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While higher interest rates and inflation have been dominant concerns in investors’ minds and hopes are high for further declines in both, Karan Phadke, portfolio manager at Calgary-based Mawer Investment Management Ltd. sees these two factors as merely having returned to normal levels based on a longer-term perspective.
“We’re now operating in a more normal environment than we were seeing in 2021 and before,” he says. He emphasizes that the Mawer motto is prepare don’t predict.
“We can’t predict the next Covid, for example, but we seek companies that are not co-related to a single driver,” he says. “We don’t know what’s coming next, so we’re always looking for vulnerabilities.”
Rates Might Not Have Even Peaked Yet in the U.S.
Despite a quarter-point drop in Canada’s leading interest rate in early June, he isn’t certain that rate cuts are imminent in the economically stronger U.S. or even that rates have peaked in that country. Growth has been slower in Canada and other parts of the world, and stock markets have also been less been than exciting than in the U.S., where the market has been propelled by a handful of mega-cap technology stocks expected to reap bountiful profits from artificial intelligence.
This trend has left global small-caps lagging broader market averages, and even in the U.S., the bellwether Russell 2000 small-cap index sits roughly where it did four years ago.
Small Caps May Not Be the Contrarian Play Forever
“No segment of the market is always good or bad,” Phadke says. “Small caps may be seen as a bit of contrarian trade right now, as U.S. large caps have been dominant for the last 10 years. But that may not always be the case, there is no rule for the next 10 years.”
The four-star, silver-medalist $3.2 billion Mawer Global Small Cap A holds a relatively concentrated portfolio of 40 to 50 small-cap stocks. It showed a 15-year average annual return of 13.02% at June 17, a five-year average return of 4.02% and a one-year return of 9.13%, according to Morningstar Canada. Returns are top-quartile for the 15-year period, but over shorter periods the fund has lagged the comparable Morningstar index.
Mawer Global Small Cap Fund
“Our stock selection process is bottom-up and we are deliberate in the companies we select,” Phadke says.
Small Cap Fund Diversification
While geographic and sector focus in the fund tends to be a result rather than a driver of stock selection, the team, which also includes deputy chief investment officer Christian Deckart and portfolio manager John Wilson, is careful to diversify in a variety of ways.
Currently the fund has 46 companies based in 19 different countries. The portfolio is diversified not only in terms of the holdings’ business operations, but in terms of other factors such as currency exposure and vulnerability to changes in governments, taxes or regulation.
The fund’s largest geographic weight is in Europe at 45% of assets, more than four times the weight of the benchmark, although Phadke points out that Europe consists of many countries and corporate revenues may come from various parts of the world wherever the head office is based. The fund has only a 23% weight in the U.S., which is about half the benchmark weight.
“My personal opinion is that if half your assets are in one country you are not diversified, even if that is the most capitalistic country in the world,” Phadke says.
Staying Away from Resource Commodities
Like other Mawer funds, Mawer Global Small Cap seeks wealth-creating businesses, with low debt, healthy return on capital, strong management teams and attractive stock valuations. Phadke prefers to stay away from firms in the resource commodity business, as they are not in control of prices for their product. Instead, the fund is focused on less cyclical companies in service-oriented sectors.
Phadke likes firms with a business-to-business model, which often offers stability in revenue due to strong client relationships. He focuses on firms that are among the most dominant players in their fields.
Finding an Edge in Small Cap Stocks
“We like companies with a competitive advantage that will help them maintain their leadership position,” he says. “They can do something better or cheaper than others can. That may be because their scale allows them to offer a cost advantage to customers, or they have a broader assortment of products or a stronger brand.”
The quality of the management team is key with small caps, where decisions have more immediate and obvious consequences. The Mawer team spends time interviewing corporate executives, board members, former employees and others who may offer perspective. A variety of numerical measures can shed light on management, Phadke says, including safety standards, staff turnover, share ownership, operational track record and financial metrics such as how capital is reinvested.
“We look for management teams with skin in the game whose interests are aligned with shareholders,” Phadke says.
Top Small Cap Stock Picks
Among the fund’s larger holdings is Ipsos Group S.A. (IPSOF), a French company that is a global leader in market research, including the collection of data through such methods as polls and surveys. Followup surveys at later dates and comparative analysis result in recurring business.
Another key holding is U.S.-based CBIZ (CBZ), which offers various financial services to mid-size companies. Its expertise encompasses accounting and auditing, insurance, payroll, employee benefits and credit risk. Like Ipsos, the firm has a large base of loyal, repeat customers, and is able to pass through price increases.
“It may appear to be a boring business, but taxes and audits don’t go away,” Phadke says. “It takes a lot of work to switch accountants, and customers tend to stay put.”
Another pick is Convatec Holdings U.K. Ltd. (CNVVY), a global provider of medical supplies. It focuses on items that need to be continually replaced by patients, such as bandages and other wound care products, catheters and ostomy bags.
Earlier this year the team sold the fund’s stake in InPost S.A. (INPOY), a Polish company that provides parcel delivery to lockbox addresses, courier and express mail service in various European countries. The stock had seen strong gains during the past couple of years and the team felt its valuation was rich relative to other opportunities.
