Baltimore’s Brown Capital Management runs one of the most storied U.S. small-cap funds. In the last 15 years, the $5.5 billion
Brown Capital Management Small Company
fund—which is closed to new investors—has beaten 99% of its peers with a 13.6% annualized return. Eddie Brown, the firm’s founder and a co-manager of the fund in its early years, was a regular guest on the widely watched PBS’s Wall Street Week with Louis Rukeyser for decades.
Less well known, however, is the firm’s newer, smaller $868 million
International Small Company
fund (ticker: BCSVX), which is run in an identical style, only with foreign small-cap stocks. Launched in 2015, the fund has crushed its category peers as well as the MSCI World Ex USA SMID index, delivering an 18.6% three-year annualized return versus the category’s average 10.8% and the benchmark’s 8.2%.
While the fund’s 1.41% expense ratio is below average for a retail fund, it is above average for
Morningstar’s
Foreign Small/Mid Growth category. That’s because many peer funds’ lower-cost share classes are available only to institutional investors.
Key to the firm’s overarching strategy is a focus on companies with strong, sustainable revenue growth. “We define company size in terms of revenues as opposed to market capitalization,” says Brown’s CIO Keith Lee, who joined the firm in 1991 to help launch its U.S. small-cap strategy. Lee points out that at various times in history, the stocks of giant companies with billions in revenue—such as
General Motors
(GM), when it was on the verge of bankruptcy in 2009—have declined so much their market values were at or near small-cap levels. Meanwhile, during the 1990s dot-com bubble, companies with little revenue had large market values. “Most of them didn’t have a sustainable business model, but their market capitalizations were billions of dollars,” he says. Revenues are reported on the top of a company’s income statement, so they’re less susceptible to accounting modifications—unlike earnings, which can be adjusted for various factors.
International Small Company only invests in companies with revenues less than $500 million. “Most of the companies we’re investing in tend to be double-digit revenue growers and have very large opportunity sets in front of them,” says Kabir Goyal, one of the fund’s four co-managers. “They tend to have a small percentage of the overall market [they’re competing in] and not only are they gaining market share, but their industries’ markets tend to be growing as well.”
The four co-managers are generalists who cover every industry, and there is no lead manager. Based on initial screens for foreign companies with strong revenue growth, the team develops a narrower list of stocks. Analytical work on those stocks is randomly assigned and rotates periodically so “that one person doesn’t feel married to a stock,” Goyal says. Typically, the fund has a low turnover rate of 10% to 20%, indicating a five- to 10-year holding period for stocks. As a result, every team member typically will get a chance to analyze each stock.
The most recent holding added to the fund’s portfolio is Japanese payments processor
GMO Payment Gateway
(3769.Japan). Though the team first purchased it in the third quarter of 2019, Goyal says different team members had researched it for years via company visits. Historically, the company’s revenue has risen 20% to 30% a year, he says. “We think that they should be able to continue to do 20%-plus revenue growth going forward.”
Understanding cultural differences is essential to investing in small foreign companies that operate in local markets. “In Japan, consumers are more tentative about shopping online,” Goyal observes. “They don’t want to pay online until they receive the good.” So, GMO Payment created a payment service that doesn’t charge consumers’ credit cards until two to three weeks after they have decided to keep their purchases. That has enabled GMO to build a 25% market share in Japan’s online payment processing industry—three times the size of its next largest competitor’s share, according to the company. The trust GMO has engendered with Japanese consumers has allowed the company to branch out into other areas, such as credit card issuance and utility bill processing. “GMO’s market share in those areas is sub-10%, so they have a lot of space to grow,” Goyal adds.
The fund is concentrated, typically holding 40 to 45 stocks. It is also sector agnostic versus its benchmark. Brown Capital created its own proprietary sector categorizations, which Lee feels are more accurate than the benchmark’s. For instance, the fund’s largest sector weighting is “Information/Knowledge Management,” at 31% of its portfolio. One recent addition there is German hospital information systems company
Nexus
(NXU.Germany). “In Germany and really across Europe, hospitals want to digitize their information so that they can more efficiently service their patients,” says co-manager Daniel Boston. “Today, only about 20% to 30% percent of the hospital information flows in Germany are digitized.”
Note: Holdings as of Dec. 31st. Returns through Feb. 7th; three-year returns are annualized.
Sources: Morningstar; Brown Capital Management
The main cultural difference in Nexus’s case is that most German hospitals are nonprofit institutions. “German hospitals are very price-sensitive because they’re not out to make money,” Boston says. Nexus’s hospital digitization software is significantly cheaper than that of its main competitor
Cerner
(CERN), giving it an edge in the German market, Boston says.
The typical company the team seeks “saves time, money, lives, or provides exceptional service” to its customers, according to Goyal. So he and Boston favor logistics software companies that accelerate the transport of goods, such as Canada’s
Descartes Systems Group
(DSG.Canada). They also like lifesaving health-care stocks such as
Ambu
(AMBUB.Denmark), a Danish disposable scope manufacturer. With a traditional endoscope, “the doctor will put it into one patient, take it out, sterilize it and put it in the next patient,” Boston says. “The problem is the reprocessing could leave contaminants behind.” By making cheaper and safer disposable scopes, Ambu helps hospitals save money and potentially lives, giving it a large potential end market.
Yet some health-care stocks don’t fit the bill because they can have “binary outcomes,” Boston says. This January the fund sold Ireland’s
Avadel Pharmaceuticals
(AVDL) because it shifted its business model from manufacturing a micro-pump drug delivery system for other companies to trying to win government approval for a narcolepsy drug administered with that same delivery system. “The story went from we’re going to have a diverse revenue stream that can grow across many drug categories,” he says. “Now you have one drug that’s either going to be approved or not.”
These are the kinds of distinctions Brown Capital must make to identify companies with truly exceptional growth potential, and so far, it’s working.
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