The following texts refer to the third quarter of 2022

Performance
In the third quarter of 2022, KOP’s Net Asset Value (NAV) declined from €238.20 to €200.32 per participation. This brings the return over the third quarter to -16.0% and over the first nine months of the year to -34.0%. KOP has averaged a return of 5.1% per year over the past three years and 1.0% per year over the past five years versus our target of an average of 10% per year in the long term.

Trading
As of 3 October 2022, the trading price was €201.32, based on the NAV of that date plus a premium of 0.5% caused by net inflow into the fund. As of the start of the fourth quarter, the fund’s size is €900 million. For the next trading date of 2 January 2023, an instruction deadline of 4pm on 30 November 2022 applies for orders in KOP (via Euronext) and a few days before that for the holding companies (via the Van Lanschot Kempen transfer agent).

Market review
The global economy finds itself at the kind of tipping point that only occurs once or twice in a generation. After fourteen years of highly expansionary monetary policies, the unprecedented upturn in financial assets has come to a halt. It will have escaped no-one’s notice that the prices of all asset classes have been squeezed severely this year. Interest rates are rising fast from extremely low or even negative levels as central banks attempt to cool their economies in a bid to curb the exceedingly high rate of inflation. The latter is the result of a combination of strong consumer demand (low rates of unemployment, the high level of savings after two years of lockdowns, supportive government policies) and persisting supply problems in many industries in part due to the lockdowns in China (e.g. electronics) and the war in Ukraine (e.g. energy, cabling).

The US central bank indicated its intention to go as far as necessary in its interest rate policy in order to bring down inflation. It’s now clear to investors that the central bank will tackle this cycle more aggressively than ever before because inflation is already at such extreme levels. From the mid-1980s until recently, the central bank has pro-actively raised interest rates and inflation remained relatively low and stable. This enabled the bank to watch how conditions evolved. With core inflation now in excess of 6%, an unemployment rate of just 3.7% and a record number of unfilled vacancies, the Fed is now busy playing catch-up. Fed Chair Powell made it clear that the bank would not make the mistake of ending tightening too soon and acknowledged that this would be a painful process. We’re hearing the same rhetoric from the ECB.

Since the start of this year, global equity markets have dropped considerably (MSCI World Index -14.6%) and within that European small-cap share prices have performed especially poorly with a decline of 30.8%. Rising interest rates usually have a delayed effect on consumer spending after about three to five quarters. However, soaring energy prices are squeezing consumer budgets in Europe and potential energy shortages this winter could lead to reduced production levels in certain industries. This makes it highly likely that Europe will enter into a recession and small European businesses are particularly sensitive to these. Although we cannot yet talk of a clear global recession, in the past few weeks we’ve seen the first profit warnings issued by e.g. Thule (bike carriers, roof boxes) and Hypoport (mortgage applications) and even a clothing giant like Nike has warned of rising stock levels in the channel caused by collapsing sales.

KOP is having a tough year, with its price declining 34.0% in the first nine months of the year. In comparison, European small caps (MSCI Europe Small Caps index) fell by 30.8% in the same period, meaning that KOP is unfortunately underperforming versus the general European small-cap market. The fund’s lack of exposure to companies that are profiting from the sharply higher energy prices and interest rates is the main reason behind this. We have no exposure to outperforming sectors such as energy, financials, telecoms and metals&mining. Price volatility has always been an inherent component of KOP’s investments but in the fund’s thirty year history we’ve only witnessed the kind of correction we’ve seen over the past twelve months twice (2002 and 2008).

Portfolio
Looking at the KOP portfolio and trends of the first nine months of 2022, the prices of our economically-sensitive holdings have been hit hard, with declines of over 50% in some cases so far this year. Demand for the products and services of Harvia, SAF Holland, Coats, BESI, Suss, Alligo, Momentum, DiscoverIE and Sthree is expected to decline as a result of the economic slowdown in Europe in particular. Yet demand and order books continue to be at record levels for most of these companies. Sauna manufacturer Harvia and semiconductor machine manufacturer BESI have specifically said that they’re seeing a slowdown in end demand but the situation is ‘so far so good’ for the other names. As far as SAF Holland is concerned, it’s logical to expect the manufacture of new trailers to collapse just as we’ve seen in previous recessions. Its recent acquisition of Haldex (brake systems mainly for lorries with a sizeable service market) will create greater stability but the company’s debts have risen as a result of this transaction and we would like to see SAF Holland strengthen its balance sheet by issuing new shares. Alligo and Momentum supply products to Scandinavian industrial clients and construction companies and a recession could cause a downturn in revenue here as well. One interesting case is Sthree, the staffing company for high-quality tech personnel. Staffing agencies are normally extremely sensitive to the economic cycle but given the current shortages of tech staff Sthree might well be able to escape unscathed on this occasion. In the three months up to the end of August, Sthree’s revenue grew by an impressive 19%.

In addition, a number of our companies are struggling with supply issues. Dustin, Washtec, Kardex, XP Power and Kendrion, for instance, reported well-filled order books but were unable to realise the corresponding revenue growth this year owing to supply issues with components (metal, plastic, cabling, computer chips, circuit boards). These problems apply to both the companies and their clients. Sometimes Kendrion can make the delivery of their products, for example, but a car manufacturer is encountering difficulties buying other components. Other sizeable projects such as in warehouse automation (Kardex) and the renovation or construction of car washes (Washtec) are occasionally also suffering delays because no (sub-)contractors are available to do the work. Moreover, they are experiencing problems with raising the prices of previously arranged orders, which is temporarily squeezing gross margins. These participations have also been subjected to severe price pressure this year, despite signs that margins will normalise in the second half of the year following a difficult first six months.

Finally, a number of companies are facing specific challenges. For example, Avon’s biggest customer, the US army, failed to get its 2022 budget approved by Congress, XP Power was accused of industrial espionage by competitor Comet and the CEO of Alliance Pharma is suspected of price fixing. In the first case, the war in Ukraine is ensuring that European NATO countries are filling Avon’s production lines with demand for gas masks and helmets and after a weak start to the year revenue and earnings are recovering further each month. XP Power was ordered to pay damages of US$40 million to Comet for industrial espionage. Two former Comet employees had taken trade secrets with them to their new employer, XP Power; they were immediately dismissed but as their formal employer XP Power was convicted for this. A surprising and embarrassing situation but, aside from the one-off costs, nothing that will have a negative impact on the long-term value of XP Power. The same goes for Alliance Pharma. The fine of GBP8 million imposed for events in the period 2013-2018 represent approximately two months’ earnings before tax for the company. The potential dismissal of the CEO would likewise be embarrassing but will have no material impact on the company’s value.

The challenges facing our companies are mostly of a temporary nature and their balance sheets are robust, despite some companies having made what proved in retrospect to be highly-valued acquisitions this year and last year (SAF Holland, Coats, Avon Protection, Premier Foods).

No new participations were announced in the third quarter but - as always - we have a number of new participations under construction at the moment; however, it’s not certain whether these will ever become full 5% stakes. Furthermore, we have taken advantage of the lower share prices to expand a select number of existing positions.

Irrespective of whether the economy is heading for a recession, long-term investors know that they’ll have to face an economic downturn sooner or later. After all, this is an inherent part of applying a long investment horizon. In our view it’s almost impossible to accurately estimate the moment when equity markets reach their peaks or troughs. Yet the troughs are when the highest future returns start to be earned and the important thing at such times is not to throw in the towel. Our strategy of being long-term engaged shareholders in solid companies with leading positions in attractive niche markets makes us confident about the future.

In the final week of September, we visited a number of our participations’ US subsidiaries. There we talked to the local management team of Lectra, which has made significant progress on its integration with Gerber. The product range has been rationalised, sales processes adjusted to each other and the service to Gerber customers improved, among other things by stocking more local spare parts and consumables in order to serve Gerber customers more fully and more quickly. Next, we travelled to Coats where we discussed in detail the plan to reduce operations in the US in favour of Mexico because of staff shortages. At Avon Protection we witnessed first-hand the very real challenges involved in retaining skilled factory workers in the US but also note that demand is strong, driven by the geopolitical tensions in the world. Washtec has far-reaching ambitions for the North American market and the company expects to double its revenue over the coming eight years, although there’s clear potential for improving the efficiency of local assembly. Our meetings with XP Power and competitor Advanced Energy served to confirm the robustness of the underlying model and end markets but we also recognise the risk of these two companies increasingly encroaching on each other’s turf.

We’re comfortable with the companies in the portfolio and impressed by their quality.

Nevertheless, the world has changed drastically as a result of the war, lockdowns in China, rising interest rates, cost-push inflation, sharply higher wages, energy shortages, risky fiscal policies and substantial currency fluctuations.

Valuations
The value of the KOP portfolio decreased across the quarter and we believe it to be attractively valued. The portfolio’s cash-adjusted price/earnings ratio (EV/EBIT 2023E) stood at 10 as of the end of September 2022 and in our view the portfolio’s long-term price potential remains interesting. The four managers of KOP expanded their private positions in the fund as of the most recent trading date on 3 October.