International Smaller Companies: Under the Radar.
Part 6 - Alignment.
The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.
Under the Radar
International Smaller Companies
Much of our task as investors is to resist the lure of certainty. The act of investing inevitably entails a leap of faith. Perhaps harder is the ability mid-leap to hold onto the promise of what might come, the potentially significant (but never guaranteed) rewards we hope to land. It can be a very long and lonely jump. Company management face a similar predicament and need the same ability to hold their nerve.
The courage to carry on in the face of terrible uncertainty, even in the most unprecedented of circumstances like global pandemics and economic recessions, often can’t be derived from extrinsic goals of reward, remuneration, or share options. The renowned French author Antoine de Saint-Exupéry writes of courage and beating the odds in his book Wind, Sand and Stars. He tells the story of a friend who crash-lands his monoplane in the Andes. Stranded far from civilization without supplies he trudges for days amid a snowstorm. It is when he is about to give up that he thinks of his wife and children and determines to keep going. Driven by thoughts of his family, he summons the energy to crawl up onto an area of exposed rock and from this vantage point he is at last able to see through the whiteout. Owing to this final gathering of strength he is discovered, and his life saved.
The determination to persist through the hardest of battles cannot merely be imitated nor simulated. Companies and founders who face lonely depths of uncertainty, where the odds are stacked high against them, must have their hearts and minds set to a greater, longer-term purpose. There will be times that alongside their daily business they must navigate complex obstacles, not knowing what lies ahead of them. Few companies have the cultural ingredients and the leadership necessary to successfully circumnavigate an uncertain environment and ultimately realise their potential. Most never make it out of the snowstorm.
This is why the consideration of alignment is an integral part of the International Smaller Companies analytical framework, as we seek to identify businesses with large market opportunities and competitive positions strong enough to allow them to capitalise on those opportunities over many years. For us, alignment constitutes an attempt to answer the question: Can we trust management (and, more broadly, the culture underpinning the organisation) to steer the companies we invest in on your behalf onto a path towards long-term success?
We seek to identify businesses with large market opportunities and competitive positions strong enough to allow them to capitalise on those opportunities over many years.
A long time coming
So, what are the key manifestations of corporate alignment that we are looking for when we consider potential holdings for the portfolio? As very long-term investors, we place most emphasis on identifying a strong alignment of time horizons. It is an unfortunate truth that financial markets have become exceptionally short term. The dramatic fall in holding periods of stocks over the last 30 years, a significant increase in market volatility and much greater turnover of corporate CEOs (as investors seek immediate performance) are all symptoms of the growing impatience and myopia afflicting our industry1.
John Bogle’s famous indictment of the stock market as “a giant distraction from the business of investing” arguably rings truer than ever. However, the real danger strikes when the suboptimal behaviour of market participants spills over into the corporate sector and starts shaping business decisions. The evidence also suggests this is happening; there is a meaningful and growing divergence between the cash flows that listed firms are directing towards organic investment in capital expenditure and research and development (R&D), and the amount they are returning to shareholders in the forms of buybacks and dividends. Indeed, the latter category is where the rising trend worryingly lies.
In our experience, many corporate management teams talk about long termism, but it is often lip service. When push comes to shove, the reality is that most would rather play the quarterly game. They would rather boost short-term earnings per share by buying back stock than initiate long-term projects with large payoffs but very uncertain outcomes. The Covid-19 pandemic brought with it the challenge for companies to manage the immediate future with agile and resilient decision-making, while building the necessary structures for operating in an uncertain long-term environment. Companies that were already executing their capital allocation strategies with the longer term in mind, with strong internal and external processes, robust brands, good human capital, and agile, scalable business models have stood out.
Hence, we aim to select companies that do not behave in a self-defeating manner, that show an unwavering focus on the long term, alongside ambition and willingness to embrace risk. We believe these attributes mean that the companies should be well placed to grow sustainably for extended periods of time. The question for stock pickers, of course, is how to identify this kind of alignment ex ante. We think one reasonable proxy for corporate long-termism is to look for businesses with a significant degree of inside ownership (in the hands of a founder or other type of controlling shareholder). A significant portion of the International Smaller Companies portfolio is invested in such companies.
While the presence of a founder is not necessarily always an unequivocal positive, our experience suggests founder-led companies show greater propensity to focus on long-term value creation, even when it comes at the expense of short-term pain. Their average tenure also often extends far beyond a conventional CEO cycle, and this alignment in time horizons is particularly important in industries that are prone to sharp fluctuations in end-market demand and where the temptation to engage in unproductive financial engineering to shore up the numbers can be compelling.
1. For more on this subject, we would refer the reader to a 2010 paper entitled Patience and Finance written by Andrew Haldane, Former Chief Economist at the Bank of England.
Tuning out the noise
Our portfolio is home to some businesses with this strategic ownership and sight of the long game beyond such fluctuations. Chroma ATE is a Taiwanese maker of testing equipment for semiconductors and power electronics, with very high shares in its niche markets. The founder and his family own 13 per cent of the business. Chroma’s revenues can be lumpy and volatile, but the company has shown an admirable consistency to its high R&D spend (typically, roughly a third of the employees are in R&D, with no cutbacks during the 2009 short but sharp downturn). This focus on long-term investment through short-term bumps has enabled Chroma to maintain very strong positions in its core market of semiconductor testing but also to successfully expand into new exciting applications, such as video colour testing, testing for EV batteries (which they supply to Tesla) and VSCELs (the 3D sensing lasers in iPhones).
Another way in which the presence of a strategic owner with a long-term focus can create tremendous value for shareholders is through counter-cyclical capital allocation. Addtech is a Swedish holding company investing in niche technology and industrial businesses. Much of its success has been down to its strong corporate culture, which marries decentralisation with accountability. Through its 100-year history, Addtech has proven itself an astute acquirer, partly because it has been brave enough to step in during macroeconomic downturns, when fear reigns and great companies become available at heavily discounted valuations. The CEO at the time, Anders Börjesson, beautifully captured the essence of this approach in a shareholder letter in 1994, at a time when the company had made a sizeable acquisition at the height of the Swedish financial crisis: “Recession or boom. What is the difference from a management perspective? In my opinion there are no decisive differences. I believe that philosophy and overall goals are long-term approaches and should not be adapted too much to economic trends.” The acquired company, Ferro, proved to be a master stroke, growing strongly for many years after.
The flipside to Addtech’s story, of course, is that for every buyer there is a seller. A great deal of value can be destroyed by selling an exceptional asset too cheaply. Here, too, the influence of a long-term owner can be very helpful. Maytronics is the worldwide leader in robotic pool cleaning solutions. It is an unusual company in many ways but one of its most distinguishing features is its ownership structure. Maytronics is owned by a kibbutz, a type of agrarian commune in Israel. The long-term survival of the entire community is largely dependent on the enduring success of the business. Back in 2012, the company was approached for a takeover by US pool giant Hayward, at premium. While the certainty of a premium would have appealed to many, and Hayward’s move came at time of some uncertainty for Maytronics, the kibbutz and the management team concluded the bid undervalued the long-term prospects of the business and rejected the offer. Maytronics has gone from strength to strength since, compounding revenues at 16 per cent over the past nine years.
Recession or boom. What is the difference from a management perspective? In my opinion there are no decisive differences.
Seeing through the whiteout
Strong alignment (like a company’s commitment to sustainability) can become a powerful source of competitive advantage that enables companies to exploit their growth potential even in an uncertain and rapidly changing world. However, it is often intangible and therefore difficult to measure or reflect in a financial model. This makes it tricky for investors to fully appreciate and price in its benefits adequately. Including alignment as a spoke in our radar methodology is our acknowledgment of this complexity and we see it as a potential source of competitive advantage within our investment approach. It is undoubtedly one of the most rewarding challenges we face as investment managers to navigate the elusive haze while improving our understanding and ability to identify alignment.
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in March 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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