Q:  How is international small cap investing evolving? What are the advantages of investing in this space? A : As an asset class, international small-cap is in its early days in terms of adoption in the traditional diversification style box. In the U.S. international small cap investing is still largely an international segment of a portfolio, but mostly as allocation to emerging markets with international small caps often being non-existent or accounting for a very small part of one’s portfolio. In general, investing in international plays is still considered risky, and the small-cap segment is perceived by many investors as even riskier. However, investing in international small-cap companies may not only give investors access to fast-growing companies with a better risk-return profile than larger businesses over the long term, but it may add diversification in the portfolio because, as a group, it has historically been a lower correlated asset class. We believe that it is an inefficiently priced equity asset class which offers an attractive opportunity set. Q:  What core principles may drive your investment philosophy? A : The first core principle is that we search for quality at the right price. We believe that high quality companies generate value over time, and investing in businesses trading at a significant discount to our estimate of intrinsic value can lead to consistent outperformance in the long run. Another core element in our process is the combination of business-specific factors that create value over time. Aspects such as a company’s business model that can survive different economic environments, the strength of its management and the industry that it operates in ultimately contribute to the success of a stock. Our final tenet is based on sticking to a focused approach. We believe a deeper understanding of companies is achieved essentially through a focused approach, which allows for concentrated investments in the highest potential opportunities. Q:  How does your philosophy translate into an investment strategy? A : Screening for quality is the first part of our process. We start by looking for stocks with a market capitalization range between $100 million and $5 billion, typically included in the MSCI EAFE Small-Cap Index. Generally speaking, companies within this market cap range that are located outside the U.S. total about 11,000. With this preliminary list in mind, we start screening every country and industry indiscriminately for quality based on our six-factor approach. The first two factors that we look for are growth and return on invested capital. We perform a primary screen for double-digit operating income per share growth and return on invested capital. Our next two factors which help us define quality are balance sheet strength and cash flow. On the balance sheet side, we look for interest coverage ratios, specifically operating income over net interest expense that is greater than six times. Those four metrics are our first key steps to finding quality. Then, the fifth factor of quality is consistency of a company’s earnings growth. And finally, the sixth factor for screening is preliminary valuation, which means screening companies that trade at 40 times enterprise value-to-free cash flow or less. This initial screening on the 11,000 names narrows the potential selection to 300 names, with the list of those names rarely changing. A further step in our process is visiting every one of those 300 companies to meet and interview their executives. Additionally, we spend a lot of time going through annual reports to get a good feel for management and how they present themselves in those documents. During our meetings and interviews we generally focus on growth drivers and how long growth can continue. Moreover, we want to determine how sensitive a business model is when compared to economic activities. Because we are focused on finding companies that have low exposure to exogenous factors, certain developments beyond a manager’s control, be it a commodity price, interest rates, currency or a supernatural relationship to gross domestic product, will prompt us to skip companies exposed to them. Those two factors mostly eliminate around two-thirds of the 300 companies we visit, so we are eventually left with around 100 names in our working list before we start preparing three documents on each of these companies. The first document in our review is a score card which bears the format of an executive summary from the metrics that we screen on to a discussion about the business model. Possible topics include – how the company makes money, why we feel the success of that business model is going to persist moving forward, a discussion about its economic sensitivity and competitiveness and even a score, and rating on management’s honesty and transparency to capital allocation. That score card generates a score out of 100, and we focus on companies with at least 70 points and above. The next document is a valuation model where we put historical financials together from annual reports and company filings. With its help we determine intrinsic value through a proprietary, free cash flow model. Having an intrinsic price target on every company that we plan to own, we will buy a company that meets all the quality criteria and is trading at multiples that offer enough upside. Finally, the third document is a virtual white board, which is where the third person on the team, Merrill Stillwell, comes in. Merrill works on the triangulation or channel checking, basically talking to any professional who can help us understand the economic sensitivity, the end demand or the competitiveness of the companies in the portfolio or those that we are considering for inclusion. Q:  Would you describe your research process and illustrate it with a few examples? A : We are constantly looking for companies that have already demonstrated success. Overall, we are value investors seeking high quality fast-growing companies with business models that allow them to continue to grow. As mentioned earlier, our preferred metric for valuation is the enterprise-value-to-free-cash-flow ratio, and we screen out companies that are trading over 40 times enterprise value over free cash flow. For example, Megastudy Company Ltd is a provider of online and in-person tutoring education services mostly for high school and college entrance exams students in Korea. There are many countries in Asia and the Middle East with a high focus on education and a lot of rigor around getting into a school that offers very few spots. The demand for outside classroom help to get into these schools is especially heightened in countries such as Taiwan, Japan, Korea and China. We found Megastudy several years ago based on the screen that I was just referring to. It emerged as a very fast growing company in terms of returns, cash generation, balance sheet strength, and net cash on the balance sheet. The company earns most of its revenue from test preparations associated with the college entrance exam. Although Megastudy is a high quality company that is well known to investors, the stock took a dive because of some government intervention. What happened was that the government felt some individuals are spending too much money on these educational services. To give an example of the demand, some tutors and professors in the Megastudy network will get paid over a $1 million a year for their services, which only indicates how lucrative that business is. Because of the high prices, the government intervened in an attempt to discourage people from going outside of the government provided guidebooks and online services. Not only did that intervention cause the stock to pull back quite a bit, but it even affected the company’s operations. However, it is not the first time when this has happened. We have seen more than once throughout history how after similar interventions the demand for that product has not gone away in the long term. Even after a short term hiccup consumers return asking for the service again, and the demand for private tutoring is always there because it is simply so competitive to get into a few top universities. Another example would be Maisons France Confort, a small position in our portfolio with an interesting story. Maisons France Confort is a homebuilder in France with a key focus on building single-family homes in rural areas in France. The company primarily attracts mostly first time home buyers who want to get out of the city and move into rural areas where population is less dense. In most cases, these consumers will already have their land purchased, which means that MFC does not buy the land and before and the consumer has to actually deposit anywhere from 10% to 20% of the total price. When we found MFC, it was not only a fast-growing business that was generating high return on cash, but it seemed attractive to us because they do not buy the land and their customers are paying upfront, which helps them to generate positive cash flow. MFC is also a great business model because the government in France has been pushing home ownership to the tune of providing zero interest rate loans and other subsidies for first time home buyers in order to encourage them to buy homes. For us, having that underlying push by the government to drive the demand up was one of the reasons why this company turned into a leader, and that is why it is in the portfolio today. Another example would be Pico Far East Holdings Ltd., a Hong Kong-based company that focuses on 3D advertising for exhibitions and conventions. They work with multinational companies looking to market their brands at events and exhibitions primarily in China, Singapore and the Middle East. Pico provides turnkey event marketing, including design/concept, construction, dismantling and peripheral services. After their business started in Singapore, it quickly spread throughout the Asian region and the Middle East, owing to their resilience and the fact that 3D-exhibits are far less sensitive to economic swings than conventions and exhibits overall. Q:  How do you build your portfolio? A : Since we manage a portfolio with holdings ranging from 35 to 60 names, we allocate no more than 6% to a single position. Generally, we enter a portfolio position at around 1% before we allow it to increase in portfolio weight as long as it offers an upside potential. We use the MSCI EAFE Small Cap Index for benchmarking purposes. Although we are benchmark aware, we are not closet indexes with regard to sector, industry or country weights. Consequently, the portfolio is all built from the bottom up with an emphasis on quality valuation. Q:  What is your sell discipline? A : First of all, we may sell a position if a company breaks down in any of the quality metrics described above. We also resort to selling if the fundamentals are degrading or when a company approaches its intrinsic price. Furthermore, we will sell a name in the portfolio if we find a better mix of valuation and quality as well as a suitable candidate for replacement. Q:  What risks do you focus on and how do you contain them? A : We use third party risk analysis on a monthly basis to correctly identify our exposures by sector, country or any other factor that might be influencing the portfolio based on price. We also do our own risk analysis at the end demand level – the revenues and earnings of all the companies in the portfolio and the top 15 exposures in the portfolio. For us, risk also plays in the portfolio construction process with a strong valuation discipline. We have the most valuation support in the portfolio on our highest weighted names. In the valuation model, one risk tool that we have is a high margin of safety in our forecast. Finally, we use forward currency contracts to give our clients the diversification and return benefits of currency, which is another effective risk control in the portfolio. Other similar measures include avoiding companies with meaningful exposure to exogenous factors, intensive ongoing research of each holding and a formal team review following deterioration in key financial metrics.