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Growth Rooted in Quality
Grandeur Peak International Stalwarts Fund
Interview with: Randy Pearce, Brad Barth

Author: Ticker Magazine
Last Update: Sep 20, 11:45 AM EDT
While smaller companies are generally underfollowed domestically, that is even more so when it comes to investing in emerging markets. Randy Pearce, CIO of Grandeur Peak Global Advisors, and Brad Barth, portfolio manager and senior research analyst, explain how the International Stalwarts Fund benefits from the firmís global reach and extensive research process in search of high quality companies that are still in the early stage of growth.

ďWe look for steady performers that we believe can continue to deliver returns over the long-term. We focus on the highest quality subset of our huge universe, but are valuation sensitive.Ē
All the companies are also assigned a risk premium based on the country in which they reside. We use the U.S. for our baseline. For example, the current account deficit issue in India would indicate a structurally depreciating currency. We expect an average of 4% annual devaluation on the Indian rupee, so we need to account for that in the valuation. We also try to account for macro or geopolitical risks in each country. All of our expected returns are discounted by the relevant country risk premium.

We constantly evaluate and make adjustments. For example, because there are structurally positive factors in India, we have revised down our risk premium there. Actually, India remains our favorite country in terms of investment opportunities and as a firm we have been materially overweight. Thereís a huge set of micro and small cap companies in India that we do not see in other parts of the world. Not only the number of companies is impressive, but also the quality of the managements and the western approach towards return. In comparison, China represents an entirely different story, where the management teams arenít as sophisticated.

Q: Could you illustrate your research process with some examples?

A: We have taken a bigger position in Aalberts Industries NV recently, because of the opportunity that has arisen. Part of our process is to know the companies over time and to wait for the right opportunity. As we get to know our companies better, we can become more comfortable with bigger positions.

Weíve known Aalberts for about five years. Based in Netherlands, the business provides parts and systems for fluid and air systems in a myriad of industries. The products are used in the automotive industry, industrial equipment, construction, etc. It is a specialized business with broad product application. Because it has its own niche, the company has strong margins. The industrial companies we select typically have niches, good margins and efficiencies over time.

In addition to having a good business, Aalberts also has a strong management team. The CEO continues to rationalize the business and to focus more on high-end, specialized applications, and on achieving efficiencies and higher return on invested capital. The business itself is focused on increasing the efficiency of their products. The story hasnít changed in five years, but the business is playing into growth markets that will continue to compound over time. It is a stalwart name because it is a high-quality company, but not a huge growth story.

We believe that the management team makes the right decisions for the long term. Historically, the numbers have been solid, but we expect acceleration due the rationalization. They sold off some of the weaker businesses and now the company is less cyclical. Following a period of sizeable investments, we expect a positive trend for the return on capital going forward.

Another example would the Metro Bank PLC in the U.K. Since the global financial crisis, the theme of the challenger bank has arguably accelerated. Metro attempts to challenge the UK banking oligopoly through a best-in-class service offering. That service attracts customers willing to make deposits without a high sensitivity to the yield they earn. The result is a large and growing base of stable-cost liquidity, which the bank can use to fund low-risk assets. That makes Metro a bank with high returns, a remarkable growth rate, and lower sensitivity to the cycle.

While most banks are developing digital platforms and closing branches, Metro has taken a contrarian view. It is building branches aggressively, aiming to make them a platform for a best-in-class customer experience. They are open seven days a week from early morning until late evening. The bank doesnít have to advertise because referrals and organic growth from customers, who consolidate accounts at the bank, generate sufficient growth.

Q: How do they handle the issue with bad loans?

A: This issue relates to high-quality service, which provides the low-cost deposit that allows the bank to invest in a lower-yielding or lower-risk asset. Banks with lesser deposit franchises are compelled to invest in higher-yielding and, consequently, higher-risk assets.

Q: What is your portfolio construction process? How important is diversification?

A: Quality is the major factor for our buy and sell decisions and also for the decisions on position sizes. We balance quality with valuation and with fundamental business momentum, or how the company is doing today and how we expect it to do over the near term. We have a QVM matrix, or quality, value, and business momentum matrix. In a nutshell, the better a company fares across those three metrics, the more willing we are to own it.

For instance, a low-quality company with a huge expected return is not a company that we would own. However, we may accept a lower expected return for our highest-quality ideas, if they have good business momentum. Then we can still hold the company at a reasonable weight.

Quality is typically static, but momentum and valuation are constantly moving. We have tools that identify when a company has shifted out of a buy box into a hold or sell box with the QVM matrix. These tools flag opportunities and help us stay on top of the portfolio from a weight perspective.

We are big proponents of diversification, but we donít need to focus on it, because we are well diversified as a function of our research process. Structurally, we are set up globally and across all industries. The Stalwart strategies have about 130 names on the global side and about a 100 on the international side and are well diversified across industry, geography, market cap, etc.

The performance of the funds is not driven by one or two ideas. We are not built to deliver huge outperformance and should not be not overly exposed to huge underperformance in a given year. If we can deliver outsized returns at a lower level of risk, thatís a reflection of a sustainable research process, not a function of a few big winners.

We are benchmark aware and use benchmarks to help measure our long-term performance, but we do not use a benchmark index to set portfolio weights.

Q: Do you have any limits on position sizes at the individual, sector or country level?

A: We donít have formal limits. Our biggest exposure has been about 3.5% in a single name, and 5% would likely be the ceiling on position sizes. There are some limits regarding our exposure in emerging markets, but because we are so diversified structurally, we are not overly exposed to any market segment. There are ebbs and flows in terms of allocation, but we typically tend to invest about 30% in emerging markets.

Q: How do you define and manage risk?

A: We view risk as the loss of value, so we always consider the probability and potential magnitude of a negative payoff. We focus on the risk of an investment failing to contribute a sufficient return over a five-year holding period.

Before we invest, we build our own models for every company. These models contain assumptions about balance sheet strength, cash flow generation, growth, and margins. We evaluate several scenarios, so we develop several sets of assumptions for each company and we distribute probabilities among those scenarios. Based on that work, we can observe the probability of a candidate failing to contribute a sufficient return and the weighted average magnitude of failure. Thatís our definition of the risk of an investment.

In terms of risk management, our due diligence and quality scoring methodology are integral parts of the selection process. We score every company that we consider and the scoring system represents 20 mutually exclusive sources of risk that could harm the investment. For us, managing risk means having a rigorous system as a decisive part of the selection process. In other words, regardless of how good value and/or momentum are, low quality is sufficient to disqualify a candidate. Quality is also the primary determinant for our position sizing.

In our quality scoring and analysis, there is an update for an endorsement or a dispute of the scores at least once per quarter by at least one analyst or portfolio manager. I believe thatís a crucial part of our approach towards managing risk in general.

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