Is It Time for International Small-Cap?
article , video 08-16-2017

Is It Time for International Small-Cap?

Portfolio Manager David Nadel makes the case for international small-caps.


What's working in International Premier?

Well, I think a lot of things are working right now. Certainly, when I think about what's working, I think less in terms of sectors and countries and more in terms of business model types.

So, we invest in four business model types: perennials, which are companies that, like a flower, you plant once and they keep blooming; differentiators, companies with high portions of intellectual property that we think are sustainable; market structure companies, companies where the structure of the market itself subdues competition. And then cost leaders, which is our smallest category of companies.

And I would say that the perennials are working particularly well. A lot of these are what I would call spares-and-repairs business models, so they have an upfront product that they sell, but they get a lot of their revenues and an even larger portion of their profits typically from after-market support.

The UK is particularly strong at those types of businesses. So, despite the fact that the UK is facing Brexit, that business model type is working for us.

You know, we faced six years of pretty much unidirectional appreciation of the dollar; the dollar appreciating about 30 percent against the basket of currencies. And so far this year, we've had finally, a little bit of a reprieve from that trend.

Why international small-cap now? What makes the asset class a timely investment?

I think that international small-caps look very timely at this juncture for reasons of dividend yield. That's certainly on the timely side.

Dividend yields abroad are substantially higher, as you would expect with that type of valuation discount. And I guess the last thing worth mentioning is that operating profit margins or profitability of international companies still have a lot of scope for recovery. So you've had a slower recovery from the global economic crisis, and you have more scope for margin recovery. And we're beginning to see that with some of our companies.

Is there a timely argument within international, for small versus large?

In terms of timeliness, international small-cap, you know, certainly tends to do well in both rising and falling rate environments. But it does even better on a relative basis versus international large-cap, in a rising rate environment than in a falling rate environment.

And if you think about, you know, German Bunds being at 25 basis points, we're probably headed into a rising rate environment more likely than a falling rate environment. So, that, as I say, outperforms in either scenario, but it's a more dramatic outperformance in rising rate environments.

From your contacts with companies, are you hearing about economic acceleration outside of the US?

I think the consistent theme is one of confidence. Another consistent theme is one of slow but steady operating margin improvement, and I think a third theme is slowly chiseling away at market share position, so companies gaining a little bit of market share each year among the investments that we have.

Our companies tend to be globally structured. They tend to have quite a bit of exposure to emerging markets. And because they are typically global number one in their fields, maybe a small niche, but they're the leading business in that field, the gold standard; they find the place in the world where there's growth, and that may be one emerging market one year, or another developed market the next year.

International small-caps have been strong in 2017. How long can you think this will last?

It is the beginning of a normalization with international investing. I think there's a few reasons why things can get better. I think there's a long way to go. I think we're maybe in inning one of a nine inning or even extra innings game. When you look at the relationship between international small-cap and domestic small-cap, in terms of how they've performed over the last, you know, on a rolling ten-year basis. You've had six years of underperformance, before January of this year, six years of underperformance of the international small-cap versus domestic small-cap. And so, that relationship actually hit a two-standard deviation low at the end of last year. So, when you think about this outperformance this year, it's really a blip in what the asset class is capable of.

And I think that this is not even terribly significant in terms of the asset class returning to its longer-term track record of outperforming.

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the person speaking as of July 12, 2017 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.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. All performance information is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

There can be no assurance that companies that currently pays a dividend will continue to do so in the future.

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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