Q: What is the core mission of the fund? How does it differ from its peers?

A: The fund focuses on international small- and mid-cap companies with an emphasis on developed markets more than emerging markets. It is one of the largest funds in the category, with about $7 billion in assets under management and a successful 10-year track record. The strategy differs from its peers by using an approach that seeks quality growth at a reasonable price with a focus on compounder types of businesses.

Since the fund’s inception in 1997 when it was one of the first to hit the international small-cap space, its investment charter has expanded to include mid-sized companies, and its name was changed to reflect this. However, our basic approach has remained the same for 23 years. To find companies that produce above-average growth and compound returns for shareholders over time, we look within healthy, growing industries for businesses that are often leaders in their niche, with an emphasis on agile, asset-light companies. The Fund is part of the Invesco Global Equity Team, which just celebrated its 50-year anniversary.

Q: What core beliefs drive your investment philosophy?

A: We look for companies that are positioned to thrive in all types of economic environments. Therefore, the fund de-emphasizes or avoids deep cyclicals to focus more so on “compounders,” or businesses delivering consistently strong profitability. Often, it can take time for their shares to react positively, but we remain patient with those investments because we believe the market will eventually recognize their value.

We try to take a business owner’s perspective when investing. I ask myself, “If I could own just one company, what sort of financial characteristics would I want that company to have?” So, we evaluate one company at a time to determine whether we believe the worth of that business will increase. I feel this is almost a late-stage private-equity approach to the public equity market, and look for some of the same things in companies that late-stage private equity investors would.

Among the attributes we think they seek are relatively reliable and preferably growing cash flow. As a result, they tend to avoid deep-cyclicals and focus on industries where cash flow is plentiful.

Q: What are the critical steps of your investment process?

A: It is primarily a bottom-up approach with quantitative and qualitative elements that recognizes macroeconomic influences on companies rather than allowing macro considerations to drive investment decisions. Our process focuses on analyzing business structure. We look for a strong competitive position, independent pricing power, and durable customer relationships.

Our process starts with quantitative screening which is more science than art. Our investable universe has approximately 15,000 companies with market caps of $150 million to $10 billion. Within this universe, we use some time-tested screening tools to find the better companies that can be self-financing, generate consistent profits, and do not have a lot of debt.

In this part of our analysis, we are look for strong balance sheets, asset-lightness and asset-efficiency.  So we like a strong equity ratio, high ratio of profits to the asset base, and above-average returns on capital.  Lastly, we require minimal level of liquidity. Our quantitative screen tends to eliminate around 85% to 90% of the companies in our initial universe.

Following the pairing down from quantitative screening, we turn to qualitative assessment. This is more the ‘art’ or judgment part of the process, and involves a formal assessment using a framework we’ve dubbed “SCORE”. SCORE is a qualitative scoring of a given company’s Sector dynamics, Competitive positioning, Operational efficiency, Record, and Ethos.

Topic number one is Sector. Let’s compare the sectors of airlines and medical devices, for example. Because the airline sector is subject to exogenous shocks, from COVID-19 to economic recessions to oil spikes, its players are very challenged to sustain a competitive advantage. The entire industry has lost money for 40 years, and the carriers tend to go and out of bankruptcy protection or bail-outs. Compare airlines to the sector dynamics of medical devices, which tend to be much more appealing for long-term investors. Healthcare is not cyclical or subject to these types of exogenous shocks, and tends to have independent pricing power with consistently strong profitability.

Next, we score competitive positioning to determine what a company can do better or cheaper than its peers. By this point, we can be comfortable the business has above-average pricing power. So onto the third topic. Operational efficiency scores how effectively a company is able to translate its pricing power into cash flows. Fourth, when looking at a company’s track record, we want to see strong financials with consistent profitability. 

Ethos, the last of the give components of SCORE, examines corporate governance and whether a business knows how to grow within its franchise. For example, we don’t typically want to see great family-owned companies acquire tangential things to diversify their business. As small-cap portfolio managers, we want to manage diversification in a more systematic manner.

A company’s final score will fall between 0 and 100, and those earning 70 or higher move further in the investment process. This leaves us with roughly 450 companies I call the “compounder wish list.” These are all high-quality companies which I monitor while waiting for valuation to become more attractive, at which point we would consider them for the portfolio.

Q: Would you describe your research process in detail?

A: Our group includes 24 investment professionals and all but a few are generalists—we don’t even have people who focus exclusively on one geography. Having specialists introduces the risk of advocacy. Our model is interactive and encourages people to be intellectually rigorous, to debate or verify ideas, or simply to be another set of eyes.

We all travel to see companies and do a lot of calls particularly with those based in Japan or Australia. We have to track down a disproportionate number of the companies we invest in because they are capital light and aren’t routinely soliciting new investors. Carl Zeiss Meditec is a great example. The lenses and optics company is family-controlled and dates back 170 years. It’s a tremendous story of industrial leadership that has thrived through two World Wars.

Q: How do you normalize the accounting standards of different countries to U.S. GAAP accounting?

A: Because we focus on developed markets, it’s rare that we encounter anything other than GAAP or IFRS, both common standards governing financial reporting and accounting. There are limitations to the knowledge we can bring to the table regarding the minutiae of accounting—we are not forensic accountants. Fortunately, this strategy has had very little experience with fraudulent businesses but there is always that risk from an accounting perspective.

On a day-to-day basis, I am comfortable that the quality of the financial information we receive is very high. We are less likely to run across real accounting pitfalls due to our companies being in developed markets, having longer-than-average operating histories, and in attractive industries.

Q: How do you handle local currency issues?

A: This strategy doesn’t hedge currency. We don’t consider ourselves to be currency prognosticators, though we do try to take advantage of currency swings. Most of our holdings are globally structured and significantly export-oriented, so for them a weak home currency is generally an advantage. But for us on a NAV basis, a weaker dollar can be a challenge. These opposing dynamics give us a built-in hedge in that sense.

There is less of a concern about currency volatility. In the developed markets where we focus, currencies are inversely or weakly correlated against equities. In emerging markets, where these move with very high correlation, currency volatility tends to be more dynamic.

Q: What is your portfolio construction process? Does diversification play any role?

A: The fund invests in three business model categories: perennials, market structure businesses and differentiators. A perennial business has characteristics that lead to recurring revenues and cash flows. Market structures are companies where the market itself subdues competition, like an oligopoly or businesses with regulatory protection. Differentiators have a technological advantage or IP we see as sustainable.

We also use an investment pyramid that separates our holdings into A, B, and C tiers, with A at the top of the pyramid, B in the middle, and C at its base. All 120 names in the portfolio are high-conviction holdings, companies with a quality score of 70 or higher—so the pyramid isn’t a measure of quality.

The fund’s benchmark is the MSCI ACWI ex USA SMID Cap Index.

Q: How long do you hold a stock? What drives your sell discipline?

A: The SMID-cap space has companies as high in quality as any global leader, so it would be foolish to sell purely on valuation. Often when an investor sells a winning stock, he or she feels like a victor until it continues to rise over time. With that in mind, we think of our preferred holding period as forever—that’s what it should be, given that every holding enters the portfolio with high conviction, after much research and soul-searching. Ours is a buy-and-hold approach.

But it doesn’t always work out that way, so we will sell under certain circumstances. One is quality scoring, which is done on an ongoing basis. Were we to have an interaction with management, a competitor, or a major supplier that influences our view of a company, we might re-score it. Because our basic requirement is high conviction, we will immediately sell a company if its quality score drops below 70. Other reasons to sell is if valuation becomes out of whack, the company is acquired, or we find a better risk-reward trade-off from our wish list.

Q: How do you define and manage risk?

A: I consider our approach as one that’s as focused on downside risk as on upside potential, and consider myself as much a risk manager as a portfolio manager. Risk to me is permanent capital loss. There is a common perception that volatility is a proxy for risk. As an active manager, I view volatility as a potential opportunity, though we do want to avoid sustained volatility. Since we can’t really predict stock prices, all we can do is try our best to predict a company’s operational success.

To reduce risk at the company level, we prefer that our companies have a diversified customer base, and without a heavy focus in a particular industry. A good example of this would be a small or mid cap company that sells heavily to say Apple. Apple seems indestructible, but it’s also extremely powerful and can push around suppliers. If a small-cap company is getting 50% of its revenue from Apple and Apple renegotiates their contract, cutting profitability at our smaller company by say 15%, suddenly our company becomes quite vulnerable. We try to avoid companies with such a heavy customer concentration.

Q: Has your investment process changed since the last financial crisis?

A: Very little. Making a major change like that during periods of volatility or underperformance is almost a sure way to go off the rails. Though these periods might not feel good in the moment, they are the times when a disciplined approach like ours can really outperform and add value. Conversely, at times when people are chasing deep cyclicals, commodity producers, and infrastructure companies, our strategy will tend to lag. But historically, these periods are fleeting. In fact, commodities have produced a negative real return for investors over most longer-term periods. So in most market environments, when fundamentals are driving the market, we feel our approach is positioned to add value for shareholders and create a positive investment experience.