Thu, 21 Jun 2012
Royce Funds' David Nadel discusses how non-U.S. cultures influence dividend payers, why Europe thrives on exports to emerging markets, and a growth story in Africa.
Bridget Hughes: Hi. I am Bridget Hughes. I am one of the mutual fund analysts here at Morningstar, and I am here with David Nadel at the 2012 Morningstar Investment Conference.
Thanks David for joining us.
David Nadel: Thanks for having me, Bridget.
Hughes: David, you joined Royce in 2006 to kind of help with the international offers. I was just curious in the past six years, how have things gone on that front and how has Royce as a firm changed, which is predominantly a U.S.-focused small-cap investment shop, to bringing in international resources?
Nadel: Well, Royce has been investing in smaller companies for 40 years and started to invest in non-U.S. smaller companies in the late 1990s, so about 12 or 13 years ago. And I joined in 2006, and essentially what's happened since my arrival is we have more or less institutionalized the approach to investing outside the U.S. So, we now invest abroad in all the same sectors that we've invested in domestically.
We've also grown out a team of portfolio managers and analysts numbering six on that side, and then one trader plus supportive, basically a half of another person, on the trading side. So, we really have a full kind of infrastructure; we opened up an office in London for our British analyst, who covers our Eastern Europe, Middle East, and Africa region for us. That's essentially the progress that we've made.
When I joined in 2006, non-U.S. companies I think constituted about roughly 4% or 5% of the assets under management at Royce and they are now closer to 15% or 16% of the AUM. So, Royce is still primarily a domestically focused small-cap manager. But we have an offering of seven non-U.S. funds, and we have worked also a number of international companies into the well-known domestically oriented portfolios that Royce has been known for, for many decades.
Hughes: You're a manager or comanager on several of the funds, one of them being the Global Value Fund.
Hughes: So I thought maybe we could talk about as you look at the world--that has a pretty flexible geographic mandate--where are you busiest? Where are you seeing the best opportunities?
Nadel: Well, in the context of the Royce Global Value fund, the opportunities have changed since we launched the fund. I think when we launched the fund in the very beginning of 2007, the world was certainly embracing risk and investors really had to pay a premium for non-U.S. companies over U.S. companies at that time. And emerging-markets companies were very hot, so they were the most expensive. And we found a relatively strong value in companies that were based in the U.S.
So, when we launched the fund, we had about a 50% weighting in the U.S. About half of the assets were domiciled in the U.S., and in the wake of the global economic crisis, 2008, fall of 2008-spring of 2009, there was enormous wash-out of emerging-markets companies and European companies, more so than in the U.S. Suddenly, valuations became much more attractive outside the U.S., and we moved within a matter of a couple of quarters from about a 50% U.S. weighting to about a 15% U.S. weighting.
The opportunities do shift, but there are certain themes which have been consistent in this portfolio since the get-go, which is that we want to be quality-focused, as all of Royce is, and so we do have a bias in favor of companies that are based into the developed markets, selling to the emerging markets. Where we invest directly in the emerging markets, we like long operating histories; we like companies that have a good disclosure and good corporate governance. So, that part doesn't change.
But with opportunities in individual markets, there are certain catalysts that can really change the profile. I guess another example I'd cite is Japan. We were visiting companies in Japan in March of last year, and we were actually leaving the country when the earthquake struck. At that time in the Royce Global Value fund, we had about a 6% weighting in Japan, and we came back and doubled that weighting because our conviction had not changed really in these companies, but the Nikkei of course after it was closed for a couple of days opened sharply down.
Hughes: You mentioned emerging markets, and I want to talk a little bit about emerging markets. We hear about that getting exposure to the emerging markets through large-cap multinational companies is a very, very popular way to do it, and of course, investing directly in the emerging markets is another way to do it. But as a small-cap investor when you're looking to invest in the emerging markets through exporters, is there a big group for you to choose from? Is that an easy way to get access to emerging markets?
Nadel: I think it's a wise way to get access to emerging markets. I'm not sure how easy it is. It's been easy enough for us. One of the key parts of the world that we go to for that type of profile, a developed market, a company selling to the emerging markets, exporting to the emerging markets is Europe. First of all, from a valuation perspective, Europe is extremely appealing at this point, trading basically at a 35%-40% discount to the U.S. in terms of trailing seven-year cyclically adjusted earnings, things like that.
But Europe for decades has been forced to think pan-regionally, even globally. If you're a Swiss company you can't sell to just the Swiss; you've got an 8 million-person population or 10 million-person population. The same is with the Fins or the Austrians. A lot of these companies are globally structured essentially, and even when you look at the large-cap area, the exposure of European companies to the emerging markets is about double what it is for U.S. companies.
You have a mentality in Europe that's different than it is here. In the U.S. you can be a $2 billion or $3 billion company and sell just to Americans because there are 300 million of them, they all speak the same language, and it's very convenient. But I think the U.S. is a little bit behind in terms of its globalization, in terms of the structure of its businesses. And Europe is a very target-rich environment for us to stick with a developed-market strategy.
Japan is also an appealing market for us in that sense. Japan is viewed I think by a lot of world as being quite insular, but I think [the companies in Japan are] starting to come around quite a bit. The companies that we're focused on are export-oriented. At least in the Global Value fund, one of our top holdings is a company which is in the convenient-store business, and 60% of its store base is outside of Japan, spread across Asia in growth markets. But [the non-Japan operations constitute] only 10% of [the company's] net income. So, you can see over time this is going to grow as a portion of its earnings.
We are invested in a pharmaceutical company that is Japan's number-one firm in ophthalmic pharma, but it is also China's number one in ophthalmic pharma, eye-related pharma. And so you can find these profiles in those markets while staying within a small-cap range. People are often surprised to hear that many of our companies occupy global number-one or global number-two market positions in their niches. Sometimes, these are very small niches.
We're invested in an Austrian company called SEMPERIT, which has a global number-one market share with 50% of the global market in escalator handrails. I mean this is not a sort of a business that people think of in terms of market share, but the firm dominates certain aspects of specialized rubber products. So, that's the type of profile we often find in developed markets.
Hughes: Now, we could talk about Europe and Japan forever, but I just want to ask you one other question. We were talking about emerging markets, and you said to me that six of the 10 fastest-growing economies over the past decade have been African. I imagine these are very small markets in and of themselves, so how do you get access to that kind of growth?
Nadel: Well, it's sort of an eye-popping statistic because if you were to ask which continent has had six of the 10 fastest-growing economies, I don't think a lot of people would have guessed Africa. Some of them are relatively small markets, but there is quite a renaissance or a growth story going on in Africa that's quite exciting.
We've chosen to access a lot of the African growth through South Africa, which is I think quite a shareholder-friendly emerging market, at least as emerging markets go. There's certainly an Anglo-Saxon legal tradition. Very profit-oriented the businesses are, most of them manage for returns on invested capital, and disclosure and kind of corporate governance tend to be at a higher standard than in some other parts of Africa. But South Africa really is at the nexus of all things sub-Saharan Africa, and that's where a lot of the growth is.
So, one of the companies we are invested in is a company called Raubex. Raubex is in the business of road construction and dam construction, and it has about a 40-year operating history, a family-founded business. I've traveled a fair amount in this part of the world, and the quality of the roads is quite poor. So, the firm has a lot of growth ahead of it. It's also quite an annuity business because roads constantly need to be repaired, and Raubex has a scale advantage over its competitors and a return-on-invested-capital focus that we really like. The firm is kind of at the trough of its profitability levels, and it is still producing about a 20% return on invested capital. Our threshold is about 15%, so the firm better not get much lower, but a normalized return for Raubex is more like 30% or 40%, so it's really quite a good business, again, with nice growth possibilities. It operates in about six or seven African countries.
Hughes: And how do you think about valuation for that company?
Nadel: So, Raubex is a very small company. It's about $300 million market cap. I think about valuation really in terms of its normalized earnings potential, but at its depressed levels of earnings, and these are really historically low levels of earnings, the company is trading at about 4 times operating income. So maybe it's about 6 times after-tax earnings and pays about a 5% dividend. So, I think valuation is pretty attractive, and obviously if the firm can come back towards more normalized levels of return on invested capital and operating margins, you are talking about multiple expansion.
Hughes: Just one last question I'll throw on at the end because you said dividend. I know that [Royce Funds president] Chuck Royce has been a big proponent of small-cap dividend investing for a number of years. Do you find a lot of dividend-paying small-cap emerging-markets companies?
Nadel: We do actually, it's really interesting. To me, once you leave the U.S. borders, dividends are almost guaranteed in the type of businesses that we look at. We don't seek out dividends, we don't scream for dividends, and we won't reject a company for not paying a dividend. But a lot of companies outside the U.S. are still in family control, and the culture of dealing in your own shares, of selling and buying your own shares is kind of frowned upon in a lot of societies outside the U.S. So, as a source of income, dividends become very important to those families and to the senior management of the companies.
So, they will often commit to a dividend payout ratio as opposed to a dividend yield. They'll commit to a fixed portion of their net income coming from dividends, and that's a comforting thing for an investor. You know that they've got skin in the game if they are doing that, and I think dividends are very common outside the U.S. I think in the Royce Global Value fund, if I am not mistaken, every non-U.S. company pays a dividend. And again, we haven't chosen them; it's just prevalent.
Hughes: Well, thank you very much for joining us today.
Nadel: Thanks very much, Bridget. I enjoyed it.