The Germans’ reputation for their persistent pessimismus (pessimism in German) is not anything new. Going back as far as the 19^th century when the pessimismusstreit (pessimism controversy) was all the rage among German philosophers such as Taubert and Nietzsche. There is a case to be made however that Germany’s woes in the last couple years, especially since the invasion of Ukraine in 2022, are deserving of such emotions. From being dubbed the sick man of Europe in the 90s after the reunification, to being its industrials crown jewel just 15 years ago (even outpacing US growth at various points), it is now again the poster child of the variety of issues that are causing Europe to lag behind its global peers.

Let’s go through the list:

• Internal politics:
  While France often takes the spotlight for its chaotic politics in Europe, Germany have its own brand of messy fiscally conservative politics. Well-renowned for their high aversion to fiscal deficit, Germany’s government amended its constitution in 2009 to include a debt brake (Schuldenbremse) which limits annual structural deficit to 0.35% of GDP. Although that rule was suspended during COVID and the Russian invasion of Ukraine, it is now back in place and spending cuts must be agreed on to get back to target. Consequently, Germans have been falling behind in allocating funds to meet climate transition targets along with making many necessary investments in infrastructure and new, growth- focused sectors. Furthermore the low government approval rating and weak economic environment has led to a resurgence of the far-right party “Alternative For Germany”. The far-right party won its first parliamentary seat in the most recent regional elections, the first time a far-right party is represented in parliament since WWII. EU elections earlier this Spring also saw a far-right resurgence from German voters, as dissatisfaction with the political and economic environment becomes more pronounced. We find it unlikely that the current divided politics will lead to any meaningful breakthrough in spending in the short term.
• Dependence on the Chinese economy:
  Of all large Western economies, Germany remains the most exposed to China. Between 2011 and 2022, growth in German exports toward China grew at a CAGR of over 4%, peaking at €107 billion and representing more than 3% of 2022 GDP. This collapsed in 2023 with the Chinese economy reopening after COVID lockdowns, as its consumers spending deteriorated meaningfully. As such, 2023 exports to China were down just short of €10 billion to €97 billion and unlikely to reach new highs anytime soon. Furthermore, the largest export to China, German-made cars, is under considerable threat from Chinese carmakers that are far ahead on EV development and selling at large discounts to European cars, implying large market share losses from German carmakers. When we factor in supply chains moving out of China and reshoring, we do not expect that China exports will contribute to Germany’s growth anytime soon.
• Energy costs:
  Germany uses twice as much energy in its industrial sector as the next-biggest country in Europe. It was one of the primary beneficiaries of cheap Russian gas exports before the Ukraine invasion that increased natural gas prices tenfold in 2022, before settling back down to more reasonable levels. Nonetheless the more energy-intensive nature of German industrials and chemicals now makes German producers uncompetitive on the global stage thanks to a higher-cost structure. There also does not seem to be a strong willingness to change its mind on turning away from nuclear energy, with insufficient investment in the energy grid. Firms like BASF and ThyssenKrupp have gone through significant restructuring of their German operations in the last 2 years, with a focus on relocating some plants to lower cost areas.
• Cautious consumers:
  A 6% unemployment rate has been gradually increasing but remains in line with the average of the last 20 years in Germany. Income is rising faster than prices and rates are coming down. So why the pessimism? Germany was one of the few economies contracting in Europe in 2023, and 2024 has not inspired much optimism so far with many pundits projecting stagnation or another slight downturn in the country. Further negative messaging on adverse demographics and underexposure to secular growth themes for the next decade (climate transition, AI, service economy, etc.) have led investor sentiment to reach new lows.

An important question mark remains around how much of this is weakness is structural and how much can be addressed in the shorter term. Consumer sentiment can shift quickly and the balance sheet of German consumers remain solid. However, no level of internal demand growth will compensate for the weakness from China, which is not expected to improvement anytime soon. There are also questions around whether that demand will be redirected toward Chinese companies as reshoring becomes an ever increasingly important geopolitical topic. When Germany was last facing such structural issues in the 90s, it showed a willingness to cut through red tape and embark on painful but necessary reforms, leading to over a decade of outperformance. We have yet to see signs from current leaders that they are willing to repeat this process.

Despite the all the gloominess, we still see pockets of opportunity within German small caps, although we remain highly selective. The downward trajectory of rates, undemanding relative valuation to large caps and declining energy costs are all positives for small caps which represent 14% of its overall equity market. We continue to prefer names with globally diversified exposure and/or a secular theme that will support growth over multiple years. Here are two examples:

Earlier this year we initiated a position in RENK Group AG, a global leader in mission-critical propulsion and drive technology components for the defense industry and a solid example of German industrial and engineering prowess. Founded in 1873, the company was spun off from a Volkswagen division and acquired by private equity. It is globally diversified as a primary provider to most NATO militaries, which are under more pressure to increase their spending to 2% of GDP. RENK is already present in 75% of tracked military vehicles (excluding China and Russia) and 33% of large surface vessels, with an average content per tracked vehicle around 15%, providing plenty of opportunities to increase its share of sales from higher-margin aftermarket content. Given the strong barriers to entry as a NATO supplier, its backlog extending to 2028 and its strong brand reputation, we find RENK to be one of the best quality names Germany has to offer.

We are also shareholders in Aurubis AG, the largest copper smelter and refiner in Europe, with a market share of over 40% in the region and a growing presence in the US. It sources copper and various other metals both from miners directly and from industrial and scrapyard waste. Copper as a commodity is set to see continued high growth in demand over the next decade given its uses across virtually all industrial segments and its central role in the renewable energy landscape. Copper can also be infinitely recycled, so being the first mover and having existing infrastructure provides a tremendous advantage to Aurubis. The materials sector – more specifically the mining industry – is often seen as a sustainability laggard, but Aurubis distinguishes itself nicely as a unique recycling play with multiple growth levers.

Most data points toward Germany facing continued headwinds. Nonetheless, we seek to retain exposure to the second-largest economy in Europe and we believe names such as RENK Group and Aurubis are the right fits for the job.

After delaying the inevitable, it’s finally time to upgrade the family car. Now you’re wondering whether to switch to an electric vehicle (EV) or plug in hybrid (PHEV) or stick to the traditional internal combustion engine (ICE) vehicle?

The answer varies by region. In key markets like China, Europe and the United States, the penetration for new EV or hybrid sales ranges from 10.4% to 51%. China leads with over twice the penetration levels of Europe and five times that of the US.

Figure 1 – Global plug-in sales in key markets

Source: Autodata, CPCA, CAAM, KBA, CCFA, OFV, Macquarie Research, August 2024; *Sales in France, Germany, UK, Italy, Norway, and Sweden comprise around 80% of the total European sales

 

A survey conducted by McKinsey found that 49% of current EV owners in Europe and 46% in the US are likely to switch back to an ICE vehicle due to the lack of public infrastructure and the high total ownership cost. In China, only 28% of current EV owners are considering switching back.

Chinese citizens have made their decision and it’s clear to us where the trend is heading. As of July 2024, China has surpassed the 50% mark for new vehicles purchases being EV or hybrids. Some might find it surprising considering the penetration was closer to 10% during early 2021, according to Macquarie Research.

Figure 2 – China vehicles sales volume

Source: Macquarie Research

 

The penetration trend is attributed to government support. The Chinese government unveiled a 520B yuan ($72.3B) package of tax breaks over 4 years for EVs. From 2024-2025 all new EVs purchased will be tax-exempt and during 2026-2027 the tax exemption will be reduced by half.

A company well position to benefit from the transition from ICE vehicles to EV or PHEV in China is Hongfa Technology (600885 CH). Hongfa is the largest relay manufacturer, with 40% share of the global market in the high volt direct current (HVDC) segment (70% in its domestic market). Hongfa supplies HVDC relays to most major EV original equipment manufacturers, including Tesla, Volkswagen and BYD.

Unlike ICE vehicles that adopt 12-48V electrical systems, EVs typically operate at over 200V requiring greater reliability, insulation, durability under high voltage, large currents, high temperatures and the ability to extinguish electric arcs.

A typical EV requires 5-8 units of HVDC relay including 2 main relays, 1 pre-charge relay, 2 normal charging relays, 2 fast-charging relays (not required for PHEV) and 1 auxiliary relay. Average content per vehicle ranges from RMB750-1,250 for battery electric vehicles (BEV) and RMB500-850 for PHEV.

Figure 3 – HVDC relay in electric vehicles

Source: Hongfa Technologies, BofA Global Research

 

 The growing demand for relays is driven by three factors:

1. EVs require a higher content per vehicles when it comes to relays.
2. EVs require special relays to handle the arcs, which has a higher price point.
3. EV manufacturers transitioning from 400V to 800V infrastructure (+30% relays vs 400V).

The competitive advantage comes from three main factors:

1. Lowest cost manufacturer due to scale and vertical integration.
2. High quality, with a customer complaint rate of ceramic high-voltage DC relays being less than 0.5 ppm.
3. Stickiness, as relays approved for car builds are not interchangeable due to third-party verified regulations. Hongfa works with EV makers during the design phase, 3 to 5 years before launch.

We believe the company will greatly benefit from the transition to EVs and is well-positioned to thrive within its market, given its leading position, high-quality products and growing demand for HVDC relays.

Decarbonization continues in parts of the world, although there is a long way to go. Ongoing use of coal amid rising energy demand somewhat negates the transition to natural gas and/or the implementation of carbon capture technologies. On average, coal-fired power plants emit about 2.2 to 2.5 tons of CO2 per megawatt-hour (MWh) of electricity produced. By contrast, natural gas-fired power plants emit about 0.4 to 0.5 tons of CO2 per MWh.

But the good news is that we are making strides in other areas. Consider green steel.

Traditional steelmaking emits approximately 3 billion tons of CO2, mostly from smelting which turns iron ore into steel. This process is very energy intensive and is a top-3 CO2 emitter, with electricity production at number one and cement number two. However, metallurgical processes to turn iron ore into steel are now converting from traditional furnace smelters, which emit 2 tons of CO2, to low-energy Electric Arc Furnaces (EAF), which emit 0.5 tons per ton of steel.

Historically, new metallurgical processes have been difficult to scale. Fortunately, the steel industry, as it moves towards greener production methods, has been borrowing proven technology from its aluminum counterparts. EAF today play a crucial role in the global steel industry, with around 2,500 to 3,000 units in operation and a combined capacity of approximately 500 to 600 million tons per year. The share of EAFs in global steel production is around 5% and growing, reflecting their expanding importance in the industry and in a (slowly) decarbonizing world.

Major steel-producing regions like North America, Europe, China, and India are enhancing their EAF capacities to improve sustainability and reduce carbon emissions. Recent EAF investments include Nucor, $2.7 billion for 3 million tons of steel in 2024, and Steel Dynamics, $1.9 billion for 3 million tons in 2024. Cleveland Cliff, Arcelor and Gerdau are also transforming to EAF.

Transforming the entire supply chain will produce green steel, which represents a transformative shift in the steel industry towards significantly reduced CO2 emissions and more sustainable practices. Key technologies in this greening process include hydrogen-based steelmaking, EAFs powered by renewable energy, and advanced methods like molten oxide electrolysis. While there are challenges, including high costs and technical feasibility, green steel holds promise for a more sustainable future in steel production.

One company benefiting from EAF is Australian-based iron ore producer Champion Minerals (CIA:AU). By acquiring a distressed Canadian asset from Cleveland Cliff in 2017, Champion revitalized the asset towards producing over 12 million tons of iron ore per year. This North American asset represents the main value of the company, as it has received over USD$4.8 billion of investments over the years from past and present owners. Its products receive a premium to market, justified by the quality of its iron ore.

Champion has multiple catalysts on the horizon. For example, they are adding transportation links to help reach nameplate production of 16 million tons, and start-up of its EAF material processing facility will soon commence. As well, any further steel tariffs on Chinese steel will help bolster demand for its production, particularly among the new EAF North American steel mills. Indeed, Champion expects its exports to China to decrease from 70% to 30% in the coming years as the firm switches to markets closer to home.

This client diversification has many positive implications for Champion, and savings on cross-ocean transit costs are worth the EAF investment alone. It is important to note that all the electricity used in Champion Minerals operations are from hydropower except for the mobile fleet. It is therefore a definite leader in green steel branding.

There are other methods of reducing CO2 emissions while producing steel. We own a small position in Aperam (Apam.NA), which produces steel from its facilities in Brazil, Belgium and France. Aperam was spun out of ArcelorMittal at the start of 2011. Their Brazilian facility uses charcoal from a series of eucalyptus forests owned and managed by the group, rather than coking coal. Their European facilities use EAF furnaces fed with scrap.

(EAF requires scrap steel, as it is does not work well with high contaminant iron ore. Producers of iron ore have adjusted and are now producing high-quality ore, as well as metal bars instead of contaminated iron powder.)

We are also exposed to EAF in other commodities, specifically copper. The copper market is 10 times smaller than steel, so CO2 headlines have been less prolific. Yet copper CO2 emissions are still fairly elevated, at 3 tons of CO2 per ton.

Aurubis AG (NDA.GY) is a leading global provider of non-ferrous metals, particularly copper, and it operates several key assets and facilities across the globe. The company’s assets include smelting and refining facilities in Germany, Bulgaria and Finland. The Helsinki and Luebeck facility are flash smelting furnaces, which emit around 1.5 to 2.5 tons of CO2 per ton of copper produced. This is lower compared to traditional furnaces. Aurubis also operates EAF facilities at different production sites.

Aurubis has leading recycling operations in Europe, especially for copper, and it is developing the copper recycling market in North America. The company recently opened a new smelting facility in Richmond, British Columbia.

The days of complete green steel are likely years away, but they are within view. We continue to follow developments in these areas so as to participate in important decarbonization investment themes going forward.

When global investors think of opportunities in Taiwan, the first thought that often comes to mind is its technology sector, particularly its world-leading semiconductor cluster. This tendency is understandable given that the semiconductor industry is a cornerstone of Taiwan’s economy, directly contributing more than 15% to the nation’s GDP. The relevance of the country’s semiconductor capabilities extends far beyond its borders. Taiwan produces over 60% of the world’s semiconductors, and more than 90% of the most advanced, leading-edge integrated circuits. Most of these advanced chips are manufactured by a single company – Taiwan Semiconductor Manufacturing Corporation (TSMC) – giving it a critical role in the global technology supply chain. From smartphones to most advanced AI accelerators, most of the tech advancements we see today would not be possible without the world leading foundry. Jensen Huang of Nvidia has repeatedly praised the indispensable role of TSMC in driving global innovation.

TSMC’s dominance has a significant influence on decisions of investors in emerging markets (EM). As of July 2024, TSMC accounted for 9.3% of the MSCI EM Index, while Taiwan as a whole made up 18.5%. Such concentration can pose challenges for investors who are trying to diversify their portfolios. Being heavily exposed to a single, cyclical company, even one as dominant as TSMC, can increase risk, especially during periods of high market volatility. This is where the benefits of small-cap equities come into play.

We believe that small-cap stocks offer a unique mix of growth potential and diversification. While the MSCI EM Index is heavily weighted toward large-cap tech giants like TSMC, Tencent, Samsung, Alibaba and SK Hynix, the MSCI EM Small Cap Index provides a more balanced exposure. As of July 2024, no single constituent represented more than 0.5% of the total weight. More than 350 companies from Taiwan accounted for 21.4% of the MSCI EM Small Cap Index. This broad distribution reduces the risk associated with any single company, making small-cap equities an attractive choice for those looking to diversify while still tapping into Taiwan’s economic strengths.

Nien Made is a perfect example of the opportunities available in Taiwan beyond the technology sector. Founded in 1974, Nien Made has become one of the world’s largest manufacturers of window coverings, including blinds, shutters and shades. The company has successfully harnessed Taiwan’s advanced manufacturing and commitment to innovation to maintain its global competitive edge. Nien Made has invested heavily in production automation, allowing the company to achieve significant cost efficiencies while upholding the highest quality standards. Nien Made has developed proprietary machines used in its production process, further enhancing its operational efficiency and product consistency. Another key factor in Nien Made’s success is its high level of vertical integration, with 90% of window covering components produced in-house.

Nien Made’s success is also driven by its strong portfolio of brands, each recognized for quality and innovation in the window coverings industry. The company’s flagship brands, including Norman and Veneta, cater to diverse market segments ranging from premium, custom-made products sold primarily through professional designers to more affordable, ready-made options available at big-box retailers like Home Depot and Walmart. These brands have helped Nien Made establish a significant presence in markets across North America, Europe and Asia. Operations outside of Taiwan account for more than 95% of Nien Made’s business, underscoring its global reach.

Innovation is a core element of Nien Made’s growth strategy. The company continuously invests in research and development to enhance its product offering and improve production efficiency. Nien Made has been a pioneer in developing motorized window coverings catering to the growing demand for smart home solutions. These products offer the convenience of automation while preserving the familiar look of traditional window coverings. One of Nien Made’s most significant innovations is the development of cordless window coverings. This initiative was driven by new US regulations aimed at improving child safety by eliminating cords in window coverings, which pose a danger to young children. Nien Made’s proactive response to these regulations not only ensured compliance with safety standards but also strengthened its reputation as an industry leader.

Nien Made’s ability to navigate global challenges has further solidified its market position. The COVID-19 pandemic, geopolitical tensions, rising raw material costs and global supply chain disruptions have all presented significant operating challenges. However, Nien Made’s strategic investments in expanding production capacity in Vietnam, Cambodia, Mexico and the US have enabled it to navigate these challenges, ensuring undisrupted customer satisfaction and product quality and availability.

The company’s commitment to sustainability and corporate responsibility enhances its investment appeal. It has implemented environmentally friendly practices in its manufacturing processes, reducing waste and lowering its carbon footprint.

We appreciate Nien Made’s product quality, competitive lead times, extensive service network, cost advantages and broad client reach. All these factors contribute to its high level of profitability, with net profit margins exceeding 20% and returns on capital ranging from 20% to 30%. Nien Made is run by the second generation of the founding family, who maintain substantial ownership in the company. The management team demonstrates a prudent capital allocation strategy, supported by a strong balance sheet with a net cash position, allowing it to weather economic cycles over time.

For investors looking for opportunities in Taiwan, Nien Made offers a compelling case. While the technology sector remains a major driver of Taiwan’s economy, companies like Nien Made offer a less conventional path to capitalize on the island’s broader success story. With its competitive advantages, clear growth strategy, robust financial position and capable management team, we believe that Nien Made stands out as an attractive investment opportunity.

On May 15, 2024, Singapore swore in its first new prime minister in 20 years. Lawence Wong, at the age of 51, previously the deputy prime minister, succeeded Lee Hsien Loong.

While Lee Hsieng Loong is the son of Lee Kuan Yew (the founding father of Singapore), Lawence Wong was born to a family he described as ordinary, growing up in a public housing flat. He started his career as an economist at the Ministry of Trade and Industry (MTI), and later held several important positions in energy, culture, national development, education, healthcare and finance, among other departments.

Last week, Wong delivered his maiden National Day Rally speech and called for major reset of policies and attitudes. He is expected to keep the city-state as open as possible, maintaining independence through a wide network of bilateral and regional free-trade agreement. He pledged to look after various groups of Singaporeans, including the elderly, families and lower-income households. A few highlighted policy changes from his speech include: more paid paternity leave and shared paternity leave; temporary financial help for lower and middle-income workers who lose their jobs; discontinuation of the Gifted Education Program in primary schools; increasing support for affordable housing; and strengthening of the sporting culture.

A top-5 country by GDP per capita

Once known as one of the four Asian Tigers, Singapore experienced rapid economic growth thanks to exports and industrialization between 1960s and the Asian Financial Crisis of 1997. The 2000s were a tumultuous period for the country, however. Faced with the dot.com bust, SARS and the global financial crisis, Singapore restructured and diversified its economy. It began to bounce back, and is now the fifth richest country in the world based on GDP per capita, according to The Economist.

Resilient economic growth

2024 Q1 GDP growth of 3.0% and Q2 of 2.9% were both better than expected. Last week, MTI raised Singapore’s annual GDP growth forecast in 2024 to 2-3%, adding that external demand outlook is expected to be resilient for the rest of the year. Growth sectors will be manufacturing (especially electronics related to smartphones, PC, and AI-related chips), chemicals, tourism, aviation, finance and insurance.

A home to multinationals

Singapore and Hong Kong have traditionally been viewed as rivals, attracting many international companies and talents to work and live there. But Hong Kong’s ever-closer ties with mainland China have raised increasing concern among some people about democracy and safety, causing more and more foreign companies and foreign nationals to leave Hong Kong for Singapore. While Hong Kong’s standard corporate tax rate is as low as 16.5%, Singapore’s 17% tax rate can be cut to 13.5% or less for some activities. As a matter of fact, Singapore was regional headquarters to 4,200 multinational companies in 2023, compared to 1,336 in Hong Kong. A list of such companies includes FedEx Corp., Microsoft Corp., Google, TikTok, Shein and General Motors Co., etc. The often-cited reasons for this big gap are better relations with the West, a broader talent pool, diversified economy, and tax incentives.

Asia’s top financial center

According to the latest 2024 Global Financial Centres Index, Singapore overtook Hong Kong for the third year in a row to become Asia’s top financial center, ranking third globally, behind New York and London. Singapore has also become an attractive asset management hub. Wealth overseen has doubled in the past six years, to about US$4 trillion, and about 80% of that is foreign. Government initiatives are the key driving forces. For example, in 2020, the government introduced a new legal structure called a variable capital company that provides tax and legal incentives to hedge funds, venture capital and private equity firms to set up in Singapore, comparable to Cayman Islands and Luxembourg.

Singapore’s economic backyard is Association of Southeast Asian Nations (ASEAN), a 10-nation region with a population of 680 million and an economy of US$3.6 trillion. Singapore’s stable political climate and high living standards make it an ideal destination for high-net-worth individuals and global financial professionals.

Our portfolio holding in Singapore – Raffles Medical Group

Founded in 1976, Raffles Medical is Singapore’s largest homegrown private healthcare provider and the first member in Asia to join the Mayo Clinic Care Network. It owns four hospitals and over 100 clinics in five countries including Singapore, China, Japan, Vietnam and Cambodia. It has over 7,000 corporate clients and 2.2 million patients.

Covid impacts on the company were mixed. On the one hand, hospital development in China was seriously delayed. On the other hand, Singapore business accelerated thanks to government-related Covid services.

Like many stocks that benefited from upticks in Covid-related revenue, Raffles Medical experienced tough comps following the pandemic. However, we are very confident about its growth potential thanks to its strong reputation in the industry, net cash position and consistent growth strategy in Asia.

Since February 2024, Dr. Loo Choon Yong, the owner and founder of Raffles Medical, has spent almost S$35 million of his own money to buy back shares in his company.

New chapter for Singapore

Although Singapore came into being only in 1965, it has developed from a red dot to a shining star in Asia. Looking ahead, Lawrence Wong, the fourth Prime Minister, will have to navigate through a challenging time with increasing geo-political tension, weak global economy and deglobalization. His party’s popularity will be tested, as will his personal popularity, in the general election to be held no later than November 2025. Let’s hope Singapore’s best years are ahead of us.

The reporting season of our international holdings gets underway in the weeks ahead. After a particularly strong Q1 reporting season, forward earnings per share estimates for the STOXX 600 have been flat since June. Some sectors, like in travel and leisure have observed an increase in their earnings revision while others, like in luxury or in construction and materials have obtained a lower-than-expected earnings revision. On the revenue side, we saw a weaker forward sales revision lately, a potential signal that the macroeconomic trends might remain complicated for the second half of 2024. On a sector basis, consumers and technology seems to be experiencing a soft patch. When not impacted by delay, new order intakes seem to be coming through but the cadence in manufacturing is progressing at a slow pace.

Political risk is back

Index performance rebased to 100 (USD)

Source: Bloomberg, MSCI.

Volatility spiked last month due to a political risk resurgence in Europe. The French election caught investors off guard and prompted many to de-risk and reallocate elsewhere. French bond yield has narrowed since the end of June, but equity hasn’t recovered much. French equities have suffered and have trailed other benchmarks since early June.

The left-wing alliance unexpectedly won the election, beating both the presidential and far-right party. Now, attention turns to the election of a new President of the National Assembly in July. The balance of power seems to have shifted towards the center-left alliance and this could be the best-case scenario for markets. The formation of a technocracy cannot be ruled out either.

The first real test for the new government will probably be to vote on the upcoming preliminary budget that needs to be submitted to the European Commission by mid-October. Last month the European Commission signaled that France should be put under excessive deficit procedure. If that proposition is adopted by the European Council, France will have to meet the requirement of the European Union’s (EU) fiscal rules. The incoming government will have little room to maneuver from a fiscal point of view. Considering that the last time France recorded a surplus was in 2001, the challenge is colossal.

Political uncertainty adversely affects the decision-making processes of companies. It will be interesting to track how companies intend to reallocate capital in the upcoming months.

Investors positioning

Fund flows are trending towards bonds and money market funds. US equity fund inflows remain high but have slowed, reflecting cautious investor sentiment. In Europe, equity funds are experiencing outflows, while Asia ex-Japan sees significant inflows, particularly in China and India. Technology remains the top sector, while materials and consumer sectors show muted interest. Shares of small caps in the US have recently surged, with the Russell 2000 Index hitting a 2024 high, fueled by optimism regarding the federal reserve’s advancements in combating inflation and the increased likelihood of interest rate cuts.

Fund Flows (last 4 weeks, % of assets)

Source: Deutsche Bank.

Cumulative equity flows (last 12m, weekly, $bn)

Source: Deutsche Bank.

Small caps is a key beneficiary of the expected lower rates, and given they continue to trade at a 20-year low valuation versus their larger counterparts, we believe now is an interesting time to own small caps.

Five longstanding ESG themes that predate responsible investing.

Environmental, Social and Governance (ESG) factors can be seen as idealistic in investing and at odds with business performance and measurable results. However, this view overlooks their financial implications for businesses and investors, with global small caps being no exception. ESG considerations, from board independence to community relations and environmental risks, can be useful to help assess financial stability, risk management and competitive advantage.

This week’s commentary will explore five themes that show how ESG factors can be important to sustainable financial success.

1. Board member independence

Good governance has long been an investor focus. Board independence helps ensure strategic guidance free from internal influences, reducing conflicts of interests. Independent directors provide unbiased oversight on risk management, which can help to avert crises and challenge management assumptions, leading to a more thorough analysis of strategic options and their implications. Independent boards often see higher profitability and navigate risks better, reflected in their market valuation and investor confidence.

An example is our holding Kurita Water Industries, which has 50% board independence, above the average in Japan. Its independent directors bring diverse perspectives, valuable in global expansion, and help Kurita maintain a solid financial position and sustainable growth in a competitive environment.

2. Product quality and safety

High product quality and safety standards fulfill regulatory requirements and boost consumer trust and brand reputation. They can reduce the risk of costly recalls and legal issues, directly impacting sales volume and the bottom line.

For instance, our holding Menicon, Japan’s first and largest contact lens manufacturer, has international quality standard certifications for medical devices, including ISO 13485/EN ISO 13485. Each of its subsidiaries maintains its own quality management system, with general managers in development, pharmaceutics and sales overseeing safety management. There have been no regulatory recalls of Menicon’s products in recent years.

3. Community relations

Strong community relations are vital for a company to obtain a license to operate, potentially increasing project approvals. Community ties can also provide supportive networks during crises and facilitate local cooperation. Conversely, community opposition can lead to project delays, increased costs and even cessation, affecting expected returns.

An example of a company holding that benefits from its community investment is Advantage Energy, from Western Canada. Although community issues are common in the natural gas sector, the company strives to be an active community member, attending monthly meetings to facilitate communication and cooperation regarding energy developments. It has faced no project opposition or delays and operates smoothly.

4. Physical risks of climate events on company assets

Climate change heightens extreme weather events and natural disasters, increasing the risk of damaging company assets, disrupting supply chains and increasing operational costs. These risks can also affect insurance premiums and lead to regulatory penalties, straining financial resources. Companies that mitigate these risks can protect assets and maintain profitability.

For example, our Arena REIT holding in Australia, with 272 social infrastructure properties, faces bushfire and extreme weather risks, leading to potential property damage, operational disruptions and higher insurance costs for tenants. Arena REIT maintains a geographically diversified portfolio and conducts thorough due diligence on bushfire zones and flood overlays during acquisitions. It also ensures adequate disaster insurance for repairs and reinstatement across its properties.

5. Employee relations

High employee morale and fair labour practices create a positive work environment, enhanced job satisfaction and reduced turnover. This boosts productivity and innovation, benefitting a company’s financial health. Conversely, poor employee relations can result in high turnover rates, lost productivity, strikes and reputational damage, negatively impacting financial health.

Our Vital Farms holding exemplifies good employee relations. The company produces and sells eggs, butter and ghee from pasture-raised hens. Certified as a B Corp, one of the highest standards of good corporate practices, Vital Farms has best-in-class initiatives for workers’ wellbeing, such as the ReVITAlize remote crew retreat, inclusive farmer open houses, comprehensive onboarding and an annual employee engagement survey.

The financial imperatives of ESG

These examples highlight how ESG integration can be used in financial decisions. As global small-cap managers, our commitment to incorporating ESG considerations into our investment decisions is one of the inputs for achieving sustainable financial success and aligning with our fiduciary duty to act in our clients’ best interests.

Disclaimer: ESG integration at Global Alpha is driven by taking into account material sustainability and/or ESG risks that could impact investment returns, rather than being driven by specific ethical principles or norms. The investment professionals may still invest in securities that present sustainability and/or ESG risks, including where the portfolio managers believe the potential compensation outweighs the risks identified.

Some of our recent commentaries (December 7, 2023 and February 8, 2024) cover the 2024 election landscape. One of the biggest surprises so far was the decision of UK Prime Minister Rishi Sunak to call a general election for July 4. In this commentary, we look at the UK economy and markets as we approach this election.

Sunak’s decision caught everyone off guard and, on the face of it, the timing seems strange. A summer election during peak holiday season usually entails poor turn outs. The general thinking behind the decision is that momentum would be strongest after a stronger-than-expected GDP print in Q1 and inflation almost back to normal. A slowdown in growth is expected, and while the drop in inflation was welcomed, it was due to a decline in home energy bills and the base effect. Consensus estimates expected a larger fall, and as such, expectations for the first interest rate cut from the Bank of England have been pushed back to September from June, keeping mortgage costs higher for longer.

Labour’s lead and Conservative struggles

At the time of writing, the Labour Party has a 21-point lead, and the incumbent Conservatives are falling into a battle with Reform UK to be the official opposition party. The election campaign is well under way and Labour seem set for an overwhelming majority. This means they should be able to implement their policies, so let’s look at their manifesto and see what is likely to impact the economy and capital markets.

Labour’s strategic plans: No EU return, but stronger ties

First and foremost, there is no return to the EU on the cards, but Labour will continue to work on EU trade and investment relationships. The main points concern economic stability, defence, housing, infrastructure and clean energy. With geopolitical tensions continuing to run high, Labour will kick off their first year in government with a Strategic Defense Review, setting out a plan to increase defence spending to 2.5% of GDP.

Push for affordable housing

As expected, housing is at the forefront. Labour would like to build 1.5 million new homes over their term with an emphasis on increasing social and affordable housing. Brownfield development is the priority and approval of sites will be fast-tracked. New developments will be obligated to ensure more affordable homes.

No tax increases, but closing loopholes

For personal taxes, Labour has pledged to freeze National Insurance, the basic, higher, or additional rates of Income Tax, and VAT. There are some changes around the fringes that will be a source of income – ending the use of offshore trusts and closing some other loopholes to tackle tax avoidance. Corporate tax will also be unchanged for the term, keeping it at 25%, which is the lowest rate of the G7, and a promise to act if tax changes elsewhere hinder UK competitiveness.

Building for the future

Infrastructure investment has been low, so public investment will be used to support and attract additional private investment, whether domestic or foreign. An overhaul of the planning system would help here. In parallel to the usual spending on roads, railways and other important national infrastructure, investments will go into upgrading ports and improving the supply chain, new gigafactories to help the automotive industry, rebuilding the steel industry, accelerating the deployment of carbon capture and supporting green hydrogen manufacturing.

Wind, solar and job creation

The UK has some natural advantages that should help the transition to clean energy – a long coastline, high winds, shallow waters and access to a skilled workforce with extensive offshore and engineering capabilities. The Green Prosperity Plan aims to double onshore wind, triple solar power and quadruple offshore wind by 2030 while creating jobs. Labour does not intend to issue new licenses to explore new oil and gas fields in the North Sea. The same applies to new coal licenses and fracking will also be banned. Labour remains committed to the EV transition by restoring the phase-out date of 2030 for new cars with internal combustion engines and will accelerate the roll out of charge points.

Financial services as a boost for innovation and investment

There was some positive language around financial services, an undoubted strength of the UK economy. Labour wants to support innovation and growth in the sector, talking about a pro-innovation regulatory framework. Also concerning financial services is the ambition to increase investment from pension funds in UK markets. Domestic pension funds are mature and have reduced equity allocations in general and even more so UK equity allocations. The UK Office for National Statistics shows that domestic pension funds own 1.6% of the UK equity market from over 30% in the 1990s, low compared to similar developed markets. Theoretically this number could go lower, but with some new incentives, arguably risk is skewed to the upside, especially if a minimum level of UK equity exposure within pension portfolios is mandated. Increased demand could see a re-rating for UK equities.

UK equities poised for growth

The party in charge is ultimately not the most important factor. The last Labour government coincided with the Great Financial Crisis in 2008, and the Labour government before that (Tony Blair) was impacted by the dot-com bubble bursting and the subsequent recovery. What has been consistent over the past 60 years has been an average 10% gain for the FTSE All-Share index in the first year of an election when a change of power occurs.

The UK market looks attractive. Valuations are depressed and the discount is broad, having seen a pickup in bids from overseas competitors and private equity acquirers opportunistically seeking assets and market positions. Losing listed companies to M&A, a slow environment for IPOs and UK-based companies choosing a primary listing overseas means UK equities are in short supply. Finding solutions for the structural challenges facing the UK economy is essential to kickstarting growth and attracting investors. If execution is successful, UK equities could gain favour the way Japanese stocks have lately.

When one thinks of high-return investments, the waste management sector rarely comes to mind. It’s not as exciting as tech or biotechnology companies. Yet, the waste services industry has captured the attention of some of the world’s most sophisticated investors. For instance, the Gates Foundation owns over 35 million shares of Waste Management, the largest waste service company in the United States, making it one of the foundation’s top holdings. Private equity funds also have a keen interest in this sector, with those specializing in environmental services amassing more than $1.3 trillion globally, according to PitchBook.

Global dry powder: private equity funds seeking investments in environmental services (in billions)
Source: PitchBook.

So, what makes the waste management business so attractive to some investors?

The sheer size and growth potential of the market. Globally, more than two billion tons of municipal solid waste are generated annually. To visualize this, if packed into standard shipping containers and placed end-to-end, this waste would circle the Earth 25 times, or to the moon and back. On top of municipal waste, human activity generates significant amounts of agricultural, construction, industrial and healthcare waste. The global waste management market was valued at $1.3 trillion in 2022 and is expected to grow at a compound annual growth rate (CAGR) of 5.4% until 2030, reaching $1.96 trillion.

Recession-resilient business model and high entry barrier. Waste management is a fundamental service in modern society. Every day, millions of tons of waste are generated, requiring efficient collection, treatment and disposal. This ongoing need makes waste management companies indispensable, ensuring a stable demand regardless of economic conditions. These companies typically generate strong cash flows, high margins and significant return on capital. Long-term contracts with municipalities and businesses provide predictable revenue streams. Moreover, high entry barriers associated with sizable upfront investment and stringent regulations deter newcomers, giving existing players pricing power and reducing competitive pressures. This stability translates into reliable revenue streams, making the sector attractive for long-term investors.

At Global Alpha, we have identified numerous promising investment opportunities within the waste services sector over the years. Here are some examples:

• Casella Waste Systems (CWST US) is a regional player providing integrated waste services, with a strong focus on the US Northeast and Mid-Atlantic regions. The company benefits from its strategic positioning in the capacity-constrained Northeast market, allowing it to capitalize on pricing power and opportunities for growth through M&A. The company also emphasizes operational optimization to enhance margins and efficiency.
• Befesa (BFSA GY) is the world’s leading recycler for steel dust and aluminum, with recycling facilities across Europe, Asia and North America. The company has over 50% market share in Europe and is a first mover in China for steel-dust recycling. With increasing regulatory mandates requiring decarbonizing steel production, Befesa is well-positioned to capture the volume growth with a well-defined capacity plan.
• Daiseki (9793 JP) is Japan’s largest liquid waste processor, including waste oil, wastewater and sludge. Its recycling technologies can treat waste oil to produce recycled lubricating oil, heavy oil and supplemental fuels. Demand for recycled oil is rising as Daiseki’s clients seek to reduce their carbon footprint.
• ARE Holdings (5857 JP) is the world’s largest precious metals refiner. The company collects, recycles and refines precious metals, including gold, silver, platinum and palladium from dental, electronics and jewelry materials. The carbon footprint of recycled silver is roughly one-third of mined silver. Recycling gold emits less than 1% of emissions than mining new gold. Many industry players, such as Prada, Tiffany, Cartier and Pandora, now use recycled metals.
• TRE Holdings (9427 JP) is one of the leading waste treatment and recycling companies in Japan, specializing in handling construction waste and waste metals from automobile, home appliances and industrial sectors. It has over 20% market share in the construction industry and recycling schemes with auto makers and home appliance manufacturers. The company also has renewable energy businesses that use recycled wood from its own operations as fuel for biomass power generation.

When it comes to waste management, Japan is known for its rigorous waste sorting and disposal practices. The country faces a challenge with limited landfill capacity. Existing landfill sites have remaining capacity of 96.66 million cubic meters, projected to reach full capacity in 23 years, so Japan tries to minimize garbage through efficient sorting and processing. That explains why Japan has such low landfill waste per capital compared to other economies.

Global landfill waste generated per capita 2022, by select countries (in kilograms)
Source: Statista.

Daiei Kankyo (9336 JP), a name added in our portfolios in a recent quarter, is a Kansai-based waste disposal company that offers one-stop services from collection, transport and intermediate processing, to final disposal. The company has top share in the final disposal market among private-sector players, accounting for approximately 11% of Japan’s total landfill capacity. The final disposal business is extremely difficult for new players to enter because of the strengthened regulatory processes and environmental concerns by local communities. Only companies with a strong track record and reputation can possibly get a permit and expand their capacity. Additionally, it takes six to seven years to open a new facility. This lengthy process further increases the barriers to entry, ensuring stable volume growth and strong pricing power for incumbents. That’s why Daiei Kankyo boasts the highest margin among its waste management peers in Japan. Over the years, the company has diversified into recycling, soil remediation and electricity generation businesses to provide a total solution to its clients.

In contrast to other markets, Japan’s waste management industry is more fragmented, with the four players accounting for only 4.2% of the market, compared to 40% to 50% of the US market, which allows ample M&A opportunities. Daiei Kankyo has acquired over 20 companies since its founding in 1979, typically at EV/EBITDA multiples of 3x to 5x. M&A will remain a growth driver in the coming years.

Another driver for the company is public-private partnerships (PPP). Many Japanese local municipalities struggle with handling household waste due to a declining population and labour shortages and have started working with private players. Daiei Kankyo pioneered PPP contracts where the plant will be built, owned and operated by Daiei Kankyo, and municipalities will pay waste treatment fees once operational. So far, the company has won three orders and expects to win 12 by 2030.

Turning waste into wealth

While only a small portion of waste is recycled, global innovators and industry leaders are finding new ways to turn waste into sustainable materials or fuels. The potential for these innovations to convert waste streams – currently incinerated or buried – into valuable resources is promising for the future.