During the quarter ended March 31, 2014, we saw European stocks do well driven by better sentiment toward Europe, the recovery of peripheral countries like Spain, and property markets like the one in the United Kingdom (U.K.) coming back, following a similar recovery to that of the U.S. The Japanese market had a very strong year in 2013 and we are not surprised there was a bit of a pull back at this point. Emerging markets have had a very rough period contending with just about every type of crisis, the main market anxiety being concern over China’s decelerating growth and deleveraging. The news and sentiment on emerging markets has clearly been poor across the board with issues ranging from slowing growth in Brazil to geopolitical turmoil in Ukraine. The Wasatch International Growth Fund returned -1.72% in the first quarter of 2014, while the MSCI All Country (AC) World Ex-U.S.A. Small Cap Index returned 3.47%.
Details of the Quarter
While the Japanese market cooled off following strong performance in 2013, the Japanese companies held in the Fund outperformed those in the Index and made a positive contribution to performance. We would like to discuss Japan in more detail. Some members of the international team were in Japan visiting a list of current holdings and prospective investments—in all we met with some 30 companies over a two-week period. What has become clearer to us as growth investors is how our views of Japan have changed, that we think the opportunity set has increased enough to have a weight in Japan that is closer to the Index weight. This has not been driven by our views on Abenomics†† or political changes, but has more to do with our belief that there are emerging growth companies in Japan that are world class, companies that are comparable to the best companies we see in Asia or Europe. Although Japan is rightly seen as a cheap market (based on price-to-book††† and price-to-earnings‡), our names tend to be more expensive than average but with significantly higher returns on capital‡‡ and strong cash generation.
It is interesting that a number of what we consider to be our best companies in Japan are Internet-related or are operating internationally—it is in these areas that we are seeing the Japanese “next generation” management teams in action. These are companies with strong accumulated know-how and technology, managed generally by founders or the second generation of a family. These managers look outside Japan to learn best practices and they are well aware of the leading companies in their fields—whether Japanese or not. For example, Sawai Pharmaceutical Co. Ltd. is led by the son of the founder. Sawai is the leading Japanese generic drug company. We believe it is well-positioned, as the government is keen to control drug costs. Internet-focused firms Start Today Co. Ltd. and Kakaku.com, Inc. are both founder-led companies. In talking to the CEO of Sugi Holdings Co. Ltd., which operates drug stores in Japan, we learned that he knows well the history of Walgreens‡‡‡ in the U.S. He believes that Sugi, like Walgreens, will be a consolidator in the market, fueling long-term growth. The common thread across most of our Japanese names is management ownership and the global outlook of the companies—and not because they compete globally, as many do not. The best Japanese baseball players no doubt watch the best players in the U.S., and not because they have to pitch or bat against them.
Just as the quality of small companies has improved in emerging markets over the last 15 years, to us it really feels anecdotally that the overall standard of Japanese small companies has improved, and that is significant for us as quality growth investors. The universe of high quality companies has increased in size. Fifteen years ago, it was hard to find Japanese small companies with returns on equity§ greater than 15%. Why should there be more high quality small companies in Japan when the country does not have a high growth economy and in fact has suffered from long-term deflation? In addition, Japan still seems culturally isolated from the rest of the world in many ways. We think the following factors may help explain the increase we are seeing in high quality Japanese small companies:
- Japan has less of a large company culture today—working for a large Japanese company is not the be all and end all it used to be. There is a more youthful technology culture.
- Downsizing: In the U.S. in the 1980s large companies downsized massively (like GE, IBM, for example). Downsizing by large companies did two things—made experienced managers more available to smaller companies and made small companies more respectable (it was OK to be an entrepreneur).
- Globalization of best practices through competition, consulting, and the Internet. For example, when we asked Start Today’s managers about companies they admired, they named Internet retailers Yoox S.p.A. and ASOS plc, two companies held in the Fund that they have studied. Start Today doesn’t have a good comparable inside Japan.
- The next generation of managers—of Start Today or United Arrows Ltd., for example—is evident from the clothing styles. The Internet is having significant cultural effects on how Japanese employees dress and see themselves. Internet companies are like technology companies in general, outward looking and not tied to legacy practices.
What has been the biggest change-making company in Japan in the last 20 years? Probably SoftBank‡‡‡ Corp.—its roots are in the Internet and it has been the classic outsider company with an outsider founder (Masayoshi Son is of Korean ethnicity). Our guess is that this has had a huge cultural effect on how new companies see themselves, and as part of the universal technology culture.
What we find striking about the companies the Fund holds is how close they are to our quality ideal (in returns, disclosure, technology platforms, etc.). We think this has come about through technology and the Internet and for others (like Pigeon Corp. and Calbee, Inc.) through their international exposure and mindset. For example, the CEO of Calbee came from Johnson & Johnson.‡‡‡ Overall, these companies seem less a product of a closed cultural and economic system.
The U.K. and Russia were the biggest detractors from the Fund’s performance in the quarter. The Fund’s holdings in the U.K. underperformed those in the Index. While several of our U.K. holdings performed well, including Fusionex International plc, an enterprise software solutions provider, others like Oxford Instruments plc and Abcam plc detracted from performance. Oxford Instruments is the leader in tools and technologies that facilitate nanotechnology scientific research. The long-term potential for nanotechnology is significant given finite available global resources and the need to do more with less. The industry is still in the early phases where most of the research is done at universities and research facilities that rely on public funding. While Oxford Instruments has been increasing its exposure to commercial end markets, research still drives over 40% of the company’s revenues. As a result, Oxford Instrument’s stock has had less visibility, and more volatility due to recent public funding cuts. As the market leader in the space, we believe Oxford Instruments will be a primary beneficiary of the long-term trend toward nanotechnology. Abcam is a web-based retailer of research antibodies. Like Oxford Instruments, a large portion of Abcam’s revenues depends on public funding for research. While public research funding trends seem to have stabilized, Abcam will be investing heavily to increase its portfolio of products and expand geographically. This will result in lower growth rates than the company has achieved historically. Given the recent sell-off in Abcam’s stock, its leading market position, and strong business model, we believe the market is presenting us with a buying opportunity.
Eurasia Drilling Co. Ltd., a provider of drilling services to the oil and gas industry, is the Fund’s only Russia-related holding and was the largest detractor from performance for the quarter. Through our bottom-up due diligence process, we often find attractive companies like Eurasia Drilling that are generating excellent returns on capital through innovative approaches to their markets, paying generous dividends and looking confidently into the future. These are the kinds of companies we have a history of investing in. However, at some point even the best companies can become difficult investments when they must contend with a consistently depreciating currency on the back of a slowing macroeconomic environment. When the Russian economy slowed to near-zero growth in 2013, we began to see diminishing pricing power as the company struggled to offset cost inflation—a typical sign of an economy beginning to face challenges. Eurasia Drilling also lost its second largest customer, but management was able to redeploy all of those assets with minimal impact to earnings. We have adjusted our position accordingly, reducing our weight as we see an increasingly difficult road ahead for even world-class companies in such a challenging macro environment. We are still optimistic about the company’s long-term prospects and continue to hold the stock. Supporting our confidence is the company’s decision to buy back up to $200 million of stock.
Our outlook remains constructive for the year given signs of bottoming in emerging markets and the ongoing recovery evident in Europe. We are excited about the long-term future of the diverse set of what we consider to be quality companies that we own in the Fund.
We thank shareholders for their support as always.
Roger Edgley and Linda Lasater
**The MSCI AC World Ex-U.S.A. Small Cap Index is an unmanaged index and includes reinvestment of all dividends of issuers located in countries throughout the world representing developed and emerging markets, excluding securities of U.S. issuers. This index is a free float-adjusted market capitalization index designed to measure the performance of small capitalization securities.
†The MSCI World Ex-U.S.A. Small Cap Index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed markets, excluding the United States.
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The Wasatch International Growth Fund’s investment objective is long-term growth of capital.
††Abenomics refers to the economic policies advocated by Japanese prime minister Shinzo Abe after his December 2012 re-election to the post he last held in 2007. His aim was to revive the sluggish economy with “three arrows”—a massive fiscal stimulus, more aggressive monetary easing from the Bank of Japan, and structural reforms to boost Japan’s competitiveness.
†††The price-to-book ratio is used to compare a company’s book value to its current market price.
‡The price-to-earnings or P/E ratio is the price of a stock divided by its earnings per share.
‡‡Return on capital is a measure of how effectively a company uses the money, owned or borrowed, that has been invested in its operations.
‡‡‡As of March 31, 2014, the Wasatch International Growth Fund was not invested in Walgreen’s Co., SoftBank Corp. or Johnson & Johnson.
§Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.