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Commentary

Strong and steady for 2023

December 22, 2022

Image of human hand stacking generic coins over a black background with hexagonal golden shapes. Concept of investment management and portfolio diversification.

As discussed recently, inflation will be supported by low unemployment in 2023. This could be described as a classic inflation gap, as we expect a wave of salary adjustments persisting well into 2023.

Many important factors will keep unemployment at low levels. These include:

  • Demographics, especially in the U.S. where more and more Baby Boomers are accelerating their exit from the workforce, following a difficult COVID period.
  • Many developed countries halted immigration during COVID, causing backlogs compared to normal intakes.
  • Long COVID among many workers has been keeping them out of the workforce for lengthy durations.

As economic data comes out, high interest rates are beginning to affect the economy, as reported by the recent consumer price index (CPI) report. Weakening demand mixed with higher costs will weigh on corporate profits in 2023. The good news is Global and EAFE Small Cap valuations are at their lowest since the 2008-2011 period. These low valuations could provide stock price support as corporations reduce their profit guidance. As well, sentiment is at multi-year low and can only improve.

So, where to position in an economic downturn? Warren Buffet once famously asked, “What was the most popular chocolate bar in 1962?” Snickers, he answered. And what was the most popular chocolate bar in 2020? Snickers. Focus on what is resilient is the moral of this story.

The second anchor in a downturn is balance sheet strength as interest expense for many corporations start to rise. Recent Federal Reserve statements forecast a lengthy period of elevated interest rates. And the recent Carvana debt debacle will not be the only one. We certainly feel that many companies and analysts are too conservative in their medium-term (i.e., two year) interest rate outlook.

A third anchor relies on themes and long-term positive industry trends. Stocks with high exposure to critical, well-supported trends (renewables or onshoring, for example) will certainly help weather markets suffering from consumer demand decelerations.

Our portfolio companies hold substantial net cash war chests, and they have important M&A growth options during a slowdown. Let’s have a closer look at some holdings.

Several of our firms have net cash as a percentage of their market cap at a level greater than 10%. These include: Mabuchi Motor Co., Ltd. (37%), LINTEC Corp. (28%), SEGA SAMMY Holdings Inc. (17%), THK Co., Ltd. (12%), and Globus Medical, Inc. (11%). In addition, Ain Holdings Inc., Sakata Seed Corp. and Daiseki Co., Ltd. are all at 10%. This is only a short list of holdings at or above the 10% mark. Many of our companies have simply no debt.

What is even more reassuring is that a variety of tailwinds benefit our holdings. Let’s take SEGA SAMMY (6460 JT) for example. The Japanese gaming provider has transformed into an integrated entertainment powerhouse. Born from gaming, Sega’s Sonic the Hedgehog brand has been featured in movies, including a recently launched Netflix animated series. Additionally, the entertainment company’s newest 3D Sonic game, Sonic Frontiers, has sold more than 2.5 million copies worldwide since its launch in early November.  

Mabuchi Motor (6592 JT), the leading small motor provider out of Japan, is flush with cash and has no requirement of large expansion capex. Small motors are growing faster than many industrial markets due to increased demand for robotics. Moreover, the market in which Mabuchi operates is highly fragmented. The company can certainly use its cash for highly accretive acquisitions in the future.

At 11% net cash, Globus Medical is a quality anomaly in the medical technology world. The U.S.-based provider of orthopedic devices and robots is clearly a technology leader. Its surgical robots increase productivity four-fold in terms of successful back surgeries. As the company will ultimately see a peak penetration for its robots, it will be in a strong position to accelerate new innovations either by development or acquisitions.

Many of our companies demonstrate three key attributes:

  • product resilience,
  • positive tailwinds, and
  • balance sheet strength.

Product resilience can come in many forms and can be found in types of business models: Software as a Service (SaaS), maintenance services, and long-term fixed agreements, just to name a few. Global Alpha initiated in Reliance Worldwide Inc. (RWC AU). The Australian company is a leading provider of emergency plumbing equipment sold through global retailers such as Home Depot and Lowes. Reliance Worldwide’s sales performed well during the 2009 real estate collapse, and we feel its sales will hold up equally well in current market conditions.

Net cash is not the only way to uncover balance sheet strength. One of our holdings, Meliá Hotels International (MEL SM), recently went through an asset valuation analysis with CBRE. The Spanish hotel owner and operator is presently benefiting from strong volumes from its quality portfolio of hotels. The CBRE valuation of real estate assets came in at € 4 billion. This is against a debt level of € 1.3 billion and a market cap of € 1.1 billion.