Investing in Visible Change
Delaware International Small Cap Fund
Author: Ticker Magazine
Last Update: Nov 02, 10:34 AM EDT
|Stock markets tend to underestimate the duration of a positive fundamental change and the sustainability of earnings growth. Focusing on this inefficiency, the Delaware International Small Cap Fund team analyzes the factors that drive earnings growth and its duration in areas neglected by the market. Portfolio manager Gabriel Wallach and his team have long-term experience in identifying above-average growth in small caps and international markets.
ďOur focus is on stocks that grow faster than the market and have a sustainable business model. Typically, these are companies that are introducing new factors to their business models, entering new markets, developing new products, have new management, new geographies, or are consolidating a particular sector.Ē
Q: What is the history of the fund? Could you give us some background information?
The Delaware International Small Cap strategy has been around for a long time; it existed before even the benchmark was launched. The team has an extensive track record of almost two decades of focusing not only on small caps, but also on growth stocks in the international space. The fund invests in companies with market cap less than $5 billion.
I have been the portfolio manager with the Global ex-US Equity team at Macquarie Investment Management since 2016. I had previously worked with Baring Asset Management, a UK-based firm. In 2004 I moved to Fortis Investments, which was then acquired by BNP Paribas, where I was head of Global Emerging Markets Equities. From 2014 to 2016, I managed the North Grove Capital long/short strategy in emerging markets before joining Macquarie Investment Management.
Q: What core beliefs drive your investment philosophy?
We focus on the fundamental changes that lead specifically to earnings growth and we aim to uncover the areas where the markets underestimate these changes. We believe that the markets tend to underestimate the duration of the change and the duration of the companyís ability to deliver earnings growth. Our process is designed to identify the factors that contribute to earnings growth and the changes in that growth, its durability, and the areas where the market tends to underestimate the longevity of that growth. That refers to all markets and sectors.
Throughout the fundís history, a key feature has been the long-term view of three to five years. We select stocks based on three factors - earnings growth, relative strength of the security, and earnings revisions. Our focus is on stocks that grow faster than the market and have a sustainable business model that supports that growth. Typically, these are companies that are introducing new factors to their business models, entering new markets, developing new products, have new management or new geographies, or are consolidating a particular sector.
An important element of our philosophy is that we need to be able to measure the change in some way. The companyís ability to capitalize on that change has to be visible and the analyst community also has to see the positive change. So, we donít buy fallen angels or out-of-favor stocks with no particular earnings momentum path. We donít look for underperforming companies with poor metrics simply because of their valuation.
We are definitely not value investors and we donít focus on the existing multiples based on current earnings. The important factor is not whether the stock is trading at three times book or 25 times earnings or 50 times earnings, but the ability of the company to deliver results above expectations.
We need to see some confirmation that earnings momentum is reflected in the price. So we focus on positive fundamental change that leads to earnings growth, but we need to see evidence that the market acknowledges the change before we purchase the security. We are interested in whether the market has underestimated the earnings power, the potential of the company and the duration of the change. Thatís where we feel we can add value and outperform the market.
Q: So the key factor in stock selection is the above-average earnings growth and the visibility and the sustainability of that growth?
Yes. We are aware that each company is unique, but the focus on growth stocks means that we look for companies on their way to generating above-average and higher-than-expected earnings growth. For example, we have active position in the technology sector, although the companies in that space may look expensive on a P/E basis because of their emphasis on revenues and market share growth.
Amazon.com, Inc is an example of a company that has focused on growing its top line, gross merchandise value and market share throughout the last 10 years. It is less focused on the bottom line or the earnings per share number. Amazon was trading at 100 times earnings in 2016 but today itís trading at 75 times earnings and the stock quadrupled its value. There was a meaningful change in profitability, despite the focus on revenue and GMV (gross merchandise volume) growth.
Q: What is your international geographical footprint?
This fund invests in developed and emerging markets. The major markets are Japan, Europe and Australia, but the team covers all the markets outside the U.S., including emerging markets. We also run an emerging markets small-cap fund.
Q: What is the process of narrowing your investable universe?
We start with an investable universe of about 2,500 companies with market cap of less than $5 billion. Then we screen for liquidity and information transparency. That screen narrows down the universe to about 500 stocks, which can be screened on a fundamental basis by looking for governance, earnings growth drivers and sector factors. The fundamental factors we use are based on positive change, which can be related to new markets, new products, macro changes, new geographies or sector drivers.
Then we debate the ideas and construct a portfolio that meets our requirements. Our experienced research team is organized by geography. We are an independent team of six individuals, looking at the stocks across different markets, including Europe, Asia, Latin America, Emerging Europe and Africa. We look for growth ideas that meet our market cap limit as we try to construct a portfolio of 75 to 100 stocks.
Internationally, we look for trends across industries, because they tend to be similar. For instance, the factors affecting e-commerce in India are similar to factors in Brazil and China, although the companies may be at different stages of development or in different sectors and verticals. From a top-down perspective, different markets have different growth and interest rates, but there are global industry trends in sectors like materials, energy, technology and consumer discretionary. We collaborate as a team to identify these factors.
Q: How important is the macro perspective? Do you have a macro overlay in your process?
We rely on a bottom-up process that aims to identify the best stocks. We are well diversified across sectors and countries, but we donít have a macro overlay and we donít make large bets at the macro level. If we identify a problem in a particular market, we wouldnít invest in it. We wouldnít try to find the best stock in the worst market just for the sake of having exposure.
Right now there are macroeconomic problems in emerging markets, particularly in Turkey and Argentina, where we had positions. Less than a year ago there were companies benefiting from the weak currency and the macro environment. However, because of the dislocation of these two markets today, we have decided to take our positions to zero and not to participate at all.
In general, we tend to be fully invested across what we identify as the best sectors and stocks with a certain growth profile. We believe that in any environment there are winners and our job is to identify them. The macro input is just one of the many factors that would drive the earnings growth of a company.
Q: How do you manage the potential currency issues? Do you hedge your exposure?
We donít hedge our currency exposure and we donít predict the direction of currencies. Certainly, Brexit had an impact on the U.K. pound; the strong dollar recently had an impact on all currencies. There is an effect on the overall performance of the index, but thatís not our focus. Instead, we focus on the companyís business model and its ability to grow above and beyond that macro effect.
If we identify stocks in a market with significant macro factors, which affect the direction of that market, we may decide not to participate at all, but we would not be hedging. Also, we may be able to find companies that actually benefit from a weakening exchange rate, such as the export-oriented companies, but we donít have a hedge or a macro overlay beyond that.