Global Small Companies and AI: Navigating Market Trends in Q2 2024

Harding Loevner International Small Companies Equity Q2 2024 Report

Small-cap companies with strong competitive advantages, like Allegro and Rightmove, can fend off larger rivals, presenting attractive investment opportunities in niche markets. What Happened International equity markets rose slightly in the quarter, led by good returns among large-cap Information Technology stocks, especially within the semiconductor industry. However, international small caps, a group that contains fewer chip-related stocks, posted more modest gains, with the MSCI All Country World ex US Small Cap Index trailing the broader international benchmark. Monetary policies continued to diverge in developed markets. The US Federal Reserve kept the federal funds rate within the range of 5.25% and 5.5%, reflecting a cautious stance aimed at containing inflation while supporting growth. Despite earlier forecasts suggesting multiple rate cuts in 2024, markets are now pricing in just two. The Bank of Japan also kept rates stable but further reduced its bond purchases; Governor Kazuo Ueda indicated that further rate hikes remain a possibility despite signs of economic weakness. In contrast, the European Central Bank lowered its key rate to 3.75% from 4%, making its first cut since 2019, even as wage cost pressures persist. MSCI ACWI ex US Small Cap Index Performance (USD %) Sector 2Q 2024 Trailing 12 Months Communication Services -1.4 6.3 Consumer Discretionary -2.1 4.3 Consumer Staples -0.3 7.4 Energy 2.3 24.0 Financials 3.9 25.2 Health Care 0.2 4.3 Industrials 1.9 15.3 Information Technology 2.3 15.9 Materials 0.9 7.7 Real Estate -3.5 4.1 Utilities 5.3 10.6 Click to enlarge Geography 2Q 2024 Trailing 12 Months Canada 1.3 8.7 Emerging Markets 6.0 20.5 Europe EMU -2.3 5.4 Europe ex EMU 3.2 14.1 Japan -5.7 6.9 Middle East -4.0 5.9 Pacific ex Japan -0.5 4.3 MSCI ACWI ex US Small Cap Index 0.8 11.8 Click to enlarge Source: FactSet, MSCI Inc. Data as of June 30, 2024. Companies held in the portfolio at the end of the quarter appear in bold type; only the first reference to a particular holding appears in bold. The portfolio is actively managed therefore holdings shown may not be current. Portfolio holdings should not be considered recommendations to buy or sell any security. It should not be assumed that investment in the security identified has been or will be profitable. A complete list of holdings at June 30, 2024 is available on page 6 of this report. Click to enlarge While inflation appears under control in most countries and bond yields remain stable, recent election results have introduced new volatility in both developed and emerging markets. In Europe, far-right parties made significant gains in the parliamentary elections in the European Monetary Union. French President Emmanuel Macron reacted to his party's rout at the ballot box by hastily calling for snap legislative elections, prompting French markets to fall. In Germany, Chancellor Olaf Scholz's center-left Social Democrats also received a drubbing and are now polling behind the extreme-right wing Alternative for Germany (AfD) party, although with elections there more than a year away, markets were calmer. In another anti-incumbent outcome, the Labour party secured the majority in the UK Parliament, bringing an end to Conservative Rishi Sunak's 20-month tenure as Prime Minister, and to the Tories' 14-year hold on power. Emerging economies also experienced political upheavals. In India, Prime Minister Narendra Modi's Bharatiya Janata Party (BJP) failed to secure a majority in that country's elections, which means that he will need to seek alliances across party lines to secure his third term. In Mexico, Claudia Sheinbaum's decisive victory over Xóchitl Gálvez led to a larger drop in Mexican stocks; investors braced for populist policies as her party's gains in the legislature may lead to an unconstrained majority. The ongoing weakness of the Japanese yen remained the headline story in currency markets, as it fell an additional 6% against the dollar, reaching its lowest level since 1990. The decline appears to be caused by local investors seeking higher real yields outside their domestic market, as policies remain targeted at stimulating inflation in the economy. Emerging market currencies in Latin America fared even worse: the Brazilian real and Mexican peso both dropped roughly 10%, weighed down by narrowing interest-rate differentials with the US dollar and, in the case of the peso, the election results. Among international small caps, Utilities was the best performing sector, with expectations of rising energy demand for the large data centers that tech companies are building for artificial-intelligence applications. Communication Services, specifically media & entertainment stocks, and Consumer Discretionary performed poorly due to signs of weakening consumer spending, which fueled recession worries. Regional performance was mixed, although there was a notable shift in investor sentiment toward Japan. Because of a government-policy-induced rally in value stocks, Japan had been the index's top-performing region in the first quarter, posing a significant headwind for this portfolio given its quality growth holdings and low exposure to the region. This quarter, however, Japan was the index's worst performer, while headwinds for growth stocks there also showed signs of waning. Meanwhile, Emerging Markets (EMs) led market returns, even though poor performance by Brazil and Mexico, which fell 17% and 18%, respectively, offset gains for China and India. How We Did The International Small Companies Equity portfolio declined 3.4% gross of fees in the second quarter, compared with a 0.9% gain in the MSCI ACWI ex US Small Cap Index. Second Quarter 2024 Performance Attribution Sector: Intl. Small Cos. Equity Composite vs. MSCI ACWI ex US Small Cap Index Geography: Intl. Small Cos. Equity Composite vs. MSCI ACWI ex US Small Cap Index "FRONTIER": Includes countries with less-developed markets outside the index. "OTHER": Includes companies classified in countries outside the index. Source: Harding Loevner International Small Cos. composite, FactSet, MSCI Inc. Data as of date June 30, 2024. The total effect shown here may differ from the variance of the composite performance and benchmark performance shown on the first page of this report due to the way in which FactSet calculates performance attribution. This information is supplemental to the composite GIPS Presentation. Click to enlarge Our underperformance was primarily due to a handful of weak stocks in the Communication Services, Industrials, and Health Care sectors. In Communication Services, market research services provider YouGov (OTCPK:YUGVF) unexpectedly lowered projections for revenue and earnings, citing weaker-than-expected sales in its data-products division and falling demand for its fast-turnaround research services. The revised outlook caused the shares to plummet. The strong market reaction may partly reflect a common misconception among investors that YouGov primarily conducts political polling, as those investors would expect the company to do particularly well in a year full of democratic elections. (Political polling is only a small percentage of overall revenue.) In Industrials, Brazilian car-rental service Localiza (OTCQX:LZRFY) fell due to concern that declining prices for used cars will lower the expected resale value of the company's fleet and increase depreciation expenses. TOMRA (OTCPK:TMRAY), a Norway-based provider of machines used in recycling and sorting, reported weak profitability because of lower volumes in its recycling and food segments. In Health Care, Germany's Evotec (OTCPK:EVOTF) lowered its guidance in conjunction with the announcement of a new chief executive. An industry downturn has hurt demand for the company's contract-research services, which help pharmaceutical and biotechnology clients in the discovery of new drugs. A bright spot was Consumer Staples. Plant-breeding company KWS SAAT (OTCPK:KNKZF) of Germany raised its outlook following stronger-than-expected demand for its sugar beet products. Stock selection was poor across geographies. The portfolio's EM holdings failed to keep up with the robust returns of their peers, especially in India. Life-insurance provider Max Financial reported strong new business growth, but margins continued to soften as the industry contends with a weaker sales mix. SH Kelkar, India's largest local flavors and fragrances company, reported a fire at one of its fragrance production facilities, forcing it to shift production to one of its flavor manufacturing sites and operate on a double-shift basis. In Europe, shares of UK-based Keywords Studios (OTCPK:KYYWF), a provider of IT services to the video-game industry, surged following a buyout offer from private-equity firm EQT. However, the declines of YouGov and Tomra more than offset that gain. What's On Our Minds Small caps have underperformed their larger peers by a wide margin over the last couple of years, as a handful of mega-cap stocks, particularly in the US tech industry, dominates overall market returns. The relative weakness in small-cap stocks has added to a perception that small companies are also generally at an inherent disadvantage vis-à-vis large companies, should the latter be tempted to encroach on their industries. In this environment, the mere rumor that a deep-pocketed competitor such as Amazon may be ready to enter a market can quickly topple the share price of smaller industry incumbents. However, the success of a large company entering a new market is not a certainty by any means. A smaller company focused on a specific region can create high barriers to entry for would-be competitors by developing a differentiated product and strong brand, while learning and catering to local preferences and requirements. A rival's product would also have to be vastly superior to win over customers should they face high switching costs. For a large company with a broad set of expansion opportunities, the attractiveness of a new market is diminished if competing with the incumbent comes at a steep cost. Therefore, attractive opportunities exist for small-cap investors in correctly identifying those situations in which the knee-jerk fears over a new entrant aren't justified. This requires an understanding of industry structure, which we evaluate using Michael Porter's Five Forces as one of the initial steps of our research process. Evaluating the threat of new entrants is particularly important in the case of small companies because any industry offering above-average growth and profitability is almost certain to attract the interest of larger, well-capitalized competitors. That's why Allegro (OTCPK:ALEGF), the leading e-commerce platform in Poland, has found itself going head-to-head with Amazon.com (AMZN), a company that is 200 times larger by market cap. Between 2017 and 2020, Allegro's revenue grew at an annual compounded rate of 34%, and it had an adjusted EBITDA margin of 40% in 2020. One reason for its strong growth is that unlike in the US, spending on e-commerce platforms in Poland is still relatively low. Naturally, Amazon, flush with cash from the pandemic-fueled online-shopping boom, initiated an attempt to seize this opportunity in 2021, hoping to leverage its existing infrastructure in Poland (including warehouses that had been supporting its operations in other Western European markets, predominantly Germany) to capture some of the growth Allegro has enjoyed and further strengthen its international business. After Amazon announced its Polish website, shares of Allegro promptly fell, with its market value shrinking by 70% over the next 18 months alongside a sell-off in tech stocks. So how has Allegro managed to fend off Amazon in Poland? A key factor has been Allegro's smart parcel distribution strategy. One of the biggest challenges for an e-commerce company operating in Poland is that the country has a low population density, which makes it difficult to deliver packages in a cost-efficient manner. To solve this problem, Allegro partnered with InPost (OTCPK:INPOY), a local logistics provider, as well as operators of gas stations, convenience stores, and other businesses, to create a network of thousands of delivery lockers in highly trafficked areas such as train stations and shopping malls. The cost of delivering orders to these lockers, called Automated Parcel Machines (APMs), is 25-30% lower than shipping directly to a customer's home. It's also cheaper and convenient for the customer. As this proposition entices users and merchants to its marketplace, additional users and merchants become interested, allowing Allegro to expand its selection -- to 445 million products sold by more than 150,000 merchants -- and offer attractive prices. In other words, network effects have begun to take hold. (If any of this strategy sounds like a page out of the Amazon playbook, several of Allegro's top managers came from the US company.) In addition to continuing to invest in its logistics, Allegro has tried to ward off competition from Amazon by lowering the price of its member subscription program, called SMART. While this initially caused the company's high profit margins to take a hit, they began to stabilize and improve early last year. Margins for Allegro's Polish operations have now fully recovered, its market share is little changed, and its stock price has nearly doubled since late 2022 (when margins bottomed). While the stock is still well below where it traded before Amazon's incursion, this is largely due to Allegro's aggressive investment in its own international expansion, an effort which may begin to bear fruit in the near future as its Czech Republic business should turn profitable within the next few years. The competition with Amazon is far from over, but to this point, Allegro's competitive advantage has proved durable. Another small company that has managed to keep a large new entrant at bay is Rightmove (OTCPK:RTMVF), the leading UK portal for residential sales and rentals. Like e-commerce, online real estate portals are subject to network effects that cause most of the market share to accrue to one company -- in this case, Rightmove, which has an estimated 80% market share. Buyers naturally flock to the website with the most listings, and sellers' agents are drawn to sites with the most buyers. CoStar (csgf), the owner of the popular US websites Homes.com and Apartments.com, has attempted to compete in the UK by acquiring OnTheMarket.com, Rightmove's distant third-place rival, in October of last year and aggressively spending on marketing to gain users. Rightmove shares dropped more than 13% on the day the deal was announced. But while web-traffic data show that OnTheMarket temporarily claimed the No. 2 spot following a March marketing campaign, the site lost ground in May, falling back to third place. To overtake Rightmove, CoStar will need to, at the very least, sustain its large marketing spend -- a strategy that runs counter to management's focus on returns on investment. More likely, it will have to settle for second place behind Rightmove. Investors' fears have also been allayed: Shares of Rightmove have recouped their losses. IT services is an industry in which many local small companies have been resilient in the face of competition from larger rivals. One that stands out is Bechtle (OTCPK:BECTY), which has a strong position in Germany as the country's largest provider of turnkey IT solutions -- called a systems house -- despite the presence of global competitors such as Accenture. Bechtle differentiates itself by focusing on the entire lifecycle of IT systems, including the purchase of new products as well as managing or retiring older tools. This makes it a one-stop shop for customers to manage technological change in a cost-efficient manner. Through a partnership that began with IBM four decades ago, Bechtle has cultivated long-term trusted relationships with local customers, including many in the public sector. It now boasts about 100 offices of consultants and IT professionals across Germany and the nearby German-speaking countries of Switzerland and Austria, enabling Bechtle to provide better customer service than larger competitors, building a strong barrier to entry. It also has partnerships with other tech leaders, such as Microsoft and Amazon Web Services, as a reseller of their products and solutions. Even as the largest tech companies in the world post robust growth -- in their businesses and their stock prices -- Bechtle has demonstrated that there remains a need for third-party value-added services that help customers solve unique challenges. It is reasonable for the market to be worried about the fate of smaller companies in a world where it seems that the bigger will continue to get even bigger and stronger. But not all small companies are alike. Our portfolio is characterized by high-quality businesses with competitive advantages in growing, profitable niches that can withstand attacks by large, well-funded competitors. Original Post Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors. Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Harding Loevner LP is a growing global asset management firm headquartered in New Jersey, USA (Metro NYC). Harding Loevner manages over $52 billion in long-only equity portfolio strategies comprising of high-quality, growing companies in developed, emerging and frontier markets. Harding Loevner's investment strategies are offered as institutional separate accounts, mutual funds, UCITS, and through sponsored wealth management programs. Our global client base includes leading global investment institutions, such as sovereign wealth funds, major foundations, endowments, pension plans, private family offices, and individuals. Our professional culture is one of transparency, collaboration, accountability and integrity. We are committed to providing all staff with opportunities for career advancement through education, training and personal achievement.

Generative AI: Software And Services Businesses Will Become Primary Beneficiaries

Nvidia's high valuation reflects market enthusiasm for AI, but software and services companies are poised to benefit significantly from generative AI adoption. The following segment was excerpted from this fund letter. In 1967, leading scientists and engineers inside the Dutch conglomerate Philips (PHG) had a tremendous achievement to showcase at the company's annual research exhibition. They had developed a six-barrel step-and-repeat camera system for semiconductor manufacturing -- essentially, the predecessor to the lithography machines used today. Although the exhibit initially attracted a large crowd of fellow researchers and top Philips executives, it wasn't long before the executives turned their attention to a nearby booth that was displaying new features of a different product, the washing machine. In the decades that followed, Philips became a leader in consumer electronics and health-care equipment, and the camera system technology -- a tiny moonshot project it never seemed to prioritize -- became ASML, a leading supplier of the intricate machinery used to produce semiconductor chips. The latter continued to take innovative leaps, and it has been rewarded. ASML now has a market value nearly 20 times larger than that of its former parent. This quarter, nothing -- certainly not washing machines -- could divert attention away from ASML or its peers Nvidia (NVDA) and TSMC (TSM). The three semiconductor stocks were responsible for a disproportionately large percentage of the overall market return. Two of them, ASML and TSMC, have been portfolio holdings since 2021, while we exited Nvidia in the first quarter after more than five years. Their strong performance is quite deserving, given that the competitive structure of their industry, oligopoly or near monopoly, is more favorable than most we encounter. But just a few years ago, as the personal computer and mobile phone cycles ran their course, the outlook for chip demand was much less sanguine. The tech world has long subscribed to Moore's Law, an observation and prediction that the number of transistors on an integrated circuit doubles every two years with a minimal rise in cost. But as it has become increasingly difficult and costly to shrink the size of transistors any further, the fear has been that without a technological breakthrough, the computational power of chips will hit a ceiling. One promising technology that has emerged to counter this fear is extreme ultraviolet ('EUV') lithography. Think of a lithography machine as a large camera that uses light to transfer precise patterns onto a wafer's surface, which is then diced into chips. The shorter wavelengths of EUV radiation can print a sharper image of tinier details, thus allowing for smaller transistors. But using a different light source also created a host of challenges that had to be solved. After spending years working to improve the performance of its EUV machines, from throughput to overlay accuracy to uptime, ASML has now shipped more than 100 of them to customers, with some configurations costing well north of US$100 million. As it was working to perfect these EUV machines, ASML also began to develop a next-generation technology called High NA (for numerical aperture), which can print even finer features on a wafer. After a decade of research and development, it shipped its first High NA machine in December 2023, leaving its competitors even further behind. With these tools, the semiconductor industry can potentially develop more powerful and energy-efficient chips to meet the surging demand for computing power coming from fields such as AI, autonomous driving, and the internet of things. Shrinking the transistor through innovations in lithography is still just one step to produce more powerful chips. The transistors also need to become more interconnected, thus allowing for a higher number of them to sit on a single chip (our Fundamental Thinking article "Third Law: How a Pair of Chip Companies Came to Hold the Keys to Everything" details this trend). In April, TSMC unveiled its plan to do this, which will advance chip technology by two generations -- from the current N3 (three nanometer), to N2, and then to A16 (meaning 1.6 nanometers, or 16 angstrom). Currently, a typical graphics processing unit (GPU) used to train an AI model has over 100 billion transistors. TSMC Chairman Mark Liu forecasts that within a decade that figure will rise to more than 1 trillion. Such a steep trajectory is a great manufacturing challenge, and if the company is successful, it will be a great testimony to TSMC's engineering capabilities. Even with such a formidable position, these industry leaders have had their share of ups and downs. We don't believe we can add much value in trying to predict industry cycles or time the tipping point of demand -- whether for hardware companies such as ASML and Nvidia or the software and IT services companies we wrote about last quarter, such as Adobe (ADBE), Salesforce (CRM), Accenture (ACN), and Globant (GLOB). Earlier this year, several software and services companies reported disappointing earnings, as overall IT spending remains muted amid high interest rates and ongoing economic and geopolitical uncertainty. But secular growth appears to be underpinned by the innovations described above, as well as the race to introduce value-added tools that use AI to solve business problems. Although the market remains enamored with Nvidia, which trades at a high price-to-earnings ratio, we continue to believe that as large companies embrace generative AI, software and services businesses will become primary beneficiaries of the AI trend. Past performance does not guarantee future results. Invested capital is at risk of loss. Please read the above performance in conjunction with the footnotes on the last page of this report. All performance and data shown are in US dollar terms, unless otherwise noted. The portfolio is actively managed therefore holdings identified above do not represent all of the securities held in the portfolio and holdings may not be current. It should not be assumed that investment in the securities identified has been or will be profitable. The following information is available upon request: (1) information describing the methodology of the contribution data in the tables above; and (2) a list showing the weight and relative contribution of all holdings during the quarter and the last 12 months. Past performance does not guarantee future results. In the tables above, "weight" is the average percentage weight of the holding during the period, and "contribution" is the contribution to overall relative performance over the period. Performance of contributors and detractors is net of fees, which is calculated by taking the difference between net and gross composite performance for the Global Equity strategy prorated by asset weight in the portfolio and subtracted from eachsecurity's return. Contributors and detractors exclude cash and securities in the composite not held in the model portfolio. Quarterly data is not annualized. Portfolio attribution and characteristics are supplemental information only and complement the fully compliant Global Equity Composite GIPS Presentation. Portfolio holdings should not be considered recommendations to buy or sell any security. The Global Equity composite contains fully discretionary, fee-paying accounts investing in US and non-US equity and equity-equivalent securities and cash reserves, and is measured against the MSCI All Country World Total Return Index (Gross) for comparison purposes. Returns include the effect of foreign currency exchange rates. The exchange rate source of the benchmark is Reuters. The exchange rate source of the composite is Bloomberg. Additional information about the benchmark, including the percentage of composite assets invested in countries or regions not included in the benchmark, is available upon request. The MSCI All Country World Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed and emerging markets. The index consists of 47 developed and emerging market countries. The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. The indexconsists of 23 developed market countries. You cannot invest directly in these indexes.Harding Loevner LP claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Harding Loevner has been independently verified for the period November 1, 1989 through March 31, 2024. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The Global Equity composite has been examined for the periods December 1, 1989 through March 31, 2024. Theverification and performance examination reports are available upon request. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Harding Loevner LP is an investment adviser registered with the Securities and Exchange Commission. Harding Loevner is an affiliate of AMG (NYSE: AMG), an investment holding company with stakes in a diverse group of boutique firms. A list of composite descriptions, a list of limited distribution pooled fund descriptions, and a list of broad distribution pooled funds are available upon request. Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Composite performance is presented gross of foreign withholding taxes ondividends, interest income and capital gains. Additional information is available upon request. Past performance does not guarantee future results. Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request. The US dollar is the currency used to express performance. Returns are presented both gross and net of management fees and include the reinvestment of all income. Net returns are calculated using actual fees. Actual returns will be reduced by investment advisory fees and other expenses that may be incurred in the management of the account. The standard fee schedule generally applied to separate Global Equity accounts is 1.00% annually of the market value for the first $20 million; 0.50% for the next $80 million; 0.45% for the next $150 million; 0.40% for the next $250 million; above $500 million upon request. The management fee schedule and total expense ratio for the Global Equity Collective Investment Fund, which is included in the composite, are 0.70% on all assets and 0.75%, respectively. Actual investment advisory fees incurred by clients may vary. The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in thecomposite the entire year. The Global Equity composite was created on November 30, 1989 and the performance inception date is December 1, 1989. Click to enlarge Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors. Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Harding Loevner LP is a growing global asset management firm headquartered in New Jersey, USA (Metro NYC). Harding Loevner manages over $52 billion in long-only equity portfolio strategies comprising of high-quality, growing companies in developed, emerging and frontier markets. Harding Loevner's investment strategies are offered as institutional separate accounts, mutual funds, UCITS, and through sponsored wealth management programs. Our global client base includes leading global investment institutions, such as sovereign wealth funds, major foundations, endowments, pension plans, private family offices, and individuals. Our professional culture is one of transparency, collaboration, accountability and integrity. We are committed to providing all staff with opportunities for career advancement through education, training and personal achievement.

Harding Loevner Global Small Companies Equity Q2 2024 Report

Small-cap stocks can thrive against larger competitors by leveraging niche markets, strong brands, and local expertise, as demonstrated by Rightmove, Simulations Plus, and Bechtle. Global equity markets rose slightly in the quarter, led by good returns among large-cap Information Technology stocks, especially within the semiconductor industry. However, global small caps, a group that contains fewer chip-related stocks, didn't see the same benefit. The MSCI All Country World Small Cap Index fell 1.4%. Monetary policies continued to diverge in developed markets. The US Federal Reserve kept the federal funds rate within the range of 5.25% and 5.5%, reflecting a cautious stance aimed at containing inflation while supporting growth. Despite earlier forecasts suggesting multiple rate cuts in 2024, markets are now pricing in just two. The Bank of Japan also kept rates stable but further reduced its bond purchases; Governor Kazuo Ueda indicated that further rate hikes remain a possibility despite signs of economic weakness. In contrast, the European Central Bank lowered its key rate to 3.75% from 4%, making its first cut since 2019, even as wage cost pressures persist. MSCI ACWI Small Cap Index Performance (USD %) While inf on appears under control in most countries and bond yields remain stable, recent election results have introduced new volatility in both developed and emerging markets. In Europe, far-right parties made significant gains in the parliamentary elections in the European Monetary Union. French President Emmanuel Macron reacted to his party's rout at the ballot box by hastily calling for snap legislative elections, prompting French markets to fall. In Germany, Chancellor Olaf Scholz's center-left Social Democrats also received a drubbing and are now polling behind the extreme-right wing Alternative for Germany (AfD) party, although with elections there more than a year away, markets were calmer. In another anti-incumbent outcome, the Labour party secured the majority in the UK Parliament, bringing an end to Conservative Rishi Sunak's 20-month tenure as Prime Minister, and to the Tories' 14-year hold on power. Emerging economies also experienced political upheavals. In India, Prime Minister Narendra Modi's Bharatiya Janata Party (BJP) failed to secure a majority in that country's elections, which means that he will need to seek alliances across party lines to secure his third term. In Mexico, Claudia Sheinbaum's decisive victory over Xóchitl Gálvez led to a larger drop in Mexican stocks; investors braced for populist policies as her party's gains in the legislature may lead to an unconstrained majority. The ongoing weakness of the Japanese yen remained the headline story in currency markets, as it fell an additional 6% against the dollar, reaching its lowest level since 1990. The decline appears to be caused by local investors seeking higher real yields outside their domestic market, as policies remain targeted at stimulating inflation in the economy. Emerging market currencies in Latin America fared even worse: the Brazilian real and Mexican peso both dropped roughly 10%, weighed down by narrowing interest rate differentials with the US dollar and, in the case of the peso, the election results. Among global small caps, Utilities was the best performing sector, as there are expectations of rising energy demand for the large data centers that tech companies are building for artificial-intelligence applications, while the more economically sensitive sectors of Consumer Discretionary and Industrials performed poorly due to signs of weakening consumer spending and recession worries. IT stocks posted modest gains, although the sector was weighed down by software & services due to disappointing demand for AI software tools. Regional performance was mixed. Japan and the US posted the worst performance, amid a notable shift in investor sentiment toward Japan, as the government-policy-induced rally in value stocks there faded and headwinds for Japanese growth stocks showed signs of waning. Meanwhile, Emerging Markets (EMs) resumed leading market returns, as returns for benchmark heavyweights Taiwan and India more than offset the poor performance by Brazil and Mexico, which fell 17% and 18%, respectively. In terms of style, stocks in the highest quintile of quality outperformed those in the lowest quintile by 280 basis points (bps), while the highest quintile of growth outperformed the lowest by 290 bps. However, the MSCI ACWI Growth Index underperformed its value counterpart by approximately 70 bps. Second Quarter 2024 Performance Attribution Sector: Global Small Cos. Equity Composite vs. MSCI ACWI Small Cap Index Geography: Global Small Cos. Equity Composite vs. MSCI ACWI Small Cap Index The Global Small Companies portfolio declined 4.8% gross of fees in the second quarter, compared with a 1.4% decline in the MSCI ACWI Small Cap Index. Our underperformance was due to weak stocks across sectors, including Communication Services and Consumer Discretionary. In Communication Services, market research services provider YouGov (OTCPK:YUGVF) unexpectedly lowered projections for revenue and earnings, citing weaker-than-expected sales in its data-products division and falling demand for its fast-turnaround research services. The revised outlook caused the shares to plummet. The strong market reaction may partly reflect a common misconception among investors that YouGov primarily conducts political polling, as those investors would expect the company to do particularly well in a year full of democratic elections. (Political polling is only a small percentage of overall revenue.) In Consumer Discretionary, US discount retailer Five Below (FIVE) reported a surprise decline in sales from existing stores, increasing concerns the company is facing competition from Chinese discount e-retailer Temu. The portfolio's Industrials stocks also performed poorly compared to index peers. Atkore (ATKR), a US-based provider of electrical conduit, reported disappointing sales growth and lowered its annual guidance due to weak demand from telecommunications customers. This more than offset gains in the shares of US industrial-battery solutions provider EnerSys (ENS), which issued a better-than-expected outlook, citing demand for backup power solutions from data-center customers. One of the bright spots was the health-care equipment and services industry. Simulations Plus (SLP), a US-based pharmaceutical software and services provider, reported improving demand from biotechnology customers that are recovering from a downturn. These companies are attracted to Simulations Plus's extensive experience in simulating the way drugs interact with the human body. By region, stock selection was particularly weak in Europe ex EMU. The republic of Georgia passed a new foreign-agent security law like the one enacted in neighboring Russia, prompting street protests and concern that civil liberties will be curtailed. This hurt investor sentiment toward Bank of Georgia (OTCPK:BDGSF). The sharp decline in Bank of Georgia's stock price, combined with the disappointing development at YouGov, more than offset gains in the shares of UK-based Keywords Studios (OTCPK:KYYWF), a provider of IT services to the video-game industry, which received a buyout offer from private-equity firm EQT. Regional allocation partially offset weak stock selection, including our lower relative weight in the poorly performing US region and our high relative weight in Europe ex EMU. Small caps have underperformed their larger peers by a wide margin over the last couple of years, as a handful of mega-cap stocks, particularly in the US tech industry, dominates overall market returns. The relative weakness in small-cap stocks has added to a perception that small companies are also generally at an inherent disadvantage vis-à-vis large companies, should the latter be tempted to encroach on their industries. In this environment, the mere rumor that a deep-pocketed competitor such as Amazon may be ready to enter a market can quickly topple the share price of smaller industry incumbents. However, the success of a large company entering a new market is not a certainty by any means. A smaller company focused on a specific region can create high barriers to entry for would-be competitors by developing a differentiated product and strong brand, while learning and catering to local preferences and requirements. A rival's product would also have to be vastly superior to win over customers should they face high switching costs. For a large company with a broad set of expansion opportunities, the attractiveness of a new market is diminished if competing with the incumbent comes at a steep cost. Therefore, attractive opportunities exist for small-cap investors in correctly identifying those situations in which the knee-jerk fears over a new entrant aren't justified. This requires an understanding of industry structure, which we evaluate using Michael Porter's Five Forces as one of the initial steps of our research process. Evaluating the threat of new entrants is particularly important in the case of small companies because any industry offering above-average growth and profitability is almost certain to attract the interest of larger, well-capitalized competitors. One small company that has managed to keep a large new entrant at bay is Rightmove (OTCPK:RTMVF), the leading UK portal for residential sales and rentals. Like other internet businesses, online real estate portals are subject to network effects that cause most of the market share to accrue to one company -- in this case, Rightmove, which has an estimated 80% market share. Buyers naturally flock to the website with the most listings, and sellers' agents are drawn to sites with the most buyers. CoStar (CSGP), the owner of the popular US websites Homes.com and Apartments.com, has attempted to compete in the UK by acquiring OnTheMarket.com, Rightmove's distant third-place rival, in October of last year and aggressively spending on marketing to gain users. Rightmove shares dropped more than 13% on the day the deal was announced. But while web-traffic data show that OnTheMarket temporarily claimed the No. 2 spot following a March marketing campaign, the site lost ground in May, falling back to third place. To overtake Rightmove, CoStar will need to, at the very least, sustain its large marketing spend -- a strategy that runs counter to management's focus on returns on investment. More likely, it will have to settle for second place behind Rightmove. Investors' fears have also been allayed: Shares of Rightmove have recouped their losses. Enthusiasm over the prospects for AI has introduced a wave of new entrants seeking to apply the technology to industries such as health care -- including large, well-funded competitors such as Alphabet's (GOOG,GOOGL) DeepMind. It's conceivable that some may try to compete with Simulations Plus in its niche of providing modeling and simulation software to pharmaceutical and biotechnology companies for use throughout the drug-development cycle, a field known as bioinformatics. The company's flagship software, GastroPlus, was first introduced in 1998 and has become a critical tool for drug researchers to evaluate potential toxicity, an important first step in drug development that traditionally had been performed through animal testing. While the earliest versions of GastroPlus simulated the ways in which a drug is metabolized in the liver (liver damage is the main reason drugs are pulled from the market), Simulations Plus has been able to use enhanced computing power to also help researchers understand how compounds are absorbed in other parts of the body, including the brain, heart, and lungs. In addition to absorption, the latest GastroPlus software can visualize a drug's pharmacokinetics (how the drug passes through and leaves the body) as well as its pharmacodynamics (how and whether a drug binds to a receptor within a cell, what happens when it does, and how it interacts with other drugs or body chemistry). The company's decades of experience refining its prediction algorithms -- by comparing results from real-world trials with that of its software -- gives it a very high degree of accuracy. Its unique, proprietary data set would be difficult for new entrants to replicate. Simulations Plus further differentiates itself from software-only competitors by providing consulting services to assist customers with the use of its software and, increasingly, to help them get drugs to the market by using simulation and modeling in the US regulatory approval process. Helping drug companies save time and money at various stages of exploration and development is one thing; getting regulators to sign off on simulated results without verifying them in human models requires another leap of faith in the technology that is only now being bridged. Simulations Plus is better positioned than most to help companies and regulators take that leap. Its knowledge of the regulatory process helps make the company a trusted partner of its customers, including Eli Lilly, Pfizer, and Roche -- major American and European drugmakers that have used its software in all phases of drug development -- and is also a key barrier to entry to any new competitors. IT services is an industry in which many local small companies have been resilient in the face of competition from larger rivals. One that stands out is Bechtle (OTCPK:BECTY), which has a strong position in Germany as the country's largest provider of turnkey IT solutions -- called a systems house -- despite the presence of global competitors such as Accenture (ACN). Bechtle differentiates itself by focusing on the entire lifecycle of IT systems, including thepurchase of new products as well as managing or retiring older tools. This makes it a one-stop shop for customers to manage technological change in a cost-efficient manner. Through a partnership that began with IBM four decades ago, Bechtle has cultivated long-term trusted relationships with local customers, including many in the public sector. It now boasts about 100 offices of consultants and IT professionals across Germany and the nearby German-speaking countries of Switzerland and Austria, enabling Bechtle to provide better customer service than larger competitors, building a strong barrier to entry. It also has partnerships with other tech leaders, such as Microsoft and Amazon Web Services, as a reseller of their products and solutions. Even as the largest tech companies in the world post robust growth -- in their businesses and their stock prices -- Bechtle has demonstrated that there remains a need for third-party value-added services that help customers solve unique challenges. It is reasonable for the market to be worried about the fate of smaller companies in a world where it seems that the bigger will continue to get even bigger and stronger. But not all small companies are alike. Our portfolio is characterized by high-quality businesses with competitive advantages in growing, profitable niches that can withstand attacks by large, well-funded competitors.