Q: Why do you invest in international small caps?

A: We do international small cap investing for two reasons. First, we find that the vast majority of American investors are still significantly underinvested in international small caps relative to the global equity market capitalization. Recent studies have shown that international small caps are about 7% of the world equity market capitalization.

Second, there is less coverage by analysts for small caps compared to large caps and that creates opportunities for fundamental investors like us with research capabilities.

Q: What core beliefs drive your investment philosophy?

A: We base our investment philosophy not on beliefs but on empirical evidence about certain investor behaviors that lead to inefficient pricing of securities. We look for companies that have recently undergone a transformational change and released information about that change to the marketplace, and investors are lagging in revising their expectations of the stocks.

Q: How do you transform that philosophy into an investment strategy?

A: We do international small cap investing and conduct fundamental research. We like to meet company management and learn more about the businesses by talking to competitors, suppliers and other industry players.

Moreover, we incorporate a lot of the recent insights from the emerging field of behavioral finance in our investment process. We focus on behavioral biases that investors repeatedly exhibit. First, the human brain has limited processing capability which means investors take time to correctly interpret data, or can even misinterpret data, both of which leads to inefficient pricing of securities.

Secondly, and even more interestingly, there are certain human behaviors ingrained in the brain, which are often irrational, and these behaviors affect how people make decisions in the stock market. For example, there is a pronounced phenomenon in the market called post-earnings announcement drift that generally occurs around earnings surprises.

What creates opportunities for us is that often when a company introduces a new product or undergoes a restructuring that will likely significantly lift earnings and cash flows in the future, investors take time to adjust their prior beliefs about the company’s earnings power to the new reality, leading to delayed share price reaction.

Generally, we look at incremental changes. The best situations are companies that are improving their quality of earnings. For instance, the incremental improvement in return on equities is even more important than the absolute levels of return on equity.

Q: What is your definition of an earnings surprise?

A: An earnings surprise by definition is a situation in which the market has not yet understood a company’s fundamentals.

This is a situation where people on the buy and sell side visit a company over and over again, therefore gaining an established set of beliefs and understanding about the company’s fundamentals.

Once something transformational happens at the company – that might be a new product launch, entering a new marketplace, restructuring, or something that fundamentally changes the business – the company’s business is now much better compared to people’s established beliefs, which results in an earnings surprise.

This phenomenon shows that people take some time to incorporate new information and adjust expectations. Psychologists have shown that people tend to stick to their established beliefs for some time.

Q: What kinds of analytical steps does your research process involve?

A: In terms of the research process, our idea generation starts with significant earnings surprises. Next is the fundamental research process where we spend 95% of our time. We get to know technologies of new products and market opportunities, the competitive dynamics in the industry, the speed of a product’s growth, the potential revenue it can generate, and its pricing power. We are also interested in determining the new margins, the competitive landscape and the technological risks before we take all those factors into account to project what could be the true earnings and future cash flows of the company over the next several years.

We also look at a company’s filings and its most recent earnings releases to focus in on how the business fundamentals are performing, how the top and bottom line have grown in the most recent quarters, and if Wall Street analysts’ understanding is keeping up with the changes.

Q: Why do you follow Wall Street analysts?

A: Our strategy revolves around taking advantage of when sell-side analysts’ estimates are wrong, or, in other words, where investors’ perceptions are still lagging with reality. We invest in situations where we believe the sell-side analysts are most wrong because it sets wrong anchored estimates for the rest of the market.

We do our own fundamental research in order to generate our estimates of future earnings. To this end, we talk to management about their business and different people in the value chain, including competitors, suppliers, peers or customers who can give us a better understanding about industry dynamics.

It is precisely because the Street often seems to have wrong estimates that these opportunities are created. In effect, these estimates behaviorally and psychologically anchor other investors in the market to the wrong estimates. That is what creates opportunities for us.

Q: Would you give one or two examples to highlight your research process?

A: Duerr AG is a Germany-based company that engineers and manufactures machinery for automotive production. The company’s primary products are paint shop systems and robots. From 2000-2005 the company operated at sub-optimal profitability levels as diversification into non-core product lines led to poor operating margins. Current CEO Ralf Dieter was named CEO to lead a restructuring. He refocused the business around the core activities of paint and assembly systems. By 2008 the turnaround had taken hold, with operating margins reaching a high for the decade. However, the subsequent recession severely impaired automotive capex, and profitability suffered throughout 2009 and early 2010. Late in 2010 as it became apparent that automotive capex spending had begun to take a turn for the positive we discovered the stock on one of our earnings revisions screens.