth, especially for large caps.

Meanwhile, central banks are raising rates across the globe. It goes without saying, we are in a very uncertain economic environment. So let’s break down the top seven reasons to invest in small cap right now.

1. A history of long-term outperformance – small cap stocks have consistently outperformed large cap over the long term by a considerable amount.

2. Unexpected inflationary environment – The data shows that small cap consistently outperforms large cap during unexpected periods of inflation.

3. Valuation – Perhaps most compellingly, small cap is very cheap compared to large cap stocks. The below chart shows that the relative P/E of the S&P 600 (which excludes negative P/E stocks) versus the S&P 500 is the lowest since at least 1992.

The story is similar if we look at the Russell 2000. The last time it traded at this depressed relative multiple to the S&P 500 was during the dot-com bubble burst. From 10/9/2002 to 10/9/2007, Russell 2000 outperformed the S&P 500 by more than 50%.

4. Small cap does well from early in the recession – While we do not know exactly when a recession will begin, it certainly feels like we’re getting close. So, getting exposure to small cap now would be a great idea for long-term investors. Small cap stocks have outperformed large cap in each of the previous six recessions that we have data for, going back to 1980.

5. Low exposure – The percentage of small cap in the U.S. equity market now stands below 4%, a level last seen at the COVID bottom. Prior to this point, we must go back to the 1930s to see such little exposure to small cap. As investors will increase their allocation to the asset class, patient investors will be rewarded.

6. M&A is another consistent tailwind for small cap – Small cap represents approximately 95% of all deal volumes globally. The average acquisition premium is in the range of 35-40%.

7. Undercovered – Small cap is far less researched than large cap. Globally, small cap is covered on average by three brokers, versus 16 that cover the average large cap. There are hundreds of small caps in any region still not covered by a single broker. This provides bigger alpha opportunities for investors.

Final thoughts

When it comes to small cap outperforming large cap during recessions, we see the same trends play out across the globe. For example, valuations in Europe have dropped to levels last seen during the Global Financial Crisis (GFC).

So, now is the time to increase exposure to small cap, as most investors are underweight in this asset class. At Global Alpha, we are patient long-term investors who should benefit as small caps return to their historical outperformance and take a market leadership position.

¹BoA Securities Global Research: The Flow Show – The Next Big Thing is Small, November 3, 2022

The UK has been going through an unprecedented time. From the death of the Queen, to three prime ministers in a little over two months, what the country needs now more than ever is stability and unity from both the new monarch and incumbent governing party.

A disastrous 44 days as prime minister by Liz Truss led to tremendous turmoil in the gilt and sterling markets. The pound hit a record low against the US dollar towards the end of September, forcing the Bank of England to step in and stabilize markets. 

New Prime Minister Rishi Sunak has an unenviable task ahead of him. While being the sole candidate to achieve enough support from MPs to stand for the Prime Minister position prevented further infighting within the Conservative Party, the fact remains that there are still factions and loyalties pitted against each other. With this as a backdrop, it is even more difficult to regain the confidence of voters ahead of the next general election. Latest opinion polls show the Conservative Party facing a 26-point deficit.

Perhaps the most difficult task of all will be to reassure investors and increase credibility concerning public finances. Initial reactions to Sunak’s appointment were positive due to some goodwill built up through his handling of COVID and furlough schemes as Chancellor, a reputation for being fiscally conservative and the belief that he and the current Chancellor, Jeremy Hunt, are both singing from the same hymn sheet. Contrary to his predecessor, Sunak has already stressed the importance of government policy working hand in hand with the central bank to combat inflation, while emphasizing the independence of the Bank of England over interest rate decisions.

The next financial statement, due on November 17, will go a long way to re-establishing some credibility. Difficult, but necessary decisions on increased taxes and spending cuts are to be expected. Even freezing income tax thresholds will see more people enter the income tax system, or into a higher tax band, due to the wage inflation currently being experienced. Only one area has been designated as off limits for cuts – the National Health Service. Other areas such as welfare, education and­—perhaps controversially given the current geopolitical environment, defense—could be in the firing lines, as well as reviewing the HS2 rail project. 

Fiscal responsibility is at odds with regaining the favour of the voting public. Just this week the Bank of England hiked interest rates by 75 basis points to 3%, the largest hike since 1989, and said that the UK is potentially facing its longest ever recession. Unemployment is expected to almost double, albeit from its lowest level in 50 years.

The instability surrounding the UK government and future economic prospects means investors want a discount on UK equities to compensate for current additional risk and uncertainty. However, based on the forward price-to-earnings ratio, the UK is at its lowest valuation versus global peers since records began. The attractive valuations combined with weak sterling and/or strong dollar leads us to believe that there is a significant opportunity for international and more specifically U.S. corporates or financial institutions to increase takeover activity. Longtime holding, Clipper Logistics (CLG.LN), was acquired by U.S. peer GXO Logistics (GXO.US) earlier this year. Current holding, Biffa (BIFF.LN) is being acquired by a private equity firm, with the transaction expected to close by the end of Q1 2023 at the latest.

The larger question is if there remains compelling reasons to own UK equities right now given the warning of a deeper recession than other regions. We would argue that this is a good environment for bottom-up fundamental stock pickers. Some quality international companies are now available at a significant discount. The FTSE 100 derives around 70% of its revenues internationally, while the FTSE 250 is at 50%.

When looking at our holdings in the UK, we have a diverse mix of companies, many of which have diversified their source of revenues away from just the UK. Often the market leaders can capitalize in economic downturns and increase market share while competitors struggle. This could also be the case for our holdings, briefly summarized below.

Our UK holdings with significant overseas revenues include:

Coats Group (COA.LN) is the world’s leading industrial thread manufacturer with market-leading position in apparel and footwear, plus a leading and growing position in performance materials. The company derives the overwhelming majority of its revenues from Asia and the Americas.

IWG Pls (IWG.LN) is the world’s largest provider of hybrid workspace with a network of 3,323 locations across 120 countries. The UK accounted for 16% of group revenues in 2021.

Oxford Biomedica (OXB.LN) is a leading cell and gene therapy group and does not disclose the geographical segmentation of revenues.

Safestore (SAFE.LN) is the UK’s largest self-storage group with 130 stores located in the UK and 48 stores located in Europe, mostly in Paris but with locations in the Netherlands and a growing presence in Spain. Around 25% of revenues come from overseas.

Savills (SVS.LN) is one of the leading real estate advisors in the world with 57% of revenues coming from outside the UK.

Our UK holdings with largely domestic revenues include:

Biffa (BIFF.LN) is a UK-based waste management company whose operations include collection, recycling, treatment, disposal and energy generation. As mentioned above, the company is in the process of being acquired.

CVS Group (CVSG.LN) is one of the largest integrated veterinary services providers in the UK (plus a small presence in the Netherlands and Republic of Ireland). The firm has four main business areas: veterinary practices; diagnostic laboratories; pet crematoria; and e-commerce (non-prescription medicines, pet foods and pet care products).

Onesavings Bank (OSB.LN) is a UK specialist lender which targets market sub-sectors that are underserved by the mainstream banks, most notably the professional landlord buy-to-let market.

In the past year or two, semiconductors have been under the spotlight across industries and countries, even in our everyday conversations. People around the world have started to realize just how much this small component affects their daily lives in significant ways, from long lead times in car purchasing, to being unable to get hold of a PS5 game console. Modern defense capabilities also rely on sophisticated electronics systems powered by advanced semiconductor components. No wonder semiconductors are considered the new oil, given their wide-spread consumer, military, and strategic significance.

However, the key difference is that chipmaking is even more concentrated geographically than oil production. The three biggest oil producing countries, the United States (U.S.), Russia, and Saudi Arabia, accounted for 15%, 13% and 12% respectively of global production in 2021. Taiwan, on the other hand, supplies 20-25% of the world’s semiconductors every year, while the U.S. only accounted for 12% in 2021. When it comes to leading-edge chips (10 nanometers and smaller), Taiwan has 92% of global production capacity. Meanwhile, China is expected to emerge as a leading player in chip manufacturing. The country plans to add about 40% of the global new capacity by 2030 and is expected to reach 24% of world’s total capacity by that same year, according to Semiconductor Industry Association. China’s potential leading position has raised concerns that it might threaten the economic advancement and national securities of other countries, especially the U.S.

In light of these threats, the U.S. government has been tightening regulations on chip exports to China. Last month, on October 7, the U.S. Department of Commerce announced reinforced regulations on cutting-edge semiconductor technology exports to China. Export controls to China already existed before this new round. So what’s new this time, and why has the market been so nervous about it? Well, this new set of restrictions have been broadened substantially. First, the expanded list of restricted exports to China now includes the most cutting-edge chips as well as chips that are one to two generations behind the cutting edge. In addition, the new rule restricts the ability of Americans to support the development or production of Integrated Circuits (ICs) at China-located semiconductor fabrication facilities without a license.

The cumulative effects of these restrictions could have major implications on the industry. For example, many scientists and engineers with U.S. citizenship or permanent residency work in the Chinese semiconductor industry, including several top executives in Chinese companies. The new controls will likely force them to choose between their U.S. citizenship or their jobs.

The new rules will affect Chinese companies the most. Without new supplies of equipment from the U.S., Chinese chipmakers could be unable to expand their production lines and wind up stuck with existing capacity for the time being. Even for existing capacity, they may not be able to get maintenance services from the U.S. suppliers, which could affect the quality of the products.

The global market for wafer fabrication equipment is also expected to be hurt by these regulations. According to Jefferies, total investment value by Chinese companies in this market in 2022 is projected to be US$18 billion. This makes China the largest investor in this global sector by far.[1] However, the impacts of these new regulations on chip exports might affect around US$5 billion of Chinese investments in wafer fabrication.

American companies could suffer as well. China is the largest market for the three biggest U.S. semiconductor equipment manufacturers, accounting for roughly 30% of the revenue at Applied Materials, Lam Research and KLA Corp. Applied Materials declared the new regulations will reduce its fourth quarter net sales by US$250–$550 million, and a similar impact is to be expected for the following quarters. Applied Materials’ 2021 annual sales, as a reference, was about US$23 billion. Similarly, Lam research also warns the U.S. ban could lead to sales loss of US$2–$2.5 billion in 2023 (their 2021 annual sales was about US$17 billion).

Japan also has a major presence in the semiconductor production equipment (SPE) industry. At present, Japanese companies are not subject to regulatory constraints if U.S.-made parts and software are 25% or less of their products. This may potentially give Japanese SPEs a boost versus their U.S. counterparts. However, a regulation-induced slowdown of investment by Chinese companies could eventually diminish overall orders with Japanese SPEs.

What is the potential impact of all this on our portfolio?

While we do not invest in semiconductor manufacturing companies directly, a few companies we invest in Japan do have semiconductor equipment manufacturers as their clients.

Horiba (6856 JP) is a Japan-based manufacturer of measurement equipment. We have introduced their automotive emission measurement business in previous commentaries. Horiba is also a leading supplier of mass flow controllers, with 60% global market share. Their measurement equipment is used to regulate gas and liquid flow rates and is a key component in the production of high-quality semiconductors. Over half of the segment revenue comes from their Japanese customers, but Lam Research and Applied Materials are also among their key customers. The revenue from its semiconductor segment is over 40% of total revenue, the demand for this segment has been strong, and the company has revised up its 2022 guidance as a result. Horiba will report its third quarter result on November 11 and is expected to comment on the impact of the new regulations.

Kurita Water (6370 JP) is a Japanese manufacturer of water treatment equipment and chemicals. There is a growing need in the water treatment industry for advanced, comprehensive solutions, especially in the semiconductor and electronics manufacturing industries. Kurita is the only company in the world that has businesses in both water treatment chemicals and facilities. The company is the leading manufacturer in the water treatment industry in Japan, and over the past several years, Kurita has expanded its presence in the U.S. and European markets. As the semiconductor makers and other U.S. high-tech companies are bringing production bases home, this will present Kurita with business opportunities. There are still many uncertainties on the magnitude of this new set of restrictions and its potential impact. We will provide updates in future communications as we gain more clarity.

[1] Masahiro Nakanomyo, “Impact of Stricter US regulations on Exports to China”, Jefferies, Oct 16, 2022

Recently, we have seen a pullback in commodity prices after the rally they experienced earlier in the summer. As many global economies are forecasted to enter recessionary environments, the demand trajectory for commodities remains uncertain. Over the longer time horizon, we believe some commodities will outperform others due to resilient demand, despite short term volatility. This week, we would like to highlight one metal that we are closely monitoring.

Following the general direction of metal prices this year, copper is down a little under 20% year to date, according to Bloomberg. The recent down trend in copper prices has mainly been attributed to the slowdown in Chinese demand. Economic doubts in the region and many other factors have been attributed to the disruption in the Chinese economy.

The troubles started this summer when the country suffered its worst heatwave in years. Being one of the regions most vulnerable to physical stress, the heatwave in China resulted in many energy generation sources going offline, causing widespread power shortages. Additionally, the country continues to keep tight COVID controls in place, with no end in sight for their zero-COVID policy. As cases spike in certain regions, they have not shied away from locking down affected areas. Finally, Xi Jinping’s political agenda to push greater state control at the expense of the private sector growth cast questions on what rate of GDP growth the country can actually achieve. 

With the rapid acceleration of the Chinese economy in the last decade, their demand for copper followed suit. The outsourcing trend accelerated in the 2000s further bolstered demand in the region. China currently accounts for 53% of the global copper demand, an increase from 38% in 2010. So, it is no surprise that downgrades in the speed of their economic development have caused a nervous sell off in the copper markets.

Traditionally, copper has been highly correlated to economic growth as it is an important material for construction, consumer durables, industrial equipment and ventilation and air conditioning. This type of demand for copper is called traditional demand. We are now seeing a more prominent demand driver for copper emerge, and it stems from the energy transition. Countries committing to net zero goals and setting strategies to achieve these ambitious targets will give copper demand an additional boost. Over 50% of countries around the world have net zero targets. Most are not yet legislated, but momentum is increasing as many feel the firsthand effects of climate change.

Energy transition enabling technologies are highly reliant on copper. For instance, electric vehicles require three times as much copper as internal combustion engine cars. Additionally, with wind and solar becoming more widely adopted energy generation sources, transmission and distribution lines require an increasing amount of the metal as well. These transport and infrastructure needs will experience a 3.9% compounded annual growth rate between now and 2040, contributing to an overall copper demand growth of 53%.

The supply side, however, is expected to experience a squeeze. Mines have been seeing declining copper grades. Additionally, new mine commissioning takes up to ten years from initial phase to operation as environmental permits, financing and operations are all lengthy processes. Other sources of copper supply will be critical to meet the roughly 14 million tons shortage (BNEF). Solutions such as copper recycling and yield improvement technologies will play a key role.

Aurubis (NDA GR) 

We currently hold Aurubis in our portfolio, a world leading copper smelter and refiner. The company is also one of the largest copper recyclers in the world. As was the case with many European companies, they experienced rising energy costs as a result of the war in Ukraine, weighing on their performance. However, we strongly believe in the positive long-term trend for the industry. Aurubis is extremely well positioned to benefit from the energy transition. Their main smelter is one of the most efficient in the world and the company outperforms its peer group in terms of GHG emission intensity. Suppliers with better performance should benefit as more and more emphasis is put on managing Scope 3 emissions. Additionally, their recycling division is bound to thrive as regulations impose higher recycling rates and natural copper deposits continue to decline. 

We believe that given the strong demand, copper prices should find a floor and stabilize, experiencing a more favorable pricing environment than other metals.

“Demography is Destiny.”

– August Comte¹

From the dawn of mankind to the 1960s, it took approximately 60,000 years for the Earth’s population to hit the 3 billion mark. All it took was just 60 more years to add 4 billion more inhabitants and we remain on track to hit 10 billion by 2060.

Demographics influence everything from politics to sociology to economic growth. In fact, economic or GDP growth is essentially driven by two factors – growth in population and increase in productivity. 

While Europe and Japan have lately been associated with aging societies, declining populations and slowing growth, emerging markets continue to be associated with mega cities and limitless demographic dividends acting as investment tailwinds far into the future. However, the stark reality is that most emerging markets have already exhausted their demographic dividends. According to research by Aberdeen, even among emerging markets, only Pakistan and Nigeria are expected to reap dividends far into the future.

In fact, we think there could be a downward bias to population growth estimates for most emerging markets for reasons that are both societal and structural. Let’s take a look at the two emerging market giants – China and India.

China’s rapid rise has been facilitated by a demographic dividend that has not sustained for as long as most analysts predicted. To the contrary, China’s population has begun to decline a full nine years earlier than expected, with the population shrinking for the very first time in 2022. From the beginning of President Xi Jinping’s term in 2012 to 2021, the number of babies born each year fell more than 45%. 

Meanwhile, India’s population is expected to surpass China in 2023, a good seven years earlier than expected. With India, one would expect the opposite trajectory with the promise of a rich demographic dividend ready to be encashed for decades to come. But according to the United Nations, India’s population is actually expected to peak a decade earlier than expected (in 2050) and at a lower level (1.6 billion vs 1.7 billion). Given how badly statisticians and demographers have been off the mark with China, it would be reasonable to assume that these numbers could be revised downwards very soon.  

The downward revisions stem from our underestimation of some of the structural factors driving this decline in both countries. These factors include: 

• The rising cost of raising a child in urban areas. This is by far the biggest factor. The average total cost of raising a child in China is seven times per capita GDP versus four times in the U.S.. 
• Increase in female literacy and labour force participation. The most extreme example is South Korea, which has the lowest fertility rate in the world, at 0.75. According to CLSA, singles in China now account for 25% of households and close to 70% of non-attached women are comfortable with their single status. 
• Impact of the environment pollutants on fertility rates. Researchers in China found that women exposed to soft particle pollution had a 20% greater risk of infertility. 
• Softer factors, like climate change.

The last point, as surprising as it may sound to some readers, could be a swing factor in decision making for the next generation of parents. According to a survey published by GlobeScan, four in ten people are not willing to bring children into a world suffering from the disastrous effects of climate change. Even growing emerging market populations in Egypt (61%), Turkey (54%), India (52%) and Vietnam (49%) are expressing doubts about having children in an uncertain world.

While no doubt many EM countries will have large growing middle classes, we remain mindful of opportunities that might arise from trends brewing beneath the surface. In some countries, the era of “easy” GDP growth might be over. This means we need to focus either on opportunities that cater to servicing aging populations or those that enhance the productivity of a smaller working age population. Below, we look at an example that services an aging population. 

Fu Shou Yuan (1448 HK) 

One of our holdings is Fu Shou Yuan (FSY), which is the largest death care provider in China. With a rapidly aging population, we expect FSY to benefit as the government slowly exits this market and releases cemetery land to the private sector. FSY operates in the premium segment, offering a full range of afterlife services, from funerals and cemetery plots to digital services, where customers can keep memories of their loved ones alive digitally.

China is the world’s largest aged society, with 10 million deaths per annum. The death care industry in China is expected to grow at 8% compound annual growth rate (CAGR) until 2024. With 3.4 million square feet of space and a valuable land bank around Shanghai, FSY has a reputation for operating clean, spacious, aesthetically designed cemeteries. In an industry where acquiring business licenses is difficult, FSY is able to leverage both its reputation and size to acquire government and private operations. 

FSY shows us that even in an industry such as death care, it is possible to differentiate a generic product through value-added services like landscaping and sculpture design, cremation jewelry, digital services and insurance coverage. At Global Alpha, we recognize that demography is not destiny and not all emerging markets are on the same trajectory. Finding horses for courses is one of the key elements of our investment process.

¹August Comte (1798-1857) was a 19^th century French philosopher whose ideas helped develop the modern field of sociology. He was one the first people to connect population trends with the future of a country. 

“It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” 
– Warren Buffet

“Anticipate trend and benefit from it. Traders should go against human nature.”
– Ramesh Jhunjhunwala

We recently passed the year mark for our Emerging Markets Small Cap portfolio. In a tough environment, there have been markets that have outperformed the EM MSCI Small Cap Index in a substantial way, and we were able to outperform some of those markets. One interesting case has been India, where despite tough valuations, the market has behaved well. MSCI India has outperformed MSCI EM SC by over 23%, according to Bloomberg.  

Why does this happen? Why does a market that trades at 20.3 forward price-to-earnings (PE) vs 10.0 MSCI EM SC index (according to Bloomberg, October 5, 2022), massively outperform in this cloudy environment? Referring to the second quote by Ramesh¹, when we are investing in India, we are thinking more long term. This is because we are able to find some of the top-quality companies among outstanding trends, which are well managed and are likely to overcome many cycles. India also conveys strong demographic tailwinds and is one of the few EM countries that is actively fostering investing and growth. Will we sometimes have to pay a higher than average index valuations? Probably yes, and that’s fair, because at Global Alpha, we like finding wonderful companies, generating cash flows, low debt and a good balance sheet at a fair price because it’s the core of our process. We are thinking more long term and it is our intention that our bottom-up selection process relates to companies with secular trends that are particularly interesting in the EM space. In the case of India, it is a good match because we can find multiple ideas with secular trends, where EPS growth is followed by stock price appreciation. 

India has been our best performing market both year-to-date (YTD), and since inception of the EM Small Cap portfolio. Although we have taken some profits, we continue to like good companies that present interesting investment opportunities. Moreover, the current administration is boosting capex spending, which benefits many sectors. According to Macquarie, the central government spending has increased 34% YTD, driven by spending on roads, railways and defence. Public Sector Undertakings (PSUs) have also increased their spending, and the trend should continue in the remaining part of the year. The private sector is also picking up, albeit not at the same pace, but increasing nonetheless. This has rarely happened in India in the last decade. Public sector spending is concentrated more on infrastructure, while the private sector focuses on renewables, automation and data centres. If we look at this in relative terms, we see some decoupling from India and the rest of the world. Considering the global recession, it’s hard to find countries in the EM space that are fostering investments and growth (Saudi Arabia is another case). As India is a domestic-oriented economy and has an enormous quantity of investment deficits (and opportunities) in different areas, the country can continue with policies that imply growth and investments. While we expect some slowdown in FY24, we anticipate that India should continue with short-mid-term growth that is higher than other countries. 

Flow-wise, foreign institutional investors are returning to India. There was a clear sell-off in this market from October 2021, with close to USD 20 billion of outflows, as noted in the CLSA report, Flowmeter: Breakdown of Foreign and domestic flows in India. The market didn’t reflect any major impact basically driven by strong domestic investors’ inflows.  In the last three months, we’ve seen foreign direct investment (FDI) coming again to the country, which still conveys strong domestic inflows support. South Africa, Taiwan and Korea have also experienced massive outflows this year. In the two last countries, this is largely explained by its tech-driven markets in a hawkish U.S. Federal Reserve (Fed) environment.  

All in all, the equation is not so complicated. Among EM Small Cap, Fed hikes have implied strong outflows in tech-related countries (USD 50 billion between Taiwan and South Korea, according to the CLSA report, Flowmeter: Breakdown of Foreign and domestic flows in India), as China maintains its own internal issues driven by zero Covid policies and the property sector. Some markets, such as Turkey, Chile and Brazil, have outperformed YTD mainly because of low valuations among a hawkish Fed. In the case of India, we think quality structural stories are likely to be favoured in this environment, in domestic oriented market focused economies, with structural demographic tailwinds.  We provide two stock examples that have been the key in our outperformance in the Indian market. 

Phoenix Mills (PML) 

Phoenix Mills is a leading Indian developer of large-format retail-led mixed use developments. Over the last few years, PML has spread its wings across Tier I, II and III cities in India by entering into joint ventures with established regional players and bringing in strategic investors to support the growth of its ongoing and future developments. It differentiates itself by its prime-location assets (currently eight shopping centres) across key cities like Mumbai, Chennai, Bangalore, Pune; steady cash flows; near-term execution visibility; and a healthy balance sheet. PML’s core vision is to create iconic city-centric, mixed-use developments with retail as the core and offices and hotels as complimentary assets, according a HSBC report published June 21, Buy: Growth beyond.  

One of PML’s main strengths is the quality of its partners. Phoenix has joint developments with Canadian Pension Plan Investment Board (CPPIB) and Government of Singapore Investment Corporation (GIC). Although both companies have huge investments around the world, it is worth noting that they chose Phoenix Mills as a strategic partner in India. We see the quality and yields of PML projects, a good track record, execution and quality of management as a key differentiator for them in order to establish long-term relationships. Moreover, these partners allow the company to expand their asset base notably with minimum debt requirements. Capex of projects under construction as of Q1FY23 accounted for INR 42 billion and the required corporate debt is only INR 3 billion; that is to say debt funding is at 8% of aggregate capex spends as of Q123, according to a Phoenix Mills presentation from September 2022.  

These partnerships are relevant because the company is poised to a strong growth phase, with most of the projects already defined and under construction. From FY22 to FY26, PML plans to increase 1.9 times its gross leasable area (GLA) of shopping centres, from 6.9 millions of square feet (msft) to 13.0 msft (75% consolidated revenues FY24E), and 3.6 times offices GLA, from 2.9 msft to 7.1 msft. Lastly, in its hotels business, the company intends to increase 1.7 times, from 588 keys to 988 keys. To fund this growth, the company has raised equity capital of INR 45 billion, where 75% comes from the capital infusion from its partners.  

PML is more than doubling in the next three to four years, with strong global worldwide partners and with almost no additional corporate debt. Currently, at a group level, PML has INR 22 billion of liquidity to fund future growth. The sound financial position of the company has resulted in some local credit rating agencies to upgrade the company. India Ratings and Research upgraded the company to AA- from A+, while maintaining a stable outlook.  

In recent months, during an interview, Shishir Shrivastava, Managing Director of Phoenix Mills, expanded more on qualities of the two partners, CPPIB and GIC . He mentioned three pillars worth noting in these comments in a HSBC report published June 21, Buy: Growth beyond: 

• “They are long-term investors and bring vast experience and a global relationship, along with 
  design and costing product specification inputs.” 
• “They are some of the biggest retail space owners worldwide and have seen how retail has 
  grown in various countries and thus have a lot to add from that experience.” 
• “ESG is something Phoenix is learning from their global teams and expanding their 
  understanding. Overall, they are not silent financial partners.” 

In the shopping centre sector, once the group reaches 13.0 million square feet, its GLA should account for roughly 45% of expected GLA of listed companies in India (PML, Prestige, Oberoi, DLF and Brigade). Looking forward, PML has set a target to add approximately 1 million square feet of GLA each year post-FY26 and is looking for greenfield opportunities in various regions, including Kolkata, Surat, Chandigarh, and Hyderabad, among others). Funding would be either solely by PML or with joint venture partner, according to ICICI Securities. Thinking long term, a joint venture with GIC and/or CPPIB can be monetized, for example, by a REIT, or the company can judiciously unlock capital via lease rental discounting (LRD) to continue its expansion, as we see more room for consolidation in the industry. 

City Union Bank

City Union Bank Limited is a mid-sized private-sector bank and is also one of the oldest private sector banks in India. The bank is focused on providing working capital finance to small manufacturers and traders with single-banker relationships; 50% of their loan portfolio goes to micro, small and medium enterprises (MSME) and 14% to agriculture. 

Driven by its improvement in asset quality and sustained economic recovery, the company revised its FY23 credit growth guidance upwards to 15-18% versus the previous 12-15%. We see this as sustainable with an expected loan book growth of 15-20% and an earnings growth of 20% over the next five years. One of the key competitive advantages for maintaining this is that management is conservative and focused in its core competency of SME lending without falling into the trap of lending to big corporates in risky sectors. 

After successfully navigating Covid-led challenges, more significantly within its assessment range, CUBK will be embarking on a higher growth journey hereon. CUBK also enjoys positive tailwinds from increasing capex growth and the financial sector, as explained above. Return on assets should remain at levels of 1.5% (1.46% as of the second quarter), implying return on equity in the range of 15-16%. We think this level of profitability is sustainable for the future, and that’s why valuations are reasonable, both in relation to its history and to other Indian banks. The company has delivered those levels in the past, pre-Covid, which have been stronger than its peers among different business cycles. Net interest margins are steady at 4% and are likely to maintain in that range. Considering the higher proportion of the floating rate book (65% is EBLR linked), asset yields are likely to inch up Q2FY23 onwards. The entire external benchmark based lending rate (EBLR) book is repurchase agreement (repo) linked. With 61% of loan book in working capital loans, repricing is also possible in short intervals. 

Several factors give CUBK a key edge over peers and sustain its profitable expansion. The company has a core expertise in high yield SMEs, the company has also been building relationships with the local business community over the years. Additionally, around 99% of the loan book is secured, with high collateral values ensuring that historical loss given default (LGDs) have remained at 30%. CUBK also enjoys a better granular balance sheet on both the asset and liability side than its peers. Dependence on large corporate deposits is low and retail deposits as a percentage of total deposits is 75% (second highest behind the Federal Bank). On the asset side, there is high granularity, with the top 20 borrowers contributing just 5.72% of total assets. Lastly, the total addressable market maintains a big opportunity. Its long runway for growth as MSME’s lending needs are met by private sector banks that now have access to better data with the introduction of GST.  

Chart 2: City Union bank current trailing PBV and historical valuation

[1] Ramesh Jhunjhunwala was a very well-known Indian investor who recently passed away. India’s Prime Minister Narendra Modi tweeted after his death: “Full of life, witty and insightful, he lives behind an indelible contribution to the financial world.”

One of the more intricate events that shareholders must assess is a change in CEO or senior management. Turnover is a reality even at the executive level: every year between 10 and 15% of corporations must appoint a new CEO, a number that is steadily increasing as investors become more actively engaged. The average tenure of an American CEO fell by half to an average of five years between 2000 and 2014. Multiple studies on the matter show how the lack of preparedness for a CEO change is costly to investors.

Despite all this, research shows that most boards are ill-prepared to deal with the transition. A survey of 140 public and private companies by Stanford researchers concluded that at least half of the CEOs surveyed were unable to name their successor, should the need arise now. Furthermore, four in ten companies had no one who could immediately replace the CEO internally. This challenge is compounded further by the changing employment landscape where role and employer changes are more frequent. The typical executive today is expected to work for more than five employers during their career, compared to fewer than three in the 1980s.

It is worth noting that the lack of a successor pipeline also means that underperforming CEOs are kept in their roles longer than they should. This creates a potential conflict of interest for CEOs, where there might be an incentive not to have a clear successor to give them leverage with the board. Given the packed governance agendas, this topic has taken a backseat, but can be just as impactful as any other governance issue.

So how does Global Alpha assess CEO changes within its portfolios? There is no one-size-fits-all approach. Understandably, it is difficult to create a policy that would account for all the factors, including the reason for the CEO’s departure, the state in which the departing CEO leaves the business, insider/founder ownership, etc. Nonetheless, Global Alpha’s idea of a successful succession scenario for its holdings includes but is not limited to the following characteristics:

• The event is anticipated: The process taking place over a long period not only provides clarity and reassurance to investors, but also implies that this is not the result of a scandal or loss of confidence in the CEO.
• There is a framework in place: CEO succession is (hopefully) not something that happens regularly. Nonetheless, there needs to be an existing framework that prepares potential successors, even if no transition is expected in the near future. Clear communication of the processes also helps setting expectations for the potential successors. It is estimated that only 50% of companies provide onboarding or transition support to new CEOs.
• The successor(s) is internally groomed: External candidates are not necessarily worse, but are on average paid more disproportionately and do not benefit from the same knowledge transfer compared to a candidate who was groomed internally over multiple years. Trending upward, roughly 25% of companies looking for a CEO replacement hire externally.
• The business strategy remains consistent: We invest in companies whose business model we believe in. Although we do not see issues with small shifts in tactics, the overall business strategy should be consistent.

One of the benefits of operating in the global small cap universe is that the CEOs of the companies we invest in are often also the founders. By having more “skin in the game” than an appointed CEO, they also have a vested interest in ensuring a successful transition for their own legacy. Additionally, founders often go on to be board members following the appointment of their successor, which is another way of ensuring that the knowledge and expertise are still available to the new management.

Loomis, a holding in our international and global strategies, is a recent case study in CEO transition. Headquartered in Sweden, the company offers cash management services and transit to banks and retailers. Patrick Andersson, its CEO since 2016, announced his resignation from the role in early 2022 along with his intent to quit within the next year. Within a month, the board was able to replace him with an internal candidate named Aritz Larrea who had been with the company since 2014 in various roles, such as President of Loomis US and Loomis Spain. In addition, Larrea was already a part of Loomis’ executive management team. Despite the abrupt nature of the CEO’s resignation, investors noted a strong internal pipeline, as well as a framework in place to ensure continuity, without having to either hire externally or resort to an interim CEO.