Global Small Cap Strategy Quarterly Commentary – CAD
30 septembre 2023
Macro-driven is an apt characterization of the markets year to date. With the third quarter now behind us, let’s assess the landscape.
US markets have spent the better part of the last 12 months debating the likelihood that the Federal Reserve (the Fed) will keep rates higher for longer. It is becoming increasingly clear that the Fed is unlikely to change its stance, as doing so would jeopardize its long-term credibility. This has led US 10-year yields to reach levels not seen since before the Great Financial Crisis (GFC).
Parallel to this, discussions around the ability of central banks to orchestrate a soft landing have yielded conflicting opinions, with a variety of data points to support either scenario. The Global Alpha team tends to think that a hard landing scenario is more likely. Excess savings accumulated during the pandemic in the US have largely been spent, except among the highest-earning households. Meanwhile, credit quality for items like credit cards and auto loans is deteriorating as rates rise to counter inflation. Also, China is unlikely to serve as the globally deflationary force it once was, given the increasing scrutiny on structural issues in its economy.
In Europe, small-cap stocks are trading at their lowest P/E multiples relative to large caps in 20 years. A mix of weak industrial activity and consumer demand, in addition to geopolitical dynamics, has led to significant outflows from small-cap to large-cap investments. As a result, the total return drawdown between European small caps and large caps over the past two years now exceeds the maximum drawdown experienced during the GFC. While there is no immediate, obvious catalyst for change, it would not take much to shift sentiment favourably toward this asset class.
Asia presents a more complex picture. Concerns linger about China’s consumer recovery, which has lagged expectations. A weaker Chinese consumer is impacting global demand for various products and commodities such as copper have seen increased inventories leading to a contango situation in their future contract curves. Nonetheless, there are reasons to be optimistic about China, as detailed in our commentary from October 6.
Japan is seeing short-term recovery signs as well as structural changes to its economy that point to a transition from prolonged deflation to a more stable inflationary environment. Supporting this are rising wages, which increased by 3.58% in April 2023 and are expected to grow by another 3% next year.
BACK TO GLOBAL SMALL CAP
During the third quarter, the MSCI World Small Cap Index underperformed the MSCI World Large Cap Index but outperformed the MSCI Emerging Markets Index.
Within the MSCI World Small Cap Index, energy, which represents 5.7% of the Index, was the strongest-performing sector, delivering a 19.0% return. Healthcare was the worst-performing sector, returning -10.9% for the quarter, with an Index weight of 9.9%.
GLOBAL ALPHA PERFORMANCE HIGHLIGHTS
Over the same timeframe, our Global Small Cap composite delivered a -4.2% gross return, underperforming the MSCI World Small Cap Index by 1.8% (gross).
Chico’s FAS (CHS US) was our top performer for the quarter. Founded in 1983 and headquartered in Fort Myers, Florida, Chico’s underwent a turnaround in 2019. It has since seen the return of growth, attributable to reduced discounting and increased customer diversification.
With the average American woman spending between $2,000 and $5,000 annually on clothing, Chico’s, with its strong brand recognition, stands to benefit. As part of its turnaround, the company has invested heavily in its online presence, which now represents more than 40% of its total sales.
So, what drove the stock up?
Chico’s acquisition by Sycamore Partners for $7.60 per share was announced in late September, valuing the company at $1 billion and representing a 65% premium to its previous closing price. The deal is expected to close in Q1 2024, but Global Alpha has started unwinding our position as the company is trading closely to its acquisition price and we see alternative investment opportunities.
Another major contributor for the quarter was L’Occitane International S.A. (0973 HK), a French company listed in Hong Kong that manufactures, markets and retails natural and organic skincare and beauty products. The company has over 3,400 retail locations in 90 countries and its main brand, L’Occitane en Provence, represents most of its sales and is well-known for its quality at an affordable price.
The size of the global beauty market is estimated at US$240 billion and growing between 3% and 5% per year, driven by demand in Asia. L’Occitane benefits disproportionately from this trend as its brand recognition in China outshines many of its Western competitors.
So, what drove the stock up?
L’Occitane stock shot up in the quarter driven by a rumour that the company’s chairman and controlling shareholder, Reinold Geiger, was considering taking the company private as its stock price was not reflecting the company’s true value. However, the stock pulled back somewhat after Geiger announced his decision not to proceed with an offer. Investors were nevertheless left with renewed interest in the company and its fundamentals remain strong. It continues to enjoy solid sales momentum, driven by the recovery in its core brands and strong growth in newly acquired ones. We remain happy long-term shareholders.
Our top detractor for the quarter was Omnicell Inc. (OMCL US). Headquartered in California, Omnicell is a leader in automated dispensing cabinets for pharmacies and hospitals. Its products are appliances enriched with significant software content that helps track, store, acquire, dispense and administer medications and supplies in hospital settings. The company has a presence in roughly 50% of US hospitals and 80% of the retail pharmacy sector.
Medical management, particularly medication management, is a complex and resource-intensive aspect of healthcare given the high level of customization each patient requires. Omnicell’s solutions offer added value on two fronts: reducing the resources required to provide the service and reducing the risk of human error.
What drove the stock down?
Going into Q3 earnings, the company’s stock was up over 25%. Despite beating analysts’ estimates and modestly raising its sales and EBITDA guidance, the stock hit a 52-week low by the end of the quarter. Investor concerns around bookings, amplified by healthcare customers facing capex budget constraints and the risk of minor regulatory headwinds in its advanced services segment, led the stock to lose all of its momentum. Nonetheless, Global Alpha remains positive on Omnicell. The long-term trend favouring medication automation is robust and the company’s fundamentals and market positioning continue to be attractive.
We concluded the quarter with a new position in Ipsos Group SA (IPS FP), a name we also hold in our international strategy. Ipsos is a market research company specializing in survey-based research, with the entirety of its revenue stemming from custom research projects. Founded in 1975 and publicly traded since 1999, Ipsos is a well-known brand that initially grew aggressively through acquisitions to expand in new jurisdictions. Its more recent acquisitions of Synovate and GfK helped elevate it to become the world’s third-largest market research company while consistently outperforming its peers.
Our team likes the exposure provided by Ipsos. Although its revenue is cyclical, the stock has been trading at a significant discount to its peers due to legacy COVID-19 contracts that are now expected to be resolved. Ipsos is now showing signs of positive momentum and we are confident in its ability to outperform competitors in a variety of environments.
OTHER NEW BUYS AND SELLS
During the quarter, we also added a new position in Cogent Communications Holdings Inc., Diodes Inc., Cerence Inc. and Hexagon Purus ASA.
We exited Rothschild & Co., LISI SA and OneSavings Bank plc.
WHAT IS OUR EAR-TO-THE-GROUND APPROACH TELLING US?
It has been a busy quarter for the Global Alpha team, filled with various conferences, trips and company meetings. Given the multi-year lows in small-cap valuations, we are finding many investment opportunities in companies that have solid fundamentals but are undervalued, as investors seem to be selling any name that does not show positive momentum.
We are not making major adjustments to the portfolio’s sector or country allocations based on these observations. Rather, we are maintaining a diversified set of holdings with defensible business models that are trading at a discount to their intrinsic value. Our portfolio remains well-diversified across the many countries, currencies and industries that comprise our benchmarks.
The Global Alpha team