After growing at 9% compound annual growth rate (CAGR) for the last decade, there is still much to get excited about regarding the long-term prospects of the video game industry. New marketable technologies, streaming that provides exposure to lesser-known games, and new phone owners becoming potential gamers, are only a few of the reasons to believe that the industry will be able to maintain this growth over the next decade.

Despite these positive secular trends, video game developers and publishers have been facing a difficult start to the year. Two years of COVID has brought production delays that had initially been offset by significantly increased consumer engagement from various lockdowns across the world. With the reopening now well underway, these “non-core” consumers are going back to their pre-COVID lifestyle. This obviously creates difficult comps for companies that saw record growth for the last two years and are still often facing production delays, with many big names, such as Activision, Nintendo and Ubisoft posting negative year-over-year (YoY) revenue growth in 2022. Although, the delays were initially blamed on the work from home situation, where collaboration was more difficult and productivity was inconsistent. It is now the talent retention that seems to be at fault.

Indeed, game designers and engineers have a long history of being underpaid, compared to their peers in other fields, often trading higher salaries in exchange for working for companies that create games they are passionate about. Payscale.com listed the median video game designer salary at $66,452 versus software developers at $73,177 for 2021. Wage inflation is now rampant across virtually the entire economy. Additionally, many employees are reluctant to go back to the office, meaning that designers, developers, and game engineers are receiving multiple offers from competitors from within but also outside the video game industry. Video game development requires substantially more collaboration than many other software developer jobs. Management teams face a difficult choice between maintaining the perks of working from home to retain talent and bringing everyone back to the office to meet production timelines without requiring more resources.

It is not all negative for game developers and publishers though; 2022 is already the biggest year on record for mergers and acquisitions (M&A) in the video game industry. Microsoft acquiring Activision Blizzard for $68 billion is on its own the biggest video game company acquisition of all time. Other recent deal announcements, such as Sony acquiring Bungie and Take-Two Interactive acquiring Zynga, have shown that there is still demand for Intellectual Property (IP) and that the studio consolidation trend is well and alive. The top 10 gaming companies already represent over 65% of the market and that share is set to grow over the next decade. Increased M&A also tend to be beneficial for small-cap as their acquisitions are usually at a premium to their market value.

So how is Global Alpha positioning itself? We currently own Sega Sammy Holdings.

Sega Sammy Holdings (6460 JP)

Established through the integration of game publisher SEGA Corporation and pachinko machine manufacturer Sammy Corporation in 2004, it has historically also been involved in amusement centres and theme parks. A defensive name in our portfolio, the company owns strong and long-lasting franchises, such as Total War and Sonic, which they have a solid history of monetizing. The company has been divesting from its arcade business in recent years to reinvest in its gaming segment, which will allow them to more aggressively acquire studios and IPs, as well as facilitate the distribution of games worldwide.

The company differentiates itself from western game publishers through its diversification in the pachinko and pachislot business, which provides them with a more consistent cash flow than its video game business. Furthermore, their Pachinko and Pachislot business benefits from the economic reopening play where the video game segment would usually suffer. Another differentiator is the labour market in Japan, which is not facing the same wage pressure as seen in the west and therefore did not see the same challenges in retaining talent.

SWOT analysis

Strengths

• Owns popular IPs and strong brand moat
• Diversified complementary revenue stream

Weaknesses

• Margins weaker than peers as it is not a pure play

Opportunities

• Margin expansion from divestment
• Deployment of cash for acquisition

Threats

• Regulatory risk in their Pachinko business
• Fail to produce or obtain exciting new titles/IP

Global Alpha is excited about the long-term growth prospects of the video game industry, and we believe the recent negative sentiment seen in markets worldwide offers good investment opportunities to stock pickers.

China accounts for about 12% of global trade. Covid restrictions have idled many factories and warehouses, and it could prove to have a great impact on local and global businesses. United States (U.S.) and European ports are already swamped from the present supply crisis, leaving them vulnerable to additional shocks.

China’s top exports are broadcasting equipment ($223 billion), computers ($156 billion) and integrated circuits ($120 billion). Top imports include crude petroleum ($150 billion), integrated circuits ($144 billion), and iron ore ($99 billion).

In the short run, the pile-ups will mean more costly headaches for the $22 trillion global merchandise trade. In the mid-term, investments in China will slow as cross-border travel will remain difficult. To give a sense of implications, there are more than 70,000 foreign-invested companies in Shanghai alone.

Chinese Covid restrictions will only accelerate the need to onshore, a theme that has been developing in the last couple of years. For a company, the risk factor of buying key components from foreign countries has become an important consideration among managers on a daily basis. The availability of goods has become critical in competitive landscapes. And, as the saying goes, the downfall of some will be the fortunes of others.

As investors, we certainly look to profit from these disruptions and seek to identify the companies who will gain market share from supply chain disruption or abrupt changes in market conditions, such as changes in tariff regulations.

Lesson learned, in 2017, Global Alpha invested in Solaredge Technologies, a small, sub $1 billion market cap technology firm providing high-quality inverters to the solar industry. At the time, Huawei was to enter the US market and compete heavily on price. The story unfolded where Huawei could not compete technically, and, deterred to enter the U.S. by international trade tariffs, Solaredge has a $12 billion market cap today. We have since exited the position.

Global Alpha believes that the China lockdown and the accelerated onshoring could provide more Solaredge-type opportunities.

Caesarstone (CSTE:US)

Caesarstone is a concept and lifestyle-driven company with a customer-centred approach to designing, developing, and producing high-end engineered surfaces used in residential and commercial buildings globally. The company has two main manufacturing facilities: one in Israel and the other in the U.S.

The company provides high-quality countertops for the professional network of architects and home designers. With time, it has expanded its offering to big box outlets, such as Home Depot, Lowes and IKEA. Its markets are global, with concentrated sales in the U.S., Canada, Australia and Israel.

In the last few years, competition from Chinese countertop manufacturers has put pressure on company margins, as well as demonstrated a deeper need to innovate from quartz to ceramics materials.

Recently, Caesarstone has shown revenue growth, both from the rebound of U.S. construction, as well as a strong focus on its product mix, both in the professional and big-box segments. With a strong presence in the southeastern United States, Caesarstone is also in a good position to benefit from a fast-growing market.

The supply shortages occurring in China could affect Ceasarstone’s competition as Chinese countertops lack availability. We would expect the company to take full advantage of this situation. Long term, non-Asian distributors could increase their relationships with Caesarstone as they implement deeper onshoring strategies.

De’Longhi (DLG:IM)

De’Longhi is an Italian manufacturer and distributor of small domestic appliances worldwide, with operations in the espresso coffee makers, food preparation, comfort and home care segments. The group’s brand portfolio comprises De’Longhi, Kenwood, Braun and Ariete.

The company competes against French company Group SEB and Australian company Breville in many home-destined consumer products. The competition in the high-end coffee maker segment has been notable with Hollywood-level advertising and De’Longhi using Brad Pitt to fend off George Clooney’s success with Nespresso.

With a strong manufacturing base in Treviso, Italy, the company may be able to navigate the Chinese supply issues with some ease. Its competitor Groupe SEB is four times the size of De’Longhi, but mostly because it has global dominance in cookware. As Groupe SEB ferociously competed with the Chinese in cookware, they moved most of their production to China. Today, De’Longhi is in a position to take the market share because of its favoured local production. 

The onshoring theme is providing many strong tailwinds in certain industries. As an example, Taiwan chip manufacturer TSMC is investing heavily in Japan in an effort to diversify from China. In fact, Japan could become a major beneficiary of moving production out of China from its industrial technology leadership, proximity to Asian markets and developed market status.

Kurita Water (6370 JP)

Global Alpha recently purchased Kurita Water in Japan. Founded in 1949, Kurita Water manufactures and sells water treatment equipment and chemicals. Revenue mix by region is Japan at 60%, Asia 18%, and the rest of the world at 22%. Water treatment equipment represents 61%, while chemical sales are 39%, a strong recurring revenue source. The main industry focus of Kurita is the electronics industry, at 63% of revenues.

Water treatment in electronic manufacturing is of high technical standard supporting Kurita’s expertise and leadership in water treatment.

Kurita Water has always been on our watch list for the quality of its products and long history. During the last eight years, it participated in a highly competitive Chinese market. The diversification decision by its clients, such as TSMC to develop chip manufacturing in Japan, should support company growth over several periods.

Globally, inflation has been a main topic of conversation among investors this year, as well as the Fed’s ability to handle it. In the last few commentaries, we shared our views on the ongoing inflationary pressures and why we think the target of 2% is hardly achievable in the near future. Aside from an unprecedented monetary and fiscal stimulus, spiking energy prices and supply chain disruptions caused by Covid and the war in Ukraine, the main driving forces of current inflation include labour shortages and rising wages.

Indeed, it’s what we are currently experiencing and what some experts in the U.S. are calling the tightest labour market in 70 years. During a panel in Washington hosted by the International Monetary Fund, Fed Chair Jerome Powell described the current state of the U.S. labour market as unsustainably hot.[1] According to the U.S. Labor Department’s Job Openings and Labor Turnover Survey, in March 2022, the number of job openings increased to 11.5 million, from 11.3 million in February. Moreover, there were almost two vacancies for every unemployed person, pointing to an intensifying tightness and further wage pressure.[2] These trends are supported anecdotally while businesses from different sectors report difficulties hiring talent and surging labour costs. When we talk to companies in our emerging markets (EM) universe, we get similar feedback with a slightly varying magnitude in different regions.

As much as one wants to credit purely Covid, the fundamental reasons underlying labour tightness started to surface before the pandemic. Demographics, immigration policy and de-globalization trends have sowed the seeds of the current environment. Covid and the fiscal response to it only added fuel to the fire. The working-age population has slowed in many Organisation for Economic Co-operation and Development (OECD) countries since early 2000.[3] Short-sighted immigration policies in some countries have contributed to that slowdown. A tremendous cost advantage that China enjoyed for years winded down by 2015-2016 due to wage growth and demographics. During the Covid pandemic, many governments found themselves navigating through unchartered territory. Some of those responded with massive fiscal stimulus, which created an unprecedented demand for goods and services, and eventually labour.

There is also a social component to the set-up as the relationship between capital and labour undergoes a fundamental transformation. For example, in the U.S., the population has higher savings, and as a result, this means an improved bargaining power over employers. In many instances, employees can dictate working conditions by pushing for more remote work. Low minimum wages became a major political issue a long time ago. Every year, a larger percentage of people of different ages are reported to be suffering from various mental health issues. Covid was an accelerator of many burnouts that happened in the last two years. And it’s far from being an issue only in developed markets.

For instance, the majority of office workers in India are reportedly suffering from enormous pressure because their colleagues are quitting.[4] The pandemic has radically changed how people work and what the job means to them. As a result, it has contributed to “the Great Resignation”. These factors are reshaping how managers think about their employees, as well as their mental health and wellness. CEOs acknowledge that human capital is the most important asset in any business. Engaging in the current wars for talent, employers have no choice but to pay up. Shorter work weeks could become more common as companies across the world are experimenting with a four-day work week. Additionally, a strong corporate culture and Diversity and Inclusion (D&I) policy have become an important differentiator of successful businesses.

We believe the current labour market issues will persist and become the major drivers of inflation. So, how do we position our EM portfolio from this perspective?

• We prioritize companies that exercise a superior level of pricing power, have a strong culture and a track record of attracting and retaining talent, have a solid D&I policy, and are relatively less labour intensive. An analysis of social aspects is an integral part of the comprehensive ESG due diligence that we make on every candidate for inclusion in our portfolio.
  
• We prefer companies with strong balance sheets and industry-leading margin profiles. As labour shortages limit capacity to grow, companies have to gain efficiencies. An economy with excessive demands creates enough incentives for businesses to invest in productivity improvement. Although we acknowledge a time lag between investments made and productivity improvements, we believe that our holdings should come out as winners in the medium to long term.
  
• We look for businesses that can capitalize on this environment, especially those in the automation space.

E Ink Holdings Inc. (8069 TT)

E Ink, based in Taiwan, is the global leader in Electronic Paper Display (EPD) technology. Also known as ePaper, it allows devices to mimic the appearance of ordinary ink on paper and is widely adopted in several end applications, including Electronic Shelf Labels (ESL), eReaders and various IoT solutions.

Unlike LCD and OLED, EPD does not require power to hold an image and consumes energy only when the content is being changed, has no backlight, uses ambient light from the environment and is easy on the eyes. It’s also thinner, flexible and rugged. ESL attaches to the shelves with EPD that show price, sales promotions, and other product information and replaces conventional paper price tags.

Due to wireless data transmission capability, the solution allows for real-time information updates. ESL not only reduces the labour cost associated with a manual replacement of price tags but also minimizes the likelihood of pricing errors and enables stores to quickly improve their efficiency in a highly competitive market. Implementation of in-store technologies and the increasing adoption of smart shelves are driving the continued growth in demand for ESL. The current penetration rate in retail markets is only 4-5%, suggesting plenty of room to grow for E Ink as it commands virtually 100% of the market share in the ESL upstream material supply. The global ESL market is expected to grow at a CAGR of over 18% during 2022-2032 and will exceed US $5 billion by 2032.[5] We like E Ink’s monopoly-like position in a niche market, with strong IP protection, vertical integration, solid R&D capabilities, and placing it in a unique stance to benefit from the rapid industry growth driven by increasing the adoption of ESL, new colour ePaper products, and wider IoT penetration.

Estun Automation Co. Ltd. (002747 CH)

Estun is one of the leading Chinese industrial robot manufacturers, with strong product competitiveness and diversified end-market exposure, including lithium batteries, solar, construction, automotive and consumer electronics. We believe the company is set to benefit from a rising demand for industrial robots in China, given labour tightness and surging wages in that country. After peaking in 2015, the labour force in China has since been on a consistent decline,[6] likely falling victim to the former one-child policy. Moreover, we believe that labour shortages in the manufacturing industry will get only worse due to competition from the new economy companies that lure talent with higher wages and other benefits. Although fighting input cost inflation and supply chain issues in the near term, we believe Estun will be among the winners in the factory automation space, enjoying favourable demographic trends and government policy tailwinds.

Guangzhou KDT Machinery Co. Ltd. (002833 CH)

Based in China, KDT Machinery is a global leader in the production of automated equipment for panel-type furniture, with significant market share growth potential. We like its solid technological know-how, strong cost competitiveness, scale and manufacturing capabilities. As furniture producers globally chase efficiency improvements, automation solutions are expected to enjoy a robust demand in the long term. KDT Machinery not only facilitates the shift from labour to automation in the furniture manufacturing industry, which has been historically high labour intensive, but also contributes to forest protection and CO₂ emissions reduction on the back of panel-type furniture replacing solid wood.

[1] https://www.reuters.com/business/finance/feds-powell-half-point-rate-increase-table-may-meeting-2022-04-21/

[2] https://www.bloomberg.com/news/articles/2022-05-03/u-s-job-openings-rose-unexpectedly-to-record-11-5-million

[3] https://data.oecd.org/pop/working-age-population.htm

[4] https://www.dqindia.com/labor-shortage-in-india-is-real-heres-why-people-are-quitting-their-jobs/#:~:text=According%20to%20a%20new%20study,the%20highest%20in%20any%20region

[5] https://www.prnewswire.com/news-releases/electronic-shelf-label-market-to-reach-usd-5-2-bn-by-2032–latest-factmr-study-301490430.html

[6] https://www.china-briefing.com/news/china-labor-market-hiring-costs-job-preferences-talent-acquisition/#:~:text=Distribution%20of%20local%20workforce,quarters%20of%20the%20US%20population

When most countries are wrestling with rising inflation, Japan is the outlier.

In March 2022, Japan’s consumer price index (CPI) growth was only 1.2% year-over-year, versus 8.5% in the United States (U.S.). Japan’s CPI has risen only 5.5% over the past 20 years, compared to 60% in the U.S.

Inflation rate in Japan (%)[1]

In theory, it is due to a long-term demand-deficient feedback loop.

1. Expectations built up through decades of low inflation or deflation
2. Weak consumer spending caused by aging population
3. Firms’ caution on wage and price increases
4. Stagnant wage growth constrains consumer spending

In reality, for many years, the story goes like this: Anyone under 40 years old in Japan has never really experienced rising inflation. If prices go up, consumers will spend less. Therefore, firms are reluctant to increase prices. To keep costs in control, firms keep wages stable, which does not stimulate consumer demand.

However, since September 2021, the inflation rate has been increasing, from -0.4% in August, 0.2% in September, to 1.2% in March, all due to high commodity prices. On April 26, the Bank of Japan (BOJ) reiterated its commitment to low-interest rates despite rising inflation, saying: “It is most important to support economic recovery by patiently continuing monetary easing.”

At Global Alpha, we are supportive of the BOJ’s policy. Rising inflation in Japan this year is inevitable but desirable. Looked at another way, the present inflationary trend could be an opportunity for Japan to finally escape from deflation.

All our Japanese holdings said they had raised their prices in the past year. According to the Teikoku Databank Ltd survey of 1,855 companies conducted in early April[2], 43.2% of the firms said they raised prices in April or plan to do so by the end of March 2023. When combined with the firms that have already raised prices between October and March, the percentage reaches 64.7% of the total.

The key for Japan to fight deflation is wage increases. According to data by the Organization for Economic Co-operation and Development (OECD), the average annual wage in Japan increased until 1997 to $38,395 and then flattened out. In 2020, the average Japanese workers made $38,515.

In November 2021, Japan’s new Prime Minister, Fumio Kishida, made it clear that raising wages is one of the top priorities for his economic agenda. He urged firms whose earnings have recovered to pre-pandemic levels to increase wages by 3% or more at their labour talks this spring. Prime Minister Kishida also pledged to raise the incomes of welfare workers, such as childcare workers, nurses and caregivers, by 3%, continuously.

Of course, a policy does not lead to easy solutions, considering Japan’s rigid employment culture, the large presence of part-time and contract workers, and a weak yen. The progress is yet to be seen.

Japan has been a very important market for our investments. Despite low inflation pressure and limited geopolitical risk, Japanese stocks are currently trading at an attractive valuation compared to other markets.

Forward Price/Earnings

This year, JPY against USD has weakened by over 10%. The 130 milestone was the highest in two decades. We believe the rate should revert to 100 – 110 in the coming years. Meanwhile, a weak yen benefits exporters and encourages inbound travel. As Japan reopens, we foresee “revenge spending” from in-bound travellers. In 2019, almost 32 million foreign tourists spent 4.8 trillion yen.

[1] Japan Inflation Rate – April 2022 Data – 1958-2021 Historical – May Forecast (tradingeconomics.com)

[2] Get ready to pay more: Over 40% of Japanese firms to raise prices within a year: survey – Japan Today

Higher input prices are having an adverse impact on household sentiment. European sentiment indicator turned negative in March, while UK consumer confidence fell close to an all-time low in April. Surprisingly, U.S. consumer sentiment unexpectedly rose to a three-month high in early April. Although consumers have accumulated savings through the pandemic, we believe that consumers may prioritize leisure spending over discretionary goods in the months ahead.[1]

Not all product categories performed equally in this context of high inflation. Companies that emerged as winners during the height of the pandemic have fallen back since. The streaming giant Netflix reported a loss of 200,000 members in the first quarter, with a forecasted drop of 2 million this quarter. The company blames the password-sharing business for the loss in subscribers. Netflix, which is already the most expensive streaming platform, has recently increased its pricing in some Latin American countries for sharing accounts between households.[2] With an increased offering of streaming platforms at the same time as consumers are shifting their dollar spending elsewhere, it will be interesting to see how loyal subscribers are.

There are still areas in the economy where demand for goods remains robust. Companies associated with recreational and outdoor activities seem to report strong trading updates. Companies like POOLCORP, Tractor Supply Co and Gardena have benefited during their latest publications compared to last year.[3],[4] In general, we feel like the big ticket items could experience a growing trend going forward. On the other hand, food, health, and some services linked to the post-pandemic reopening might still experience robust growth.

There are some interesting data points that suggest strong spending patterns in service-related categories:

• OpenTable data suggests that consumer demand for restaurants continued its upward trajectory as of April 19, 2022. The Dining Out index, which tracks restaurant reservation data for approximately 20,000 restaurants across seven countries, shows that so far in 2022, the number of seated diners increased by 24% in the UK, 17% in the U.S. and 45% in Germany. Historically, higher gas prices have negatively impacted restaurant consumption as consumers change their eating habits, but this time around, consumers seems to be holding on to that spending category.

• Airlines and hotels have also seen an important surge in demand. Delta Air Lines returned to profitability during March, thanks to a passenger revenue that is back to 75% of pre-Covid levels. According to a survey conducted by the World Travel & Tourism Council, travellers are currently planning on spending more on travel leisure than they have in the past five years. [5],[6]

As the economy and consumer behaviours turn more towards services over goods, the exposure to small caps could provide investors with some upside.[7] Small caps, which tend to be more domestic, seem to have a stronger representation of services as opposed to goods. According to the Bank of America, the S&P 500 index derives around half of its earnings from spending on goods, whereas the Russell 2000 index generates only a quarter of its earnings from spending on goods.

Small-cap indices have a better representation of leisure services when comparing it with the S&P500. The weight in the leisure industry services is approximately 1% for the S&P 500 index, as opposed to 3% for the Russell 2000 index.

Some companies we own should benefit from that spending pattern:

Autogrill is the global leader by revenue in the F&B concessions market in airports, motorways, and railway stations. Autogrill and its subsidiary, HMSHost, manage a portfolio of about 300 owned and licensed brands in over 30 countries, including proprietary brands (Spizzico, Puro Gusto, etc.) and third-party franchises with a particular emphasis on global brands (Burger King, Starbucks, etc.).

Meliá is one of the leading European hotel groups; it owns and manages more than 326 hotels and resorts in 33 countries, mainly in America and Europe. Now that the majority of travel restrictions have been lifted, Meliá is seeing an uptick in demand for its leisure hotels. The Easter holiday was strong, and booking trends for the upcoming summer look firm. Although wider concerns around consumer softness are unlikely to completely fade at this stage, investors are likely to focus on mix shifts and changes in demand across product categories. Companies that have continued to invest and managed to enlarge their market positioning should be in a better position to offset the broader market slowdown.

[1] https://www.reuters.com/world/uk/uk-consumer-morale-plunges-near-all-time-low-april-gfk-2022-04-21/

[2] https://www.google.com/amp/s/www.cnbc.com/amp/2022/04/19/netflix-nflx-earnings-q1-2022.html

[3] https://finance.yahoo.com/news/zacks-analyst-blog-highlights-j-113011500.html

[4] https://www.google.com/amp/s/www.marketscreener.com/amp/quote/stock/HUSQVARNA-AB-PUBL-6498674/news/Husqvarna-Group-INTERIM-REPORT-JANUARY-MARCH-2022-Strong-demand-but-sales-affected-by-supply-ch-40125061/

[5] https://www.hospitalitynet.org/news/4110148.html

[6] https://www.barrons.com/articles/-travel-booming-again-hotels-airlines-51649890847

[7] https://financialpost.com/pmn/business-pmn/two-speed-euro-zone-economy-as-services-shine-factories-struggle-pmi