In physics, acceleration measures change in the rate of speed. At American Century Investments®, a deep understanding of acceleration in revenue and earnings growth is central to all portfolio construction, but it’s the beating heart of the workings of its Global and Non-U.S. Small Cap strategies.
Entering his 20th year with American Century, Trevor Gurwich, vice president and senior portfolio manager, has devoted his career to small-cap investing and wouldn’t have it any other way. Among the many reasons Gurwich has a big crush on small caps is that they are often companies run by entrepreneurial founders, tend to generate faster earnings growth than their large-cap peers, and there is a dearth of information, analyst coverage, and transparency regarding small caps. Further, there is the advantage that revenues tend to be generated in local markets, and thus insulated from trends like the current bent toward trade protectionism. That said, an inflection point indicating earnings acceleration to come, whether based on a new product launch or expanding into a new geography, will often lead to a sustainable improvement in a company’s ability to grow its earnings.
All of these reasons combined, says Gurwich, “are why actively managed global and non-U.S. small caps are an invaluable piece of any truly diversified portfolio.”
Global small cap is a world of discovery. Two decades ago a researcher at Cambridge University recognized that proteins in milk affect people differently, and that cows produce milk with different protein types, called A1 and A2 (essentially free of A1 proteins). The professor, Dr. Corran McLachlan, also hit upon a safe, simple way to identify cows that produce A2 milk, which people who suffer from digestive discomfort find easier on the stomach. For Gurwich and his team, a business that took advantage of this knowledge, such as a2 Milk Co. Ltd., looked like a potential multi-bagger investment – and it was indeed. True to American Century’s process, the team uncovered a2 Milk as its revenues were inflecting positively and prior to the market giving the company full credit for its improving earnings outlook. The company’s earnings benefited as the company rolled out new products, including infant formula, and expanded into new markets, notably China. A sweet spot in small-cap investing often involves a company rolling out a new product or expanding into a new geography that drives a sustainable acceleration in earnings growth.
“Our entire Global and Non-U.S. Equity team takes a particular interest in developments like these because they very much fit our investment process,” says Gurwich. “As a team, we know what we’re looking for. Earnings drive stock prices, and with small-cap companies the market is extremely inefficient in seeing inflection points for earnings growth. When there is awareness in the greater market, that brings the re-rating boost that we look for once the original earnings acceleration has occurred.”
Management changes can also set the stage for inflection and acceleration. The Global and Non-U.S. Small Cap team noticed that Rentokil, under the new leadership of CEO Andy Ransom, who joined the pest services company from ICI in 2013, was focusing on the higher margin, higher recurring revenue pest control and hygiene service businesses, and de-emphasizing the lower revenue workwear business. Ransom helped drive sales growth both organically and through select acquisitions in the pest control and hygiene businesses. From 2013 to 2017, the company’s pest control revenues more than doubled.
An advantage in flying under the large-cap radar
When you learn or uncover something in the small-cap world, you have it much more to yourself than you would as a portfolio containing very large companies. There is much less coverage of the businesses the American Century team invests in – a half-dozen or fewer analysts versus 18 or 20 assigned to the typical large-cap name.
It’s plausible to think that the new MIFID II rules might reinforce this scenario. Some feel there may be opportunities for active managers to further take advantage of the lower levels of research available on global small caps. “If we see a reduction in the number of analysts, it follows that we would see more market inefficiency, and that would be advantageous to our efforts,” Gurwich says.
The information-gathering in the American Century team purview includes extensive face-to-face work. Gurwich’s well-resourced team of 11 meets each year with over 2,000 companies, from Sao Paolo to Singapore to South Africa, in an effort to learn the dynamics of each visited business and the strategic outlook of its decision-makers.
It’s a process that rewards innate curiosity and the ability to discern among types of risk and degrees of opportunity. Over a multi-year period in mid-decade, the Macau-based casino operator Melco International Development Ltd. found its fortunes deeply impacted by political shifts in China after Xi Jinping came to power. A nearly 50 percent drop in gross gaming revenues stemmed from reform measures that halted visits from government dignitaries and otherwise sought to rewrite public views on corruption among higher-ups. American Century’s Global and Non-U.S. Small Cap team studied the company’s prospects over a period of time, including meetings with chairman and chief executive Laurence Ho.
“Metrics were critical in guiding our analysis,” Gurwich recalls. “Towards the latter part of 2015 and 2016 we noticed big improvement off the lows in terms of average bets at the tables, room occupancy rates, plus more ferry boat service to the island, heliports being added – everything put together showed a legitimate inflection point foretelling acceleration in top-line and bottom-line performance that had good reason to prove sustainable.” The Chinese government’s deployment of $2.3 billion investment on the bridge that now links the mainland with Macau and Hong Kong was a macro indicator that Melco Development’s business would have all the room to run that it needed – and both American Century’s Non-U.S. Small Cap and Global Small Cap strategies still own the Melco stock.
Large institutional investors have become enamored with small-cap stocks based on strong performance. “The majority of our investors are institutional investors,” says Gurwich. “We believe the long-term risk-adjusted returns support their decision to hire us. As bottom-up, fundamental investors it takes a bit of extra work to study our universe and understand the opportunities, but it’s well worth it.”
Historically, small cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments portfolio. This information is for educational purposes only and is not intended as investment advice.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice.
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