Q: What is the history of the fund? Could you give us some background information?

The Delaware International Small Cap strategy has been around for a long time; it existed before even the benchmark was launched. The team has an extensive track record of almost two decades of focusing not only on small caps, but also on growth stocks in the international space. The fund invests in companies with market cap less than $5 billion.

I have been the portfolio manager with the Global ex-US Equity team at Macquarie Investment Management since 2016. I had previously worked with Baring Asset Management, a UK-based firm. In 2004 I moved to Fortis Investments, which was then acquired by BNP Paribas, where I was head of Global Emerging Markets Equities. From 2014 to 2016, I managed the North Grove Capital long/short strategy in emerging markets before joining Macquarie Investment Management.

Q: What core beliefs drive your investment philosophy?

We focus on the fundamental changes that lead specifically to earnings growth and we aim to uncover the areas where the markets underestimate these changes. We believe that the markets tend to underestimate the duration of the change and the duration of the company’s ability to deliver earnings growth. Our process is designed to identify the factors that contribute to earnings growth and the changes in that growth, its durability, and the areas where the market tends to underestimate the longevity of that growth. That refers to all markets and sectors. 

Throughout the fund’s history, a key feature has been the long-term view of three to five years. We select stocks based on three factors - earnings growth, relative strength of the security, and earnings revisions. Our focus is on stocks that grow faster than the market and have a sustainable business model that supports that growth. Typically, these are companies that are introducing new factors to their business models, entering new markets, developing new products, have new management or new geographies, or are consolidating a particular sector. 

An important element of our philosophy is that we need to be able to measure the change in some way. The company’s ability to capitalize on that change has to be visible and the analyst community also has to see the positive change. So, we don’t buy fallen angels or out-of-favor stocks with no particular earnings momentum path. We don’t look for underperforming companies with poor metrics simply because of their valuation. 

We are definitely not value investors and we don’t focus on the existing multiples based on current earnings. The important factor is not whether the stock is trading at three times book or 25 times earnings or 50 times earnings, but the ability of the company to deliver results above expectations.

We need to see some confirmation that earnings momentum is reflected in the price. So we focus on positive fundamental change that leads to earnings growth, but we need to see evidence that the market acknowledges the change before we purchase the security. We are interested in whether the market has underestimated the earnings power, the potential of the company and the duration of the change. That’s where we feel we can add value and outperform the market. 

Q: So the key factor in stock selection is the above-average earnings growth and the visibility and the sustainability of that growth?

Yes. We are aware that each company is unique, but the focus on growth stocks means that we look for companies on their way to generating above-average and higher-than-expected earnings growth. For example, we have active position in the technology sector, although the companies in that space may look expensive on a P/E basis because of their emphasis on revenues and market share growth.

Amazon.com, Inc is an example of a company that has focused on growing its top line, gross merchandise value and market share throughout the last 10 years. It is less focused on the bottom line or the earnings per share number. Amazon was trading at 100 times earnings in 2016 but today it’s trading at 75 times earnings and the stock quadrupled its value. There was a meaningful change in profitability, despite the focus on revenue and GMV (gross merchandise volume) growth.

Q: What is your international geographical footprint?

This fund invests in developed and emerging markets. The major markets are Japan, Europe and Australia, but the team covers all the markets outside the U.S., including emerging markets. We also run an emerging markets small-cap fund.

Q: What is the process of narrowing your investable universe?

We start with an investable universe of about 2,500 companies with market cap of less than $5 billion. Then we screen for liquidity and information transparency. That screen narrows down the universe to about 500 stocks, which can be screened on a fundamental basis by looking for governance, earnings growth drivers and sector factors. The fundamental factors we use are based on positive change, which can be related to new markets, new products, macro changes, new geographies or sector drivers. 

Then we debate the ideas and construct a portfolio that meets our requirements. Our experienced research team is organized by geography. We are an independent team of six individuals, looking at the stocks across different markets, including Europe, Asia, Latin America, Emerging Europe and Africa. We look for growth ideas that meet our market cap limit as we try to construct a portfolio of 75 to 100 stocks.

Internationally, we look for trends across industries, because they tend to be similar. For instance, the factors affecting e-commerce in India are similar to factors in Brazil and China, although the companies may be at different stages of development or in different sectors and verticals. From a top-down perspective, different markets have different growth and interest rates, but there are global industry trends in sectors like materials, energy, technology and consumer discretionary. We collaborate as a team to identify these factors.

Q: How important is the macro perspective? Do you have a macro overlay in your process?

We rely on a bottom-up process that aims to identify the best stocks. We are well diversified across sectors and countries, but we don’t have a macro overlay and we don’t make large bets at the macro level. If we identify a problem in a particular market, we wouldn’t invest in it. We wouldn’t try to find the best stock in the worst market just for the sake of having exposure. 

Right now there are macroeconomic problems in emerging markets, particularly in Turkey and Argentina, where we had positions. Less than a year ago there were companies benefiting from the weak currency and the macro environment. However, because of the dislocation of these two markets today, we have decided to take our positions to zero and not to participate at all.

In general, we tend to be fully invested across what we identify as the best sectors and stocks with a certain growth profile. We believe that in any environment there are winners and our job is to identify them. The macro input is just one of the many factors that would drive the earnings growth of a company.

Q: How do you manage the potential currency issues? Do you hedge your exposure?

We don’t hedge our currency exposure and we don’t predict the direction of currencies. Certainly, Brexit had an impact on the U.K. pound; the strong dollar recently had an impact on all currencies. There is an effect on the overall performance of the index, but that’s not our focus. Instead, we focus on the company’s business model and its ability to grow above and beyond that macro effect.

If we identify stocks in a market with significant macro factors, which affect the direction of that market, we may decide not to participate at all, but we would not be hedging. Also, we may be able to find companies that actually benefit from a weakening exchange rate, such as the export-oriented companies, but we don’t have a hedge or a macro overlay beyond that.

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

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 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. That’s 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 that’s 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 that’s been growing rapidly both in and outside the U.K. In contrast, we don’t currently have a large weight in Germany, although it’s 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 company’s ability to reinvest these assets in other companies. 

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

It’s 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?

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 don’t 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?

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.