Unearthing gems in global small caps

For institutional investors, global small caps offer an opportunity to diversify into companies that may have years of high-growth runway in front of them—but it’s critical to choose investments carefully. Connor Gordon and Chris Maludzinski had been research analysts at Fidelity for more than a decade, covering a wide array of industries, when chief investment officer Andrew Marchese asked them to join forces and co-manage the Fidelity Global Small Cap Opportunities Institutional strategy, launched on November 4, 2019. The idea behind the new portfolio was to give this team the biggest possible opportunity set in an inefficiently followed asset class. This would allow their success in bottom-up fundamental stock picking to shine and potentially generate strong returns for clients. They have exceeded expectations, ranking top of their peers since launching the strategy three years ago.


What sets your investment process apart and allows you to outperform peers in up and down markets?

CG: We don’t have a distinct style bias. Many growth mandates underperform when growth isn’t in favour, and the same is true for value mandates. We try to stay in the middle. We summarize our style as “quality + change = mispricing.” We’re a core mandate with a baseline of business quality, including profitability, predictability and growth. Then we focus on idiosyncratic mispricing. It’s opportunistic and situational: is there is a positive change happening in the business or is there a temporary dislocation that’s causing the stock to be mispriced? Focusing on bottom-up opportunities instead of styles means there’s a constant flow of new opportunities regardless of what’s happening in the macro environment.

CM: We look for great franchises— companies that are simple, predictable and generate high returns on invested capital. More importantly, we look for companies that generate free cash flow with high-calibre management teams that are great capital allocators. They take cash flow and reinvest it back in the business at higher rates of return or find inorganic opportunities that don’t dilute return profile. We look for these quality companies and then wait for change. We wait for an opportunity where a stock is mispriced and there’s a chance for the market to recognize that mispricing and attribute a higher multiple to the earnings stream.

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How do fidelity’s global research resources support your work?

CM: They’re an integral part of the process. We’re based in Toronto, but we interact with more than 140 research analysts across Asia, Australia, Europe, Latin America and North America. Our research analysts produce investment research while maintaining direct relationships with company management teams.

This is important for many reasons: the more companies we meet and the more companies we analyze, the more investment ideas we’re likely to generate. Our analysts have been following companies for years. As it relates to our strategy, when there’s a “change,” our team is quick to identify it. We have the history, analysis and relationships to engage a management team quickly and take advantage of potential mispricings.

How do you integrate ESG considerations into your analysis of companies?

CG: ESG is integrated into Fidelity’s fundamental research; every stock rating analyst is also responsible for an ESG rating on that company. In our portfolio specifically, ESG provides an enhanced risk mitigation framework that considers a broader spectrum of risks that might not affect the business today, this month or next quarter, but might have a material impact on a company’s profitability three, five or 10 years down the road. ESG analysis also helps us assess opportunities. For example, in the “E,” decarbonization is a long-term trend. One stock we’ve owned in the past, Darling Ingredients, is an animal-rendering company that pivoted to renewable diesel, which has a low carbon intensity score and is being used in California to decarbonize heavy trucks.

Can you share examples of stock stories that illustrate your process?

CM: BJ’s Wholesale Club is a Costco competitor operating up and down the east coast of the United States. The company had a good base business and a sticky income stream, thanks to high membership fees. However, following its initial public offering in 2018, it was extremely levered, over-merchandised and wasn’t growing fast enough. Then the coronavirus changed the company’s paradigm. People flocked to wholesale clubs and cleaned out all the excess merchandise. BJ’s transformed its balance sheet, brought in a ton of new members and its prospects were suddenly extremely bright. We started buying in March 2020. Fast forward to today, and the company continues to benefit from disruption. Its earnings are up threefold and its multiple is up by a factor of two.

CG: D’Ieteren Group NV is a good example of how we use Fidelity resources to find companies that are under the radar of most investors. It’s a Belgian family holding company that had a market cap of about €3 billion three years ago. Its main asset is Belron, the biggest auto glass replacement company in the world, but the business had been undermanaged for many years. Then we saw the change: the company sold a minority stake to a private equity company that completely replaced the management team. We spoke to them and the new plan made sense. The margins of the business went from five per cent to almost 20 per cent in 18 months and the stock price quadrupled.

How easy will it be to scale up your approach as your assets under management grow?

CG: The average market cap in the portfolio is about US$5 billion. These are not micro caps. We’ve been managing the strategy with an eye to future growth, which means we won’t need to change our approach as our assets under management grow.

What excites you the most about the global small-cap space?

CM: Because the small-cap space is generally under-covered relative to larger-cap companies, we can really dig in and find mispricings. Also, small caps are generally able to grow their revenue at a faster rate for a longer period than their large-cap counterparts, so we can often be long-term owners rather than selling after a year or two of outperformance. A lot of these companies have an opportunity to grow for decades above the market.

CG: Part of Peter Lynch’s legacy at Fidelity was the idea that the person who turns over the most rocks, wins. So the person who looks at the most ideas is most likely to find the best or more ideas, as well as drive returns. What gets me excited is finding the hidden gem that people aren’t paying attention to, which is easier to do in global small cap where there are fewer eyes looking at the stocks. We feel that with Fidelity’s vast global research network and two of us co-managing this mandate, we’ve got more eyes on the often under-researched global small-cap space. We think we’re set up for success.