Episode Transcript
Narrator:
[Music] Welcome to Pzena Perspectives brought to you by Pzena Investment Management, a global value manager known for our commitment to fundamental research and disciplined value investing. This podcast is presented by Pzena Investment Management LLC, an SEC-registered investment adviser and is intended for institutional investors only. The views expressed reflect the current views of Pzena as of the date hereof and are subject to change. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance is not indicative of future results. In the UK, this podcast is for professional clients only. This marketing communication is presented by Pzena Investment Management Limited, which is an appointed representative of Victoria and Partners LLP. Victoria and Partners LLP is authorized and regulated by the Financial Conduct Authority.
On today's episode, Director of Client and Portfolio Services Tyler Zadalis sits down with Portfolio Manager Jason Doctor to discuss Pzena's International Small Cap strategy.
Tyler:
Thank you for joining us today. My name is Tyler Zadalis and I'm a Director of Client and Portfolio Services here at Pzena. Today I'm joined by Jason Doctor, who is a Portfolio Manager on our International Small Cap strategy. Thanks for joining me, Jason.
Jason:
Thanks for having me.
Tyler:
So let's jump right in. There was an article making the rounds a few weeks ago that caught my eye, and it said that U.S. stocks are now, by some metrics, the most expensive they've ever been. And that's even pricier than they were in the buildup to the dot-com bubble. And by U.S. stocks, we're talking about the S&P 500.
So my question for you is: are you seeing similarly stretched valuations in the international small cap space?
Jason:
No, actually, Tyler, it's really the opposite. Not only, I think, as you may have heard, people may have seen other places, there is this large dislocation in valuations between international and U.S. stocks, but we actually get a double discount in the International Small Cap portfolio because the spread between large caps and small caps is also at, I think, the ninth percentile or something like that of the historic experience that we've seen there. So even though the asset class has had a little bit of strong performance so far this year, it's almost like a little blip on a long downward trend in those valuation spreads.
Tyler:
So, in general, what is it about the international small cap space that's particularly compelling from the perspective of a fundamental active value manager?
Jason:
Yeah, I mean, we think as a team, this is a place where we can really shine. It's a place with a ton of potential investments. Super diverse in terms of end markets, in terms of countries, things like that. Not really covered by the sell side. Pretty inefficient as an asset class. And on top of that, similarly to what we've seen in the U.S. where small cap has beaten large cap outside of the U.S., that small versus large premium also exists. So it's really a place where we think Pzena's structured, process-driven approach to active value equities really makes a lot of sense. It's really a sweet spot for us.
Tyler:
And you're visiting these management teams around the world wherever they're domiciled.
Jason:
Right. Yeah. I mean, you know, it's a core part of our investment process, and kind of what's so cool about the international small cap space is, you know, you're looking at these small discrete little businesses. There are small discrete little investment controversies where our team of analysts can really get in there and dig into the ideas and sort of figure out, like, okay, here's what's gone wrong with this business, here's sort of the opportunity set for us, here's what needs to be fixed.
But on top of that, then when you get on a plane or when you get on a train and you go and see these guys, you get a degree of openness and transparency from them that you may not see with larger cap companies once you kind of establish that really you're there because you want to learn about the business, not because you want to learn about the stock price.
Tyler:
That makes sense. So, let's talk about the small cap portfolio that you co-manage. So, currently you hold 45 companies, and that's across 26 industries and 18 countries, which is a fair degree of diversification. So, that's by design, correct?
Jason:
Absolutely. You know, when you think about that 40 to 60 name international small cap portfolio, you should think of it as a ton of different idiosyncratic bets, idiosyncratic investment controversies that really aren't correlated with one another. I always think one of the best ways to show this is just, like, look at a sector and look at the different bets we have inside of that.
So, right now actually one of the biggest overweights in the portfolio is in the materials space. But once you get inside of that, you start to see that actually these stocks have nothing to do with one another. So I just like to rip through them really quickly:
KDK – Japanese electronic gases, really one of the core things that enables processes at places like TSMC. Really driven by that continued process improvement you see at those semiconductor businesses.
KH Neochem – Sort of a world leader in a very specific lubricant for the inside of HVAC compressors. Again, very specific business, very specific controversy.
Tokai Carbon – Semiconductor-related, but a different part of the process than what we saw at KDK.
Parenti – Totally shifting gears here. It's mostly driven by underground gold mining in Africa and Australia.
Transcontinental – Classic value story of a great Canadian printing business that's sort of slowly in decline, but you've been taking those cash flows and reinvesting them in a specialty packaging business in the U.S., and you've actually done a pretty good job of that.
Ibstock – We think this is just a really special business. Well showcases the pain you've seen in the UK on the housing market. Ibstock's a brick manufacturer; the brick market in the UK is very highly concentrated, very highly disciplined—exactly the kind of market we like to invest in.
Ferrexpo – Totally out of left field. It's a Ukrainian iron ore miner. We bought it at what we think are sort of two to three times normalized free cash flow once we get some kind of stability in the region again.
Jason:
Archroma – Classic great story of a little bit of a cyclical chemicals business going out and sort of reframing their portfolio to really become a specialty story, and the cycle we've seen in chemicals is sort of preventing the market from really realizing the specialness of the portfolio.
And then finally, like, the group that is kind of one of my favorite themes we've seen over the last couple years is Umicore and Aurubis. I'm gonna sneak a non-materials name in here because I think it fits in the same basket: Ariston.
These were all stocks where they got huge run-ups, huge multiples, in the sort of ESG excitement in 2022. And in reality, what was going on is they were making some not-great investment decisions during that time period. Once the ESG wave kind of crested and you saw the markets sort of realize that, oh no, you know, the battery materials business, that heat pump business, those weren't really going to work out the way that people thought they were. But they de-rated the stocks to a level where you were forgetting that the core business of these companies generated real cash flows.
And so we've been able to buy what we think are fundamentally good old businesses at great prices because of how people handled the ups and downs of that excitement cycle.
Tyler:
So basically these loss-making projects that were essentially value destructive were masking otherwise good solid core franchises, and you feel like when you've spoken to these management teams, they're not going to continue going down that road.
Jason:
That was really one of the core conversations we wanted to have with them. We needed to feel like, okay, they understood that this is not something that they want to throw good money after bad at.
Tyler:
And you don't feel like the market is giving these companies credit?
Jason:
Not today, no.
Tyler:
So switching gears a little bit here, trade policy uncertainty is still very much top of mind for many investors, and, you know, this being an international portfolio, you must have some exposure to U.S. tariffs.
Jason:
I mean, inevitably we do, right? That being said, smaller-cap companies do tend to be a little bit more domestically focused. So it's not as exposed to the trade tensions we've seen in other places. But, you know, there are a couple places in the portfolio where we have some pain.
Jason:
It’s not always intuitive as to sort of how that's actually played out economically. The first stock where we felt a little tower of pain was Yuyuan. Really the core business of Yuyuan is contract manufacturing sneakers for the likes of Nike and Adidas. The market really beat the stock up when the tariffs were coming down the turnpike, but in reality, the math is actually pretty compelling because the tariffs are taken on the landed cost. And if you think about a sneaker, really the landed cost of a pair of shoes that might retail for $200 is only $20. So the impact of the tariff on that, on an absolute basis, is actually relatively small. So, once the market figured out that math, you saw the share price begin to rebound.
The counter example of that is Spin Master, which is a Canadian toy manufacturer. And I think at first we kind of took the view of, well, this isn't going to be a big deal because all of the toy manufacturers make their stuff in China and what you're going to see is just, you know, everybody sort of pushes their price up by the same amount. In reality, what's happened is you have seen a little bit more elasticity than we expected there.
But also, we saw some really interesting dynamics in terms of how the large toy retailers tried to mitigate some of their tariff risk. You basically saw a big shift in deliveries being transferred—ownership at the port in Los Angeles—as opposed to historically, they would have transferred ownership in China. And so you basically created this big gap in demand over the course of the summer as you saw that happen.
And if you think about it, it makes total sense, right? Because if Walmart takes possession of the toys in LA, any changes to the trade policy that happened while the boat was on the water is on Spin Master’s part versus historically Walmart would have taken possession of them in Hong Kong and paid for them on the boat themselves, but then you would have been subject to the vicissitudes of trade policy during that time period. So you had this big gap.
We're hoping, we're expecting that we'll start to see this normalize in the second half of this year, but in the meantime, it's been one of the weaker performers in the portfolio.
Tyler:
Something that stuck with me that you said is that although this is an international portfolio, it's also a small-cap portfolio. So a lot of these companies are domestically focused. They're not as exposed to US tariffs as, say, a multinational, large-cap, international company is. So I guess, in that context, are there any themes you've been hearing from management teams that you've spoken to about tariffs? Is there any sort of commonality as far as the risks that management teams are dealing with?
Jason:
We generally do ask the question.
So far what we've mostly found is that our companies just aren't that impacted by it. If you're a German home retailer, what happens in the US kind of doesn't really matter to you, other than, obviously, a global decline in GDP is going to be bad for demand. But in terms of direct impacts, there's not really much in the portfolio. Even our businesses that are distributors or resellers of things, they're mostly distributing things that are bought locally, right?
If it's like Solar, our Danish electrical equipment distributor, they're really buying European product and selling it into a European market. If it's someone like Hornbach, which is my aforementioned German home retailer, again, it's sort of local-for-local sales. So, it's not really something that impacts the portfolio.
Certainly, I think it's probably one of the least impacted investment universes we have here.
Tyler:
So it's more about this secondary impact, the indirect impact on economic growth, which is going to be difficult to avoid for any risk asset.
Jason:
Yeah. You can't run away from weak GDP growth. You can't run away from weak industrial production. That's going to hurt the business.
But you're not seeing those direct impacts. You know what else is important, too, is you're not really seeing people having to reshape their supply chains. I think we underrate how hard that can be. Go back to my Spin Master example—think about the dislocation you saw just from the fact that Walmart wants to take control of cargo at the port of Long Beach instead of in Hong Kong, right? Those little things all accrue and all matter.
We don't have a ton of that exposure in the portfolio. Even where we have some auto exposure—something like a Linamar—you know, there we're USMCA compliant. Even there, we haven't really felt it. Actually, it's been a little bit of a tailwind for them because they're getting some volumes because of that USMCA situation.
Tyler:
So Jason, can you talk to me about some really interesting controversies that the investment team has underwritten recently?
Jason:
Yeah, I mean, there's two that we've just pulled through the process that I think are really fascinating. One of them is a new idea. One of them was us re-underwriting a name that hasn't been working.
The new idea is Barry Callebaut, which is one of the major cacao processors in the world. And I don't know if you've seen this in the news or in the Journal or something like that, but cacao prices have just gone crazy. And the cacao processing cycle is extremely long. It's something like 18 months long or something like that.
Jason:
Um, and one of the issues for a cacao processor like Barry is, um, you have to hedge the price of the cacao beans during that 18-month time period. And that hedge is very capital intensive. So, it's been a huge suck of cash flow, um, for really the last two years or so. And the share price has really sort of negatively responded to that.
And so the question that we were faced with was, you know, how to think through the elasticity of demand, um, with higher cacao prices, but also think through sort of how you can manage, um, that balance sheet in this sort of very interesting, sort of unprecedented time period for cacao prices.
And so, you know, talked through it with the company, talked through it with the CFO, really started to understand all the degrees of freedom they had to sort of, sort of deal with the issue if the price spike continues.
Um, got comfortable with sort of the elasticity of demand for confectionery, um, sort of where that trajectory could go to and also, most importantly, sort of how big the lag is between the risk Barry is taking on the volumes that they're buying versus how much they end up delivering to the Marses and Mondelez of the world, um, and learned that they've materially cut their exposures.
And then I think the thing that makes it really interesting is then you sort of get into the economics of, um, actual cacao farming and you learn really quickly that the price has gotten so high that it's really incentivized, um, a lot of increased acreage of cacao, which obviously takes some time to come through, but it's also incentivized, um, you know, better farming practices in some of these countries which have a relatively quick, um, increase in yields.
So, you know, the expectation is that we should see significant supply growth as a response to this cacao thing. I kind of love it because it's a great example of one of the things I think we do really well at Pzena, which is sort of understanding these incremental microeconomics of these businesses and sort of what that means for things, um, long term.
So, you know, in a way Barry's almost a bet that capitalism works, um, in the cacao business. Um, so I, you know, I think, I think you roll that all up and you have fundamentally a really high-quality business that, without this cacao spike, would be something that, you know, maybe not, wouldn't ordinarily trip across our screen as something that we should look at.
Tyler:
And part of what underpins that thesis is ultimately, you know, we're assuming you're going to see a normalization of cacao prices.
Jason:
Yeah, absolutely. And that normal is sort of materially below where we are today. I actually think, on a personal, the normal will be lower than where the industry thought the normal was two years ago because you've created all of this new capacity in the market, and demand for cacao doesn't grow that fast, right?
Um, so I think we're going to end up in a place, actually, where the profitability, the capital needs of the business are actually less than they were historically. Not only that, but it's a business where, because it was so good, you never had to really be that thoughtful about how you managed your working capital before.
Jason:
And so now you kind of see it in the CFO's eyes when you're talking to him. He's kind of figuring out, okay, how do I sort of, um, how do I sort of manage my business just a little bit more smartly, um, to make sure that everybody's getting the value that they want to get.
And then the second I wanted to talk about is, you know, an idea that really hasn't worked in the portfolio. We've owned it, um, I think for more than two years at this point, which is Wizz Air. Wizz Air is, um, an ultra-low-cost carrier in central and eastern Europe.
Um, you know, we do think, um, the ultra-low-cost carrier model is what wins long term. Um, it and Ryanair we think are the two lowest-cost airlines in Europe. You know, Wizz Air is one of those businesses where anything that could go wrong with it over the last four years really has happened.
Since COVID, it's just been a series of sort of bad outcomes off of sort of reasonable decisions. Uh, the current pain is really caused by the fact that Wizz Air is actually part of a corporate family that's the largest buyer of A320 family planes in the world, and, um, one of the decisions that they made was to go forward with the Pratt & Whitney geared turbofan for those planes.
And, uh, the geared turbofan has really not performed to expectations. And so, as a result of that, Raytheon, Pratt's parent, has been forced to really take the planes back and fix the parts on the plane that have failed. And managing that process has just been incredibly difficult.
Right? Think about it. You're running an airline and you don't really know how many planes you're going to have in three months, right? And so how you manage that—and while you do get directly reimbursed for it, um, by Raytheon, Raytheon’s not paying you back for those network inefficiencies that happen.
Tyler:
Yeah, it seems like a logistical nightmare.
Jason:
Yeah. And, you know, we did the math and we think that, you know, while the direct costs are something like €400 million, um, we actually think the total costs were more like €700 million. And what we think is interesting is if you do that math and you run it through the numbers, what you actually realize is that the underlying cost performance of Wizz Air has been better than Ryanair’s over the last three years.
And, ultimately, in a low-cost airline, it's who is the lowest-cost that's going to win. Now, we don't think they're going to beat Ryanair. We think the endgame is a relatively stable duopoly in that low-cost market. But, you know, doing this work again, spending the time with them, walking through the numbers, building it up as a team, sitting down as a team, talking through it, really made us feel like this was a really attractive investment opportunity. So, we actually increased the weight of the name in the portfolio. And it's not like they have to beat Ryanair for the stock to work.
Tyler:
No, no, no, no. They just need to stabilize the operations, get things back to normal. And of course, since we've bought the stock, you exclusively fly Wizz Air when you're traveling in Europe, right?
Jason:
I mean, we are a value manager.
Tyler:
Yeah, that's why I had to ask. You know, as we were speaking, I was looking at the portfolio here, and you know, one of the main takeaways that I have is there's just a ton of companies in this product that I've actually never heard of before.
Jason:
Um, so, but that's the point of this product, isn’t it?
Tyler:
Yeah.
Jason:
Yeah, I mean, in a way it's funny that you say that because you're not the first person to tell that to me, but the fact that these aren't household names, you know, the fact that these aren't things that you're going to read about in The Wall Street Journal is part of why the value opportunity here is just so incredible, whether it's in the short term when these valuations are so disjointed, or even if you go back and look at the Fama-French data, you know, small international is a place where value really, really works.
Tyler:
Well, thanks Jason. And I appreciate the insights as always.
Jason:
It's great to be here.
Narrator:
Thank you for joining us for today's episode of Pzena Perspectives. If you'd like to hear more, be sure to subscribe to this podcast. And for more insights on value investing, visit our website at www.pzena.com.
That's www.pzena.com.
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