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Investing in Visible Change
Delaware International Small Cap Fund
Interview with: Gabriel Wallach

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 type of earnings do you focus on? How do you handle the issue of the varying accounting standards?

A: We focus on earnings growth and EPS, but when non-operational factors have an effect, we need to value the company on other terms, such as top-line operating profits or EBITDA above the EPS line. We need to identify if accounting standards affect earnings or our ability to predict earnings.

There are differences across markets, but there has been a trend toward convergence in accounting standards. We aim to select transparent companies without corporate governance issues and, essentially, we focus on similar growth factors across geographies. So the accounting differences should not have a big impact on our stock selection.

Q: Could you give us some examples that illustrate your research process?

A: A good example would be an Asian consumer staples company, which focuses on baked breads and coffee. It is one of the leading companies in the market and is expanding across China and the U.S.

As it was becoming a multinational company, we were looking at store expansion, same-store sales, EBITDA margins, capital expense requirements, the return on capital for that Capex, and the positive momentum from the higher revenue and profit per store coming from the expansion in the U.S. market. We compared the company to others in that space across Asia, emerging and developed markets. We were impressed with the changes in profitability as a result of the expansion in more dynamic markets. Thatís an example of a consumer discretionary retail name that is growing its earnings by more than 20% and is attractive relative to the universe.

In Europe, we favor U.K. stocks despite the macro and Brexit concerns, because thatís where we find a lot of good ideas. Within that market, we have had exposure to consumer discretionary, consumer staples, homebuilders and mining names. In the U.K. there are many small companies with attractive growth, because they have focused on a particular niche. For example, one of the discretionary names is developing a type of beverage thatís been growing rapidly both in and outside the U.K. In contrast, we donít currently have a large weight in Germany, although itís one of the larger markets in Europe.

The common factors for the stocks we select are that they may be entering a new market or developing a new product, and those factors are reflected in metrics like revenue growth, same-store sales growth, the underlying assets and the companyís ability to reinvest these assets in other companies.

Q: How do you identify growth and what stages of growth do you typically invest in?

A: Itís great when we can pick a stock early in its growth cycle. For example, two years ago we bought a brick-and-mortar retailer in Brazil that was entering e-commerce. The market was slow to identify the change and the stock was undervalued relative to its growth rate. The market was too focused on the recession in Brazil and was not rewarding traditional retailers.

As the company transitioned away from the brick-and-mortar model and developed its e-commerce business, the underlying trends turned positive. We were able to get not just the growth, but also the multiple expansion. We saw a positive trend becoming even more positive.

Today the retailer continues to deliver above-average growth that exceeds expectations, but the stock is already trading at a much higher multiple, because the market has priced it accordingly. When companies are trading at high multiples because the future growth is already priced in, there is a risk that they might disappoint. So we have become better at identifying when trends are changing and when companies might disappoint.

Sometimes small-cap stocks become large caps as they grow and develop. If we still see growth over the future years but we can no longer hold them in our small cap fund, we may hold them in our large cap fund. It is interesting to see companies evolve from $1 billion to $5 billion to $15 billion and how the market prices them. Obviously, as the company becomes larger, the investor base also expands. There is more coverage, so mispricing tends to diminish.

We have seen that evolution of the business model, the company and its valuation. We own one e-commerce company in Latin America that grew its market cap from $4 billion to $16 billion. It used to be a fast-growing company at 30%, 40% a year, which is now growing at 90% across the region. As it began to deliver that 90% growth rate, the entire valuation of the company changed.

Q: What is your portfolio construction process?

A: We hold between 35 and 125 equities, and individual stock weightings are limited to 3.5% of the portfolio. In terms of country weights, we can be two times the index. We focus on tracking error of about 5% to 10%. The limit on market cap is about $4.5 billion, although we can hold companies as they appreciate for a short period of time.

We donít asset allocate by region, country or sector; we let the stocks that we identify drive that allocation within our restrictions. Because we try to minimize risk at the stock level, our position sizes tends to be around 1% at purchase and 2% in the long term. Currently our largest positions are slightly above 2%. Our benchmark is the MSCI ACWI ex-USA Small Cap Index.

Q: How do you define and manage risk?

A: We try to limit our country risk, especially in emerging markets, by limiting the size of the exposure. We utilize risk measurement tools by looking at tracking error and beta versus the market. We aim to diversify the risk across 75 or 100 stocks not only by limiting the size of the positions, but also by limiting stock-specific risk. We have found that if you are concentrated in strong ideas with earnings and price momentum, you might end up with high momentum risk, so we monitor and control that risk as well.

We have regular meetings to examine and discuss the risk metrics and to make sure that the risk is not excessive. If we identify a particular country problem, we may decide to entirely eliminate our exposure to that particular market.

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