While many global small-cap companies have gotten their balance sheets in good shape over the last few years, valuations are currently a concern. The MSCI World Index is up 184% since the market low on March 9, 2009,1 and we believe most equities are at or near full value. This makes it much harder to find high-quality companies at cheap prices. Against this backdrop, the challenge is to find the hidden gems within the vast universe of global small-cap companies.
What we look for
Only a handful of sell-side analysts cover many of the companies we’ve invested in, compared with the 50-plus teams watching a large firm like Apple (not a holding in Invesco Select Opportunities Fund). This lack of attention allows us to develop our own unique outlook on small-cap companies. As we navigate the small-cap universe in search of value, three main criteria guide our investment decisions:
- Sustainable competitive advantage that keeps competition at bay. Patents, for example, prevent competitors from copying a company’s products. High switching costs that discourage customers from buying from a competitor are another advantage.
- High-quality management that acts in shareholders’ interest. We gauge this by several measures. Do the top decision makers own a lot of stock? Is the majority of compensation based on three- to five-year long-term metrics — such as total shareholder return and profit growth — rather than one-year metrics? Top managers at small-cap firms are more accessible than their large-cap counterparts, and we have extensive discussions based on their track record to filter out spin. We also attend industry conferences, speaking with competitors and digging deeper if we hear divergent stories. Sometimes we discover the competitor is a better investment.
- Attractive valuations. Strong competitive advantage and management don’t mean much if the stock is expensive. We invest when a company is undervalued, meaning priced below its long-term intrinsic value. Because our time horizon is about five years, we can overlook short-term market fluctuations and overreactions to short-term events. This patient approach allows us to focus on the value a company can generate over the long-term.
Where is opportunity?
In this challenging environment, our investment process filter has disclosed some companies we like, including industrial automation and tech services companies.
Hollysys Automation Technologies Ltd. (4.42% of Invesco Select Opportunities Fund as of June 30, 2014) is a Chinese company; while this dissuades many investors, we see great potential. With Chinese wages increasing, factories need to find ways to improve productivity. Major foreign companies such as ABB, Emerson and Siemens hold 70% to 80% of the industrial automation market share. Hollysys is the largest player in China, and while it lags foreign firms in technology, its product is 30% cheaper. (ABB, Emerson and Siemens are not holdings in the fund). In addition, Hollysys makes signaling systems for high-speed trains, another growth opportunity in the wake of the Chinese government’s relaunch of high-speed rail projects in late 2013.
Global Payments Inc. (2.59% of Invesco Select Opportunities Fund as of June 30, 2014), is a software and services firm that processes credit and debit transactions, and it’s a good example of technology sector opportunities. Switching costs are an advantage for this company, along with low costs for adding new customers. Scale grows exponentially with every new client. Global Payments is a top-10 firm in the US and the second largest in Canada, with a strong presence in the UK and Asia. The key growth opportunity for the company is to enter countries with lower card-payment penetration, such as Spain, Russia and China.
1 Source: Lipper, Inc.
Important Information
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
Smaller companies offer the potential to grow quickly, but can be more volatile than larger-company stocks, particularly over the short term.
The investment techniques and risk analysis used by the portfolio managers may not produce the desired results.
The Invesco Select Opportunities Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the fund.
The MSCI World Index is an unmanaged index considered representative of stocks of developed countries. An investment cannot be made directly in an index.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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