Equity Outlook  |  Q2 2019

A rich pool of choices

Karan S. Sodhi, CFA, Portfolio Manager, Putnam International Capital Opportunities Fund

A rich pool of choices

For small-company stocks outside the United States, the past two quarters have been a study in extremes. After a challenging fourth quarter of sharp declines, these stocks have rebounded just as dramatically in the early months of 2019.

In both environments, one thing didn't change: We have a rich pool of attractive investments from which to choose.

International small caps: An inefficient universe

In our segment of the market, we believe there are many unrecognized opportunities, where stock prices do not accurately reflect the value of the businesses. This is partly due to limited coverage by industry analysts. One-quarter of all companies in our index have no sell-side analyst coverage, while half of the companies in the index have three or fewer analysts covering them.

Attractive valuation. Our benchmark index is trading at a meaningful discount to the Russell 2000 Index while offering a similar, if not better, growth profile, in our view.

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Currency tailwinds. U.S. dollar strength over the past five years has created a meaningful advantage for international companies that have a non-dollar cost base.

Our approach: Three research buckets

We narrow our research focus to identify stocks in three categories.

Franchise companies
Portfolio allocation: ≈50%

Characteristics: Competitive edge: Moats enable them to maintain or increase profitability and grow for extended periods; large addressable markets; durable business models; profitably reinvest their capital

Sample holding: Sarana Menara
This is the largest-independent owner and operator of towers for wireless operators in Indonesia. We believe the business offers attractive upside potential due to consolidation opportunities and growing demand for data and bandwidth in Indonesia.

Cyclical companies
Portfolio allocation: ≈30%

Characteristics: Current profitability is depressed relative to normalized earnings power; solid businesses with current cyclical challenges

Sample holding: Bank of Ireland
The company's earnings have been depressed due to a high level of non-performing loans. These are declining, and we are seeing early signs of loan growth. The business has the potential to benefit significantly if European interest rates were to rise.

Transformative companies
Portfolio allocation: ≈20%

Characteristics: Profitability could improve dramatically due to significant changes in their industry or sector; unrecognized or underappreciated transformation potential

Sample holding: Air Canada
We expect the airline's capital expenditures to decline dramatically in the next two years, resulting in meaningful free cash flow generation. We see upside from the company's rewards program, which was recently reacquired from an external service provider. We also anticipate an improved competitive environment as WestJet Airlines, a Canada-based rival, faces cost pressure.

As of 12/31/18, Sarana Menara represented 1.49% of Putnam International Capital Opportunities Fund assets; Bank of Ireland represented 1.79%; and Air Canada represented 2.14%.

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