Equity markets started the year on a positive note. Developed markets were resilient, buoyed in part by the start of quantitative easing†† in Europe and further macro improvements in Japan. We see good technical breadth across developed markets. Canada was the laggard, hurt by a falling currency and fears about the energy market. Emerging markets were robust, with particularly strong showings from Korea, China and India. The Wasatch International Growth Fund gained 6.21% in the first quarter of 2015, outpacing the 3.93% return of the MSCI All Country World Ex-U.S.A. Small Cap Index.
Details of the Quarter
Our research process continues to focus on finding attractively priced high-quality stocks. In particular, we are finding opportunities in Japan, Korea and Hong Kong/China. We also have been adding to our weight in Europe because eurozone fundamentals are looking more attractive. We’re optimistic about the investing environment as we expect accommodative fiscal and monetary policies to take hold in coming quarters.
Japan has long been a rich source of ideas for the Fund, in part from its large number of listed companies, and in part from the number of companies that we consider to be high quality trading at attractive price-to-earnings multiples.†††
As the investing environment in Japan has improved, we have increased our weight in Japan from less than 10% of the Fund on December 31, 2012 to over 25% on March 31, 2015. Our investment team’s deep experience in Japan and multiple research trips per year have allowed us to maintain what we believe is a high-quality bar in the portfolio.
We have previously discussed Japan’s transition to higher-quality management teams, improved corporate governance, and the ability of small, entrepreneurial companies to disrupt the market. We continue to see positive trends in Japan, particularly in the areas of operational efficiency and overseas expansion.
Misumi Group, Inc. manufactures machinery parts for industrial use. Management’s focus is to improve delivery times and expand its global footprint. It has done this through the introduction of a new enterprise resource planning (ERP) system, as well as through automation in its factories. For example, at the start of 2014, it took Misumi 13 days to process a large order in its China plant. Today, it can process the same order in five days. The company has strengthened the supply chain between Japan, China and Vietnam and is building efficiency that will be difficult for rivals to match. This has enabled the introduction of an online ordering site, which is rapidly gaining traction and expanding the customer base.
Calbee, Inc. dominates the snack-food market in Japan with market share of over 50%. The company has an enviable brand, though for many years Calbee was only able to generate single-digit margins, far lower than its global peers. The current CEO, Akira Matsumoto, previously worked at Johnson & Johnson‡ and has brought a focused discipline to margins and returns on capital. Mr. Matsumoto has also led an aggressive push into international markets, growing Calbee’s international business by an annualized 57% over the past four years. His leadership is one of the key reasons the company’s return on equity (ROE)‡‡ has nearly doubled over the same time frame.
Pigeon Corp. manufactures baby bottles and has over 80% of the market share in Japan. The company is aggressively taking its strong brand to overseas markets. The overseas business now contributes 74% of earnings, up from 49% four years ago. Sales to international markets have grown at an annualized 22% over the past four years. Pigeon is now leveraging its brand to expand its product line into diapers for the Chinese market.
Historically, Japan has generated some of the lowest ROEs among developed markets. Symptoms of this malaise include lazy balance sheets, poor acquisitions, and a focus on market-share growth instead of profitable growth. Today, we are encouraged that corporate managers in Japan seem to be shifting their focus toward productivity and capital returns. This is evident from our conversations with management teams, from the increasing dividends from our holdings, and from a focus by the national pension fund to invest in high-quality companies.
The increased focus on capital returns should improve the quality of mergers and acquisitions (M&A) going forward. Japanese firms in general have not had tremendous success with overseas acquisitions, and Western companies have long had difficulty purchasing Japanese companies. With Japan’s management teams increasingly speaking the same business language as Western management teams, the quality of M&A should increase, and integration pains should lessen.
Japan exhibits one of the lowest levels of labor productivity of the OECD‡‡‡ countries. We expect to see significant improvement here. Wages are rising, and many companies are shifting away from the long hours and late-night outings of the past. These changes will encourage more women to enter the workforce (easing the labor shortage), and longer term, will lower the hurdles for both men and women to start families. As Japan improves its labor productivity, we expect to see improvements in automation and software, and for the manufacturing chain to become leaner.
In many ways, Korea is undergoing a similar transition to Japan. In Korea, we are seeing an increasing number of what we believe are high-quality entrepreneurial firms, often with deep technical expertise. The government has encouraged the growth of these firms as it has weakened the chaebols§ and encouraged growth through investments and low interest loans.
Over the past nine months, we have added three Korean companies to the Fund. ISC Co. Ltd. has a leading technology in the test socket market for semiconductors. The product is consumable, which we believe will generate strong recurring sales going forward. The company has high inside ownership and is still run by its founder.
Medy-Tox, Inc. has developed the next generation of Botox and has a strong supply partner in Allergan§§ to distribute it globally. Medy-Tox’s new product, Innotox, has a number of benefits over Botox such as greater stability, no animal by-products, and greater precision when mixing the final solution. The market applications for Innotox and Botox are increasing, both for cosmetic purposes and for therapeutic uses. The founder of Medy-Tox is a scientist and continues to drive new-product innovation at the company.
KEPCO Plant Service & Engineering Co. operates and maintains power plants. The contracts the company signs with the plant owners tend to be long term in nature, and are typically renewed upon completion, providing a long-term recurring revenue stream. KEPCO Plant Service has expanded outside of Korea, with the overseas portion comprising nearly 15% of revenues and providing a boost to growth over the long term.
Similar to Japan, Korean companies have historically generated low ROEs, have underutilized their balance sheets, and have made capital decisions that benefit insiders over public shareholders. We are seeing the tide shifting in Korea, with increased dividends, improved government regulations, and greater labor productivity (Korea has the lowest labor productivity in the OECD). We expect to see entrepreneurialism increase among Korea’s highly educated workforce (it was long seen as desirable to join Samsung§§ after graduation, and this may be changing) and for more women to enter the workforce and hold management positions.
The malaise in Continental Europe is starting to erode as quantitative easing spurs growth and companies become more nimble. Criteo S.A. is a French Internet company with leading technology in display advertising. The company’s global customer base includes some of the top retailers in the world. Patrizia Immobilien AG has been transforming itself from a pure residential property owner in Germany to a pan European real-estate asset manager. Management is committed to deep research on the company’s markets, and has one of the strongest reputations in Europe. This transition is leading to an improvement in the quality and returns of Patrizia Immobilien’s business, which is now starting to be recognized by the market. (Current and future holdings are subject to risk.)
We are excited about the quality of companies in the Fund and believe these companies have a long runway for growth. Many of our companies offer unique services that are in high demand, which is a key factor in reducing the market risk around these holdings.
We continue to see opportunities across developed markets, especially in Japan and Europe. The Hong Kong H-share market (which includes a number of China-headquartered companies) looks attractively valued, and we have been actively researching potential investments. Additionally, the weakening euro has improved the outlook for eurozone-based companies with a global footprint, though it remains a challenge to find high-quality names.
In the first quarter of the year, the Wasatch research team visited companies in the United Kingdom, Canada and Australia. In the second quarter, we expect to meet with companies in Japan, Korea, Continental Europe, New Zealand, Australia, Taiwan, Hong Kong and China.
We thank shareholders for their support.
Roger Edgley, Linda Lasater and Kabir Goyal
**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.
You cannot invest in these or any indices.
Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
CFA® is a trademark owned by CFA Institute.
The Wasatch International Growth Fund’s investment objective is long-term growth of capital.
††Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
†††The price-to-earnings (P/E) multiple, also known as the P/E ratio, is the price of a stock divided by its earnings per share.
‡As of March 31, 2015, the Wasatch International Growth Fund was not invested in Johnson & Johnson.
‡‡Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
‡‡‡The Organization for Economic Cooperation and Development (OECD) is a forum where the governments of 34 democracies with market economies work with each other, as well as with more than 70 non-member economies to promote economic growth, prosperity and sustainable development.
§The word “chaebol” means “business family” or “monopoly” in Korean. The chaebol structure can encompass a single large company or several groups of companies. Each chaebol is owned, controlled or managed by the same family dynasty, generally that of the group’s founder.
§§As of March 31, 2015, the Wasatch International Growth Fund was not invested in Allergan, Inc. or Samsung Electronics Co. Ltd.