Jen Taylor

As stock prices plummeted over the past year, a lot of new names have joined the micro-cap universe. Has your stock selection process changed now that the universe has expanded?

While this has always been a tremendous investment universe, with thousands of companies to consider, that number grew significantly over the course of the past year, as prices dropped precipitously. In fact about 68% of the small-cap index, the Russell 2000, is now micro-cap by our definition (market capitalizations up to $500 million).

We haven't changed our process—it has served us well in lots of different markets. When we evaluate companies, we look at the balance sheet first. It's our most important metric. In the case of micro-caps, we like to see a little more cash on the balance sheet vis-à-vis assets, as a backstop against the stock price slipping. Usually if a company has cash, and very little debt, you don't see stock prices that drop too far below the cash value. In the last six months when there were companies that had traded down to or below their cash value per share, so you literally got the business for free. It surprised me how many companies fell into that category over the last six months.

Operating margins are also important to us. We look at a combination of those two metrics, and talk to senior management about how they see the levers of their business. We want to know how they can improve their margins, and how much capital would be required to do that. Is there a need for revenue growth? Meetings with management are especially important when you are assessing micro-cap companies, because the facts aren't always transparent. They often don't have a long history to review; they may be growing very quickly; or they may have had a hiccup in their business. These issues aren't always readily apparent, so we spend a lot of time talking with management teams to find out which ones will hopefully be gems. Essentially, we are looking for diamonds in the rough.

We also run a lot of screens. At the end of 2007, I actually stopped running our "high quality" screen because at that point almost nothing in the micro-cap universe was showing up. In the middle of 2008, as the market was just beginning to get truly ugly, I ran it again, and about 50 companies screened; by the end of the year there were155. Recently, about 180 screened—and we were pleased to see that we already owned many of them.

Once you know and like a company, how do you know when it's the right time to buy?

We will wait to find the right opportunity at the right price, so patience is important. We approach micro-cap investing with a long-term time horizon. It's not rushed. It's a day-by-day, methodical process that we think has worked very well. The markets have taught us that eventually there will be opportunities to buy just about any good stock. Generally it is some kind of an event, be it market- or stock-specific, that provides an attractive entry point for us.

I tend to be very conservative in terms of entry price—I'm cheap! I don't want to overpay, and I am willing to wait. We work to build a position over the course of a year or two, and I think that our long-term results validate this process.

There's also an advantage I think Royce provides—namely access to companies. We meet with five-to-ten companies on average each day, and many of these companies would like us to be shareholders given our long-term investment horizon.

Has the recovery begun?

In general, I feel better about investing now than I have in a long time. Micro-caps across the board look pretty attractive right now. We've certainly seen a very strong move in the markets over the last 6-8 weeks, and everyone is looking to see if this is a real recovery, or just a temporary rebound off a ridiculously low base. I think the next month or two will tell us a lot in terms of trying to discern that. Regardless, two main themes are especially interesting to us now: quality and international investing.

I think from a valuation perspective, as often happens, the pendulum probably swung a little too far to the negative side, particularly for micro-caps. We saw companies that we were invested in trading at negative enterprise value—and not just one or two, but many companies across the board. That's unprecedented, certainly in the 20-plus years that I've been looking at micro-cap companies. So while there has been some genuine recovery, I think there are still legitimate concerns about credit and about the consumer. But we're still seeing opportunities every day. The high volatility in the markets is kind of exciting and exhausting at the same time.

What pitfalls do you watch out for that are specific to the micro-cap world?

Well, there is less research coverage, though that's been changing over the years, so we learn a lot from meetings with management teams. Problems can come up when a management team doesn't really have their arms around a situation in their business. Or maybe they have been less than forthright in our conversations. But more often the issue stems from the inherent characteristics of micro-cap companies themselves—they tend to be volatile, which presents both risk and the potential for higher returns—possibly higher than any other capitalization sector of the equity marketplace.

But problems at a micro-cap company can create a bigger drain on the balance sheet than they would at a larger company, which can have a big impact on the share price. That's been a real issue during the credit crunch. Businesses couldn't get financing, and their customers couldn't either.

As of May 31, Royce Micro-Cap Fund had just under 25% of its portfolio invested in foreign securities. What kind of opportunities are you finding abroad?

Investing in international companies has given us a valuable element of diversification, but it's even more than that, from a value standpoint. In the European markets, for example, when there's a sell off, micro-caps are sold off first and fast; their prices are "whipsawed." Everyone sells them, and there are no buyers around. We are often able to pick through what we regard as very high quality companies that wouldn't have been micro-caps prior to the wave of selling. I think our work in the international arena has a lot of potential and is something that I suspect most other micro-cap funds are not yet doing to the same degree that we are here at Royce.

How did you become interested in micro-cap companies?

I had a background in micro-cap companies even before I joined Royce. It's a dynamic area because they are under-followed and present some of the most outsized opportunities (and risks). And they tend to be dynamic situations—they may be new, fast-growing companies with a compelling product or service or they could be companies that have fallen on hard times and management is looking for a solution that will turn things around.