4 Quality Cyclical Small Caps

PM Lauren Romeo discusses recent market volatility and gives a deep dive on four key holdings in our Premier Quality strategy.

Q1 hedge fund letters, conference, scoops etc

With more market volatility in May, where have you been most actively investing?

Investors’ concerns about the escalation of the trade war between the U.S. with China—and its potential impact on growth in the U.S. and around the globe—all weighed on U.S. small-caps in May. Every sector in the Russell 2000 declined, with cyclicals, where we are currently overweight, hit especially hard.

We used share price weakness and higher volatility to add to existing names in Royce Premier Fund. Most were holdings in Industrials, Information Technology, and Materials that we had initiated during the prior two quarters. In some cases, stocks declined to a degree that seemed to price in a fair amount of the potential near-term negative impact of higher and broader U.S. tariffs, creating valuations that looked attractive to us when viewing the businesses on their long-term earnings power.

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Can you discuss a holding in which you have high confidence that has not yet taken off so far this year?

One holding that struggled in May but whose long-term prospects we have high conviction in is Cabot Microelectronics (CCMP). Cabot manufactures high-performance specialty chemicals that are critical for manufacturing semiconductor wafers, which are the substrates upon which integrated devices, or chips, are built. Its stock fell almost 23% in the month as industry wafer starts continue to decelerate because chip makers have been reducing production to address excess inventories and falling prices, particularly in the memory segment.

Decelerating global growth, along with related trade war worries, could push out a recovery, yet we believe these near-term headwinds are temporary. The key secular growth trends in technology from which Cabot is well-positioned to benefit remain in place. Semiconductor chip usage is proliferating beyond the traditional domains of personal computers and smartphones and into myriad applications including data centers, artificial intelligence, automotive, home appliances, aerospace, and industrial equipment. These expanding addressable markets for semiconductors will drive more wafer starts, the key volume driver of Cabot’s growth.

Does Cabot have any other notable advantages?

I think so, yes. At the leading edge, each next-generation chip has new and more complex architectures for which older materials and process chemistries are no longer adequate. This creates the need for different semiconductor materials that in turn require new, higher-priced process chemicals from Cabot.

This complexity also increases the number of steps in the chip-making process, which results in more chemical usage. For example, for leading-edge 3D memory chips, the number of steps using Cabot’s polishing slurries doubles. Cabot has about a 33% market share in its core polishing slurries business, almost three times that of its next closest competitor. Given its track record as a leading electronics materials innovator, chip makers collaborate closely with Cabot as they map their transition to each new technology node, enabling Cabot to gain the inside track in developing new yield-enhancing chemicals for next-generation chips.

After an expensive and extensive qualification process, Cabot’s slurries become part of the process recipe for customers’ fabs (a semiconductor fabrication plant). High switching costs, combined with the long, useful life of a fab, mean that each node win for Cabot creates a protected and steady revenue stream.

Finally, Cabot has broadened its product portfolio via acquisitions. For example, the firm bought a polishing pad manufacturer in 2015 and an electronic chemicals producer in 2018, both of which provide it with more products to cross-sell for different process steps in the fab.

Can you talk about another high-confidence holding that hasn’t enjoyed a great year so far?

We really like the long-term prospects for Wolverine Worldwide (WWW), which designs and markets performance and lifestyle footwear mostly for retailers on a wholesale basis. It has a portfolio of really strong global brands, including many market share leaders, such as Merrell, which is number one in hiking; Sperry, which is number one in boats and number two in in rain boots; and Saucony, which is fourth in trail running shoes. In Wolverine and CAT, it also has the number one and number three work boot makers.

The stock was down around 13% year-to-date through mid-June—and fell 24% in May chiefly due to disappointing first-quarter results and a more muted outlook for the second quarter that were largely the result of unseasonably cool and wet spring weather that crimped demand for boat shoes and sandals.

All of this raised concerns for investors about whether Wolverine can achieve its 2019 guidance while working down elevated inventory levels. Of course, we always take the long view, and from that perspective, we see a company that’s permanently improved its profit model via the restructuring actions it’s taken over the past three years. During that period, Wolverine divested itself of underperforming brands, rationalized its core brand product offerings, and closed more than 70% of its company-owned stores while reinvesting in its e-commerce infrastructure. These actions helped operating margin to improve from 8% to 12%.

What other efforts has Wolverine made to improve its business?

After bolstering its operational foundation, Wolverine pivoted toward reaccelerating revenues through meaningful incremental investment spending in three areas. The first was a faster and more innovative new product design engine. Merrell and Sperry, its two largest brands, were the first to adopt this new concept-to-market model, and each saw solid sales lifts in 2018. This year, all of Wolverine’s brands will have implemented this model.

The second is a digital direct-to-consumer initiative. Its e-commerce business currently accounts for roughly 9% of sales compared to 28% for the U.S. footwear industry as a whole. This channel has become Wolverine’s fastest growing and highest margin area. Its digital strategy also entails a more aggressive use of online advertising, content creation, and data analytics to allow Wolverine and its customers to more effectively market to each brand’s target consumer.

The third effort centers on international expansion. Although about a third of its revenue is generated from outside the U.S., Wolverine is underrepresented in the fastest-growing non-U.S. region—China and the rest of the Asia Pacific—which accounts for just 8% of sales. The company is aggressively investing in its personnel and distribution in the region and last year entered into a joint venture in China for its Merrell and Saucony brands.

Wolverine’s three-pronged global growth initiative is no layup; it will take time for increased spending to yield results. But if management can execute its plan successfully, the associated sales leverage from faster organic growth should drive additional operating margin expansion. It would also create additional reinvestment opportunities, giving Wolverine a robust “plug and play” platform onto which it could add acquired brands.

Can you discuss a holding that’s done well so far this year?

The stock of John Bean Technologies (JBT), which we first bought in Premier in 4Q18, has risen more than 60% in 2019. The company provides manufacturing equipment, automation systems, and technology solutions primarily to the food and beverage industry, which accounts of approximately 70% of revenue. It also sells mobile and fixed equipment for the airport and defense markets.

Its share price has risen in part due to improved sentiment about global growth following 4Q18’s recession scare, as well as increased orders and sales growth in its FoodTech segment over the past two quarters and substantially improved operating margins as the benefits from significant cost reductions undertaken in 2018 began to pay dividends.

While John Bean’s capital equipment sales are not immune to cyclicality, its results have not been as volatile as investors seem to perceive. About 40% of the company’s revenue is recurring in the form of aftermarket sales of parts, services, and leasing from its installed equipment base. Also fueling organic growth are favorable secular macro trends such as rising protein consumption (especially in developing economies as incomes rise), the growth of liquid and organic foods, an increased focus on food safety, and factory and warehouse automation.

Finally, John Bean has a demonstrated track record of supplementing growth with strategic acquisitions that have broadened its product and service portfolio and/or expanded its geographic footprint. So far in 2019, the company has purchased three companies, including its largest acquisition ever, a U.K.-based food packaging technology company with 50% recurring revenue, global growth opportunities, and an operating margin accretive to John Bean’s.

Can you give us another example?

Bio-Techne (TECH), which manufactures biotechnology products and clinical diagnostic controls, is up more than 45% year-to-date as it continues to exceed its 10% organic sales growth goal thanks to broad strength across product lines and geographies. About two-thirds of Bio-Techne’s revenue comes from consumables, primarily reagent solutions used in pharmaceutical research and development. (A reagent is a substance or compound added for the purpose of causing a chemical reaction, or added to test if a reaction occurs.) Accelerating revenue growth for these products is being driven by Bio-Techne’s ongoing new product introduction, strong end market demand (as new drug therapies are proven out), and robust placements of the company’s analytical instruments that also use its reagents—a highly attractive “razor/razor blade” model.

Its current growth appears sustainable as the firm is building capacity to make reagents for the nascent, but rapidly expanding, cell and gene therapies development market. Additionally, revenue at two companies Bio-Techne acquired over the last few years appears poised to ramp up aggressively in the coming year—one due to new management returning growth to 20%-plus levels after four quarters of deceleration; the other a function of the timing of Medicare reimbursement approval for the company’s unique and clinically superior liquid biopsy method. As the acquired companies’ revenues scale, their margins should expand toward the corporate average, driving the firm’s overall already robust operating profit margins even higher.

Article by The Royce Funds