International Equity Strategies – Q1 Review
The Pembroke International Growth Fund lagged the MSCI ACWI ex-US Small Cap Index during the first quarter of 2021. The fund’s growth orientation was a significant detractor amid a rotation in market leadership to value stocks which had previously underperformed. This rotation was driven by the strengthening global economic recovery and investor expectations for rising interest rates and inflation from historically low levels.
From a sector perspective, relative performance was hampered primarily by stock selection within the Industrials and information technology (IT) sectors – which had been the strongest contributors in 2020.
Within industrials, Japanese automation company Harmonic Drive Systems (6324 JP) was the largest detractor. Harmonic Drive dominates its niche in small speed reducers (80% market share), resulting in consistently high profitability and returns. Long running relationships with robot OEMs, technical advantages for a high cost of failure product, and scale are competitive advantages. The share price weakened during the quarter despite a strong recovery in orders, and management’s increased operating income guidance for the 2022 fiscal year which exceeded consensus estimates.
Within the information technology sector, Nihon Unisys (8056 JP) was the largest detractor during the quarter. Nihon Unisys is a traditional IT services vendor based in Japan. The company still has a large part of its business in traditional IT services, but it has focused more on building standardized products that it can deliver to multiple clients, improving operating margins and creating more stable revenues. Negative revenue growth during the fourth quarter was driven by system services declining due to low demand for legacy system development projects. Smaller projects continued to be pushed-out by customers due to the pandemic, while operating expenses related to order activities stayed high, driving a 15% decline in EBIT. Although the quarter was weak, orders rose, and the order backlog increased.
These negative effects were partially mitigated by the underweighted allocations to real estate and the developed Asia ex-Japan region. Two contributors to performance included Be Semiconductor Industries Nv (BESI NA) and Au Small Finance Bank Ltd. (Aubank IN). Be Semiconductors, a Netherlands-based manufacturer of equipment for the semiconductor industry, announced strong fourth quarter 2020 revenues and orders. India-based Au Small Finance Bank announced strong net income numbers in its third quarter ended December 2020.
From a positioning perspective, information technology exposure was reduced during the quarter, mostly due to reductions in software exposure. This was offset by increases to communication services and consumer discretionary exposures.
We continue to expect the economic recovery in 2021 to be strong and surprise to the upside. Consumer spending is likely to grow smartly across developed markets, as pent-up demand and high aggregate savings rates work in tandem. Indeed, retail sales volumes already surpassed their prior peak. At the same time, industrial production, which enables the consumption of these goods, remains some 7-10% below pre-COVID recession levels.
In short, high aggregate savings rates and strong acceleration in consumer spending, especially on services, together with still-depressed levels of industrial production suggest that economic growth in 2021 is likely to be the strongest in many decades and exceed current forecasts. Corporate profit growth is therefore likely to be underestimated as well.
If economic growth is to trend higher this year, so is inflation. For now, an inflation “spike” beyond a 3% annual rate in 2021—if that can even be considered a spike—looks likely to be transitory. Even if growth surprises to the upside and developed markets grow at well above current consensus forecasts, major economies (excluding China) are unlikely to regain their pre-crisis trajectory of output until 2022 at the earliest.
Thus, we believe we will see corporate profit growth ahead of general expectations, with a broadening out to include many of the industries that were left behind in the second half of 2020. At the same time, rising interest rates will prove to be manageable, creating a positive backdrop for equities.
Consistent with our expectations, the broadening of growth in recent months has supported the performance of stocks in value-oriented industries that will benefit from increased economic activity. We still believe the long-term investment potential of creators of long-term value (growth stocks) will prove to be superior to that of companies and industries in competitive decline.
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This report is for the purpose of providing some insight into Pembroke and the Pembroke funds. Past performance is not indicative of future returns. Any securities listed herein, are for informational purposes only and are not intended and should not be construed as investment advice nor is it a recommendation to buy or sell any particular security. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Pembroke seeks to ensure that the content of this document is correct and up to date but does not guarantee that the content is accurate and complete and does not assume any responsibility for this. Pembroke is not responsible for decisions or actions taken or made on the basis of information contained in this document.