article 09-03-2015

Searching for Sustainable Growth in Malaysia

As an active manager with a value orientation, Portfolio Manager Dilip Badlani seeks to locate inexpensive companies helmed by management teams that have demonstrated an ability to consistently execute plans to grow their business irrespective of economic conditions. Though not without its challenges, Malaysia's history of perseverance makes it an attractive market for disciplined and patient investors.

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What do you find interesting about Malaysia?

This was my second visit to Malaysia since I joined Royce and my fifth historically. It's the twenty-third largest exporter in the world and, according to a 2014-2015 report by The World Economic Forum, is also one of the globe's most competitive countries.1 (It's also the thirty-fifth largest economy in the world and the third-largest economy in the Association of Southeast Asian Nations, also known as ASEAN.)

Additionally, Malaysia is far more developed than one might expect from an emerging market country—the infrastructure is first class, and the roads are well maintained. Malaysia was also the first of its neighboring countries to recover from the 1998 Asian financial crisis, which suggests to me that it has the wherewithal to overcome setbacks of a seemingly calamitous nature. This is especially significant considering what's been happening on the ground as of late.

What's your view on some of the country's current challenges?

As with any emerging market, there are positives and negatives to investing in Malaysia. On this particular trip, the negatives far outweighed the positives. The country's most recent challenge has been a corruption scandal involving Prime Minister Najib Razak and the sovereign investment company 1Malaysia Development Berhad (1MDB). Evidence surfaced in early July which revealed that nearly $700 million was transferred from 1MDB directly into the prime minister's personal accounts.

Given the country's record of progress and position within the emerging market community, I don't think the 1MDB scandal is something investors would have typically expected. While corruption is often an issue in the emerging markets, this negative attention has caused an effective standstill of any decisions being made in the country and a removal of confidence from business leaders and foreign investors.

To me, the scandal is unfortunate, most particularly in its timing—coming during a period when the country's economy is slowing. Clearly, structural reform is needed. But reform usually comes as a result of crisis, so maybe this hopefully temporary headwind will be a catalyst for change. The best solution is likely patience—which we apply heavily here at Royce.

Another critical issue is Malaysia's dependency on exports. The country is a large producer of commodities, particularly oil and agricultural resources. With agriculture and oil prices being down, Malaysia is suffering. As external consumption from its neighbors is slowing, particularly in China, Malaysia is seeing reduced demand for its largest exports. With global GDP slowing, it has seen a deceleration in its own GDP. According to the Nikkei Asian Review, real GDP growth slowed from 5.6% year over year in 1Q15 to 4.9% year over year in 2Q15, a decrease caused primarily by a weakness in exports.2

How do you seek to mitigate risk in tumultuous environments such as Malaysia's?

We're always vigilant; we always want to approach our investments with a cautious eye. Being mindful of the investment landscape is the first step. In Malaysia, the situation could get worse—the potential for capital controls, for example, is not unlikely—they were put in place during the Asian financial crisis. We are already seeing investors remove capital from the country at an estimated rate of $2 billion a week. The Straits Times, an English-language newspaper based in Singapore, has reported that Malaysia's foreign reserves have fallen to a six-year low of $94.5 billion and are down 19% year to date.3 

But as long-term investors, near-term headwinds—even significant ones—may offer attractive buying opportunities. So we want to be on the ground, meet with as many management teams as possible, conduct field research, and do our due diligence. I have gotten to know the heads of research at several different research houses in Malaysia, which helps in identifying companies with good corporate governance—they know the good actors and the bad ones. I also have a valuable network of CEOs and analysts who I can reach out to very quickly to get a good grasp of the situation on the ground.

Can you talk about your criteria for stock selection?

What's important to remember is that wherever you are in an economic cycle, there will be businesses that benefit and businesses that won't. Our role as active value managers is to locate the former and purchase them at a discount to what we consider to be the intrinsic value.

What's important to remember is that wherever you are in an economic cycle, there will be businesses that benefit and businesses that won't. Our role as active value managers is to locate the former and purchase them at a discount to what we consider to be the intrinsic value. Given what's happening in Malaysia, this seems as good a time as any to be paying attention. Just because the economy isn't growing as quickly doesn't mean you can't find cheap stocks.

In Royce International Small-Cap and International Micro-Cap Funds, we like to focus on companies that are growing irrespective of the market environment. This is either because they operate in a small niche where they can continue to take share or that part of the market is growing. Generally, we want to own companies with sustainable growth.

We own Scientex Berhad, a Malaysian packaging company that has been growing by taking organic share in the country. The company is blocking and tackling as it's adding multinational companies to its portfolio of customers, which it's able to service more efficiently than some of the smaller players. The company is run by local entrepreneurs, which is important because they know the way the country functions, the issues, and how to get around them.

Additionally, I'm constantly in touch with management teams to ensure that they are doing what they say they're going to do. With small-caps especially, you want to see consistency of thought and consistency of execution. Quite often you meet a management team for the first time and their plans sound great, but without knowing the history of that company or that management team, there are potential pitfalls you can fall into.

How does currency factor in Malaysia's export orientation? Where are you seeing opportunity, especially as demand for many of the country's exports has weakened?

The currency has weakened immensely—the Malaysian ringgit is close to a 20-year low and has declined by more than 20% against the dollar year to date—so many exporters are actually seeing their positions get stronger. One example would be Kossan Rubber, a rubber glove manufacturer that I met on my first trip to the country in 2006. The primary competition for Malaysia's rubber glove industry comes from Thailand, and the Thai baht has not depreciated as much as the ringgit, so the competitive positioning of the industry in Malaysia has only gotten stronger even as other areas are not faring as well.

The company's selling prices are all in dollars or euros, and a weaker ringgit benefits the company. To us, long-term demand for rubber gloves appears sustainable—the use of rubber gloves is shifting from just healthcare demand to food services and other industries. Additionally, the price of its input, which is rubber, has fallen along with the prices of other commodities.

The rubber glove industry is a classic example of an industry that we believe has a long runway for growth, despite what's happening in Malaysia. Increased hygiene awareness globally really benefits Kossan. Of course, there are a lot of different glove companies we could own. The reason we like Kossan is because it has a long history of execution and a high degree of management competency. I think three years from today the earnings from this company could be much higher, and the stock price could move higher as well.

Do you have any final takeaways about Malaysia you'd like to share?

My overall takeaway from the trip was that investors seem likely to be in for some more pain, but if you look hard enough there are still plenty of opportunities to buy quality businesses at below average prices. Ultimately I think rationality will take charge, and Malaysia will resume growth—it's more a question of how long you're willing to wait.

Historically, Malaysia has been viewed positively by foreign investors. I think current events appear more alarming because, at least in recent memory, we haven't typically seen this kind of behavior in the country. Again, given Malaysia's history, I believe the country has the ability to eventually turn itself around.

Important Disclosure Information

Dilip Badlani is a Portfolio Manager of Royce & Associates, LLC, investment adviser to The Royce Funds. He serves as a portfolio manager of Royce International Small-Cap Fund, Royce International Micro-Cap Fund, and Royce Global Value Fund. The thoughts and opinions expressed in this piece are solely those of Mr. Badlani and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce International Small-Cap and International Micro-Cap Funds invest primarily in small-cap and micro-cap stocks, respectively, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Funds may invest a significant portion of their assets in foreign companies, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, currency, or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) In addition, as of 6/30/15 the Funds invested a significant portion of their assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Funds' overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.)

Percentage of Fund Holdings as of 8/28/15 (%)

  Scientex Berhad Kossan Rubber Indust. Berhad
International Small-Cap 0.00 0.63
International Micro-Cap 0.66 0.00

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security

1 http://reports.weforum.org/global-competitiveness-report-2014-2015/rankings/
2 http://asia.nikkei.com/Politics-Economy/Economy/Growth-slows-to-4.9-as-exports-ebb
3 http://www.straitstimes.com/business/economy/malaysias-reserves-fall-to-6-year-low-of-us945b-as-global-currency-rout-deepens

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