Q: Would you give an overview of the history and mission of the fund?

Advisory Research, Inc. was founded in 1974 as a domestic value manager.  The Small Cap Value strategy launched in 1987 and the international business started in 2006, leveraging a similar investing philosophy. 

The firm manages more than $7.5 billion in assets across a broad spectrum of traditional long only and alternative investments. This mutual fund originated in 2010, and I joined the team in 2013.

We are disciplined, long-term value managers focused on small-cap companies with market caps below $5 billion, whereas most international strategies primarily have a large-cap and growth-oriented focus. 

We combine rigorous fundamental research and quantitative tools to add value from a bottom-up security selection standpoint, and emphasize capital preservation to compound capital long term. That generally manifests itself in below benchmark portfolio average multiples, price to book, price to earnings, or EV to EBITDA, and better downside capture and lower standard deviations versus the fund’s benchmark, the MSCI EAFE Small Cap Value Index.

Our benchmark includes all developed market countries outside of the U.S. The largest countries in our portfolio currently include Japan, Germany, UK, Sweden, Switzerland, Norway, Australia, and Canada. 

Q: What core beliefs drive your investment philosophy?

We are value-oriented. Security selection drives our alpha, so we don’t make large country /or currency bets. We incorporate a variety of quantitative and risk management tools in conjunction with deep fundamental and bottoms up company specific research.  To generate superior investment outcomes, we seek to outperform consistently, through various investment cycles. 

Capital preservation and downside protection come into play even before we think about an investment’s upside opportunity.

Q: Would you describe your investment process?

We have a disciplined four-step investment process. The first step is identifying our opportunity set; the second and third determining downside protection and upside potential; and the fourth, deciding the appropriate weightings for the securities that we want to purchase.

To identify our opportunity set, we first narrow our universe using our proprietary quantitative screening tool which we call the  alpha scoring tool. We rank the entire universe of stocks based on a multifactor model that incorporates 56 different fundamental factors which get reweighted every month. 

Once we arrive at the top 20%, we narrow the list even further identifying those that look attractive relative to underlying fundamental valuation and those securities exhibiting strong, defensive balance sheets.

Step two, downside protection, consists of our research analysts performing financial and business downside risk analyses, including historical and peer valuation analyses, to quantify downside potential in a bear-case scenario. We want businesses that exhibit cash flow generation and profitability throughout the business cycle. 

We eliminate stocks that are deep turnarounds, unprofitable, excessively overleveraged, or exhibit risk of financial distress. We analyze closely at management team quality and corporate governance, which are particularly important when screening international investments. The stocks that fail step two go into our knowledge database for future consideration should circumstances change. 

In the third step we identify upside potential, including management’s ability to unlock and enhance company value. We research capital allocation to ensure management uses capital most effectively, and analyze opportunities to improve corporate governance.

We like catalysts, so we pinpoint potential catalysts, without insisting on strict time horizons. We also analyze the industry business cycle and potential changes in the industry outlook and competitive landscape that drive value, and look for asset utilization improvements. 

The fourth and final step is determining an appropriate weighting for a new security based on how it fits into the portfolio. We utilize an optimization engine combined with our fundamental conviction to determine an appropriate portfolio weighting. This minimizes portfolio risk and ensures we do not take on any unintended bets in the portfolio. 

A key part of our philosophy is to ensure we drive alpha through portfolio security selection and avoid taking on excessive amounts of country, currency, style or factor risks. 

Q: How do you standardize the accounting statements of different countries?

We don’t try to convert everything over to one standard. Instead, we typically take each company at face value, making adjustments as needed depending on classification differences and accounting standards.

For example, in Hong Kong, real estate companies disclose fair market value of their real estate quarterly or semi-annually, when they report their earnings. Other jurisdictions do not make this fair value change. So, when comparing a real estate company on price-to-book value basis, we recognize that Hong Kong companies will trade at lower multiples compared to global peers and make adjustments as necessary to compare on an apples to apples basis.  

Q: Do you take a macro view in your strategy?

Macro is something we monitor; however, it doesn’t drive investment decision making. It comes in occasionally, from a risk management standpoint in more extreme scenarios, but primarily shows up in our bottom-up analysis—calculating our upside/downside scenarios and talking to management teams and understanding industry and company outlooks.

Q: Can you provide an example of your research process?

One example would be Safestore Holdings plc, the largest self-storage provider in the UK. We found the stock through a screen, had extensive discussions with an industry expert, met the management team, and then proceeded with fundamental research. 

It fit our downside protection and capital preservation criteria in several ways. First, in London, U.K. and Paris, France, the barriers to entry, to build new self-storage facilities, is extremely high due to land values, limited site availability, and extensive planning regulations when getting permission to build a new facility. Supply growth over the next few years is estimated to only be about 1%- 2% compound annual growth rate (CAGR), giving the businesses strong pricing power and entry barriers against new competitors.

About three-fourths of lead generation comes through websites on Internet. Most mom-and-pop stores can’t afford to invest in IT infrastructure and internet search engine marketing to compete with the two big players, Safestore and The Big Yellow Group plc. 

Also, the company has refinanced its balance sheet twice over the last three years, and brought down its loan-to-value ratio to 31%, with an interest coverage ratio of 5.5 times, which provides a lot of headroom to conduct accretive M&A opportunities and to consolidate the market. Additionally, the stock was trading at a discount versus its U.K., Europe, and U.S. peers, with a growing dividend yield of about 3.5%.  In doing our downside analysis, the stock looked attractive, and at the time of our investment, the stock was trading at only 15 times earnings.

Notably, Safestore maintains occupancy levels of about 72% and targets 85%. It has implemented sophisticated pricing models to increase occupancy, and in conjunction with the industry’s low supply growth, that should drive mid- to high-single-digit organic revenue growth over the next three or four years. As well, their underleveraged balance sheet should allow them to conduct M&A deals accretive to shareholders. 

In September, Safestore bought Stork Self Storage (Holdings) Limited, which added 12 stores to their portfolio. 

The U.S. self-storage market has been around for about 40 or 50 years, while the European and the U.K. markets lags several decades behind, with room for strong organic growth.

Q: Would you cite another example?

One of our larger positions, a company called Austevoll Seafood ASA, comprises two businesses, salmon farming in Norway as well as a fishmeal and fish oil business.

When we first looked at it, Austevoll was trading at one times book value and less than seven times earnings, at a discount to net asset value, based on fairly conservative assumptions, and with a dividend yield over 3%. Our upside case was driven by a narrowing of that net asset value discount, continued pricing power, and strong overall salmon prices, began to reveal itself, following our initial investment, combined with improved operational efficiencies in their salmon farming practices.

Prices remain robust today, driven by low-single-digit limited supply growth and strong per kilo margins. The company continues to generate a significant amount of free cash flow and the stock is trading at only five times cash flow. Even on an earnings basis, it’s trading below 10 times earnings, and maintains a net cash balance sheet.

The thesis behind investing in the salmon industry is supported by the favorable supply-demand outlook. On the supply side are constraints driven by regulatory biomass limitations, while demand is steadily rising, driven by per capita consumption increases, primarily from emerging markets. Our outlook on this company continues to be strong.

Q: What is your sell discipline?

There are four circumstances that cause us to sell a security. If we feel that the full valuation of the business or the investment is realized and we don’t see any additional upside potential, we’ll sell; and if we identify better opportunities within an existing sector or country from a new idea standpoint, we will consider selling as well. 

Any significant negative news that could alter our investment thesis is another part of our sell discipline. Finally, if the company is acquired or merges into another entity we often sell.

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

Portfolio construction incorporates two critical elements. We combine the upside/downside analysis stemming from our fundamental research and conviction in the underlying businesses and investment opportunities with a proprietary optimization tool that helps us construct the portfolio. The appropriate portfolio weighting of each investment is based upon maximizing the information ratio of the portfolio to generate the most alpha without taking on excessive amounts of risk.

Diversification is important, given the diversity of countries and currencies we deal with, so we generally target 60 to 80 holdings in the portfolio.

Once a stock is in the portfolio, we utilize proprietary security and portfolio tools to regularly, proactively monitor our positions. Our upside/downside analysis is updated quarterly, or more frequently, depending upon news or developments. 
We generally do not exceed 4% for one particular position, and target to maintain30% or less in any single country and sector.

Q: How do you define and manage risk?

Bottom up, at the security level, we think about three main risk elements: valuation, financial distress, and business obsolescence. Valuation, what the investor pays for a particular asset, is critical—we want to ensure we don’t overpay for our investments. We look for opportunities where bad news is priced in and stocks have minimal downside risk and a strong margin of safety.

In terms of financial distress risk, we avoid overleveraged securities, companies at risk of insolvency or liquidity problems, and any that might need to tap the equity markets to dilute minority investors.

To avoid business risk obsolescence, we avoid binary outcomes or situations. We look for profitability and cash flow generation throughout the cycle to avoid any significant business risk. 

And from a portfolio level, our optimization tool ensures we do not take on unintended bets from a factor, style, sector, or country standpoint.

Q: What lessons did you learn from the financial crisis?

Downside protection and capital preservation are paramount. Liquidity is part of our screening process, because it can be completely washed away in a crisis or market downturn, and move rapidly against you. We make sure that if things change with any security, we can exit our position in a timely fashion, something that proved challenging during the financial crisis.