This fund has outperformed with stocks that are ripe targets for other companies

By Philip van Doorn

Managers of the Harbor Capital International Small Cap Fund look for compelling valuations for stocks outside the U.S.

Here's a look at another strategy to continue a series of articles about ways to diversify beyond broad index strategies in the stock market.

The $340 million Harbor Capital International Small Cap Fund seeks long-term capital growth in developed markets outside the U.S. The fund is subadvised by Cedar Street Capital Advisors of Chicago and has been co-managed by Cedar Street founder Jonathan Brodsky and the firm's chief investment officer Waldemar Mozes since 2019.

During a MarketWatch interview, Brodsky and Mozes described their strategies for selecting stocks, focusing on one in particular: Holding shares of companies that might become targets for acquirers that would presumably pay premiums for the stocks, or that are ripe for other types of corporate actions that would increase value.

Previous stories in this series:

This quality approach to a cheap part of the stock market garners a five-star ratingThis ETF is beating the S&P 500 - and it's completely different from the index

The Harbor Capital International Small Cap Fund is rated four stars (out of five) within Morningstar's "Foreign Small/Mid Value" category for its Institutional and Retirement share classes, with a three-star rating for its Investor share class. Information about the fund's performance is below.

"We are very much classic value investors," Mozes said, meaning that he and Brodsky were looking for companies trading at low valuations to their markets or "to their own history." But he clarified that the value philosophy encompassed entire business and market cycles, which could take years.

Brodsky emphasized that the fund was looking for value among smaller companies outside the U.S. to provide "differentiated portfolios" for U.S. clients.

Mozes called the U.K. stock market "particularly cheap because of the macroeconomic dynamics that have not been favorable there since Brexit." The U.K. withdrew from the European Union early in 2020.

Brodsky said the U.K. was unique as the base for many "global operators [that] often have limited exposure to the U.K. market." In other words, their post-Brexit stock valuations may have been overly punished.

Examples of stocks that are potential takeout targets or that trade at compelling valuations

Mozes said: "When we find quality companies trading low to their histories, while operating well, our thesis is some investors will seek to take advantage of that inefficiency."

One example is Virgin Money U.K. PLC (U.K.:VMUK), which accepted a GBP2.9 billion buyout offer from Nationwide Building Society early in March. The deal announcement pushed Virgin Money's share price up 35% on March 7. Mozes said Virgin's share price following the deal announcement was higher than the fund's initial entry price for the stock. He also said he and Brodsy had "opportunistically traded... since initial purchase and generated a gain for the fund's investors."

Mozes and Brodsky talked about three other stocks of UK-based companies held by the Harbor Capital International Small Cap Fund:

Serco Group PLC (U.K.:SRP) traded at a forward price-to-earnings ratio of 11.7 at Wednesday's close, compared with an average forward P/E of 14.7 over the past five years, according to FactSet. The company provides industrial services globally, mostly through government contracts. "It generates returns on equity at the midteen levels, which is kind of a trough at where they operate historically," Mozes said. Brodsky called Serco "a high free-cash-flow business, when they get it right."

Brodsky said Serco was a good example of a company trading at a compelling valuation, for which a takeout offer hadn't been accepted. Sky News reported on Jan. 26 that Serco had been approached by American Industrial Partners "late last year," and that according a source close to Serco, the companies were no longer discussing a tie-up.

Even if Serco isn't acquired, Brodsky and Mozes are glad to hold it within their portfolio. Serco "ranks among the British government's most significant contractors," according to the Sky News report, but Mozes said that the company has "a low percentage of revenue that comes from the UK." Some of the company's largest contracts are with the U.S. government, he said.

Another holding of the fund is TP Icap Group PLC (U.K.:TCAP), which Mozes described as "one of the last interdealer brokers that provide customized quotes for various types of financial derivatives."

TP Icap helps other companies develop custom sets of hedging contracts to mitigate risks particular to their industries or business models.

Shares of TP Icap traded at a forward P/E of 7.3 at the close on Wednesday, in line with their five-year average P/E. But back in July 2022, the stock traded at a much lower P/E of 4.5. "In a market environment with low volatility and lower interest rates, the stock was trading at less than 50% of book value," Mozes said.

Brodsky said TP Icap was still a compelling stock because of the high growth rate for its Parameta Solutions unit, which provides pricing and indexing for securities traded over-the-counter worldwide.

And on March 12, when TP Icap announced its results for 2023, CEO Nicolas Breteau said the company was "exploring options for unlocking value for shareholders, whilst retaining ownership of the asset, which include a potential IPO of a minority stake in the business."

The last holding the portfolio managers discussed was Direct Line Insurance Group PLC (U.K.:DLG), which Mozes said was "purely a U.K. business."

This stock languished following the worst of the Covid-19 crisis because of a mismatch in auto insurance claims expenses and premiums, brought about in part by the increase in auto prices, Brodsky said. The sale of one of the company's property insurance line had stabilized its capital base and "pushed them more to the auto side" of the business, he said.

Mozes described a rejected $4 billion takeout offer from Ageas N.V. (BE:AGS) as "a lowball offer at the bottom of the operating cycle."

Looking ahead, he added that new auto insurance policies being written by Direct Line were likely to be profitable. "They raised premiums significantly, and these have not flowed through the financials yet."

Both Mozes and Brodsky emphasized the importance of not taking balance-sheet risks when selecting stocks. Brodsky said they would have held shares of Direct Line if the company had not secured its capital base.

Top holdings

Here are the largest 10 holdings (out of 70) of the Harbor Capital International Small Cap Fund as of Dec. 31:

   U.K.:SRP                                            Ticker  Country      % of Harbor Capital International Small Cap Fund as of Dec. 31 
   Construcciones y Auxiliar de Ferrocarriles, S.A.    ES:CAF  Spain                                                                 2.03% 
   ISS A/S                                             DK:ISS  Denmark                                                               1.93% 
   Genuit Group PLC                                    UK:GEN  U.K.                                                                  1.90% 
   Huhtamaki Oyj                                      FI:HUH1V Finland                                                               1.89% 
   TP ICAP Group plc                                  UK:TCAP  U.K.                                                                  1.87% 
   BOC Aviation Limited                               HK:2588  Singapore                                                             1.86% 
   Spin Master Corp                                    CA:TOY  Canada                                                                1.86% 
   Resorttrust, Inc.                                  JP:4681  Japan                                                                 1.83% 
   Serco Group plc                                     UK:SRP  U.K.                                                                  1.83% 
   Transcontinental Inc. Class A                      CA:TCL.A Canada                                                                1.81% 
                                                                                                           Source: Harbor Capital Advisors 

Click the tickers for more about each company.

Click here for Tomi Kilgore's detailed guide to the wealth of information available for free on the MarketWatch quote page.

Performance

The Harbor Capital International Small Cap Fund has outperformed its benchmark, the MSCI EAFE Small Cap Index, since the fund was established on Feb. 1, 2016. EAFE stands for Europe, Australasia, and the Far East. The index includes more than 2,000 companies in 21 developed markets, excluding the U.S. and Canada, according to MSCI.

Looking at the components of the iShares MSCI EAFE Small-Cap ETF SCZ, which tracks the benchmark index, component market capitalizations range up to $8.7 billion, according to FactSet.

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