article 03-05-2013

Market Perspective

Are Investors Returning to Business Fundamentals?

Does a decline in correlation imply that the spotlight will shine once again on quality? Portfolio Manager Lauren Romeo talks about how she defines company quality; how quantitative easing has benefited lower-quality companies; the suffering of quality under macro-driven concerns; Royce's business-buyer's approach to investing and bottom-up stock-selection process; and what matters most when meeting with a company's management and positioning portfolios.

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What are the most important markers of company quality for you?

For us, the key markers of quality are a strong balance sheet, good free cash flow generation, and a history of high returns on invested capital (ROIC). A strong balance sheet gives a company the financial wherewithal to weather times when their operational results come under pressure due to cyclical or temporary company-specific factors. Net cash on the balance sheet and the ability to generate free cash flow allow a company to self-fund growth rather than be a hostage to the state of capital or lending markets.

Consistently high ROIC typically signals that a company has a sustainable competitive advantage (e.g., low cost producer, proprietary technology, brand equity, etc.) that gives it an "economic moat," making it difficult for competitors to dent its market position and profitability.

High ROIC may also indicate that a company operates in an industry with a favorable structure supportive of high returns (e.g., with high barriers to entry; consolidation that has led to rational competition). I see sustained ROIC in excess of a company's cost of capital as the formula for shareholder value creation.  

Why do you expect quality to do well in 2013?

Quality small-cap companies have lagged their lower-quality peers in terms of stock market performance over the past several years.

The Fed's monetary policy of quantitative easing (QE) has created a significant and sustained tailwind for lower-quality companies that tend to have a fair amount of financial leverage. With interest rates at historic lows, many of these companies have refinanced their debt, materially lowering their interest burden and boosting earnings growth.

Deep into round three of QE, however, we may be reaching the point of diminishing returns as the universe of companies that have not capitalized on this "easy money" opportunity shrinks.

Improving U.S. economic indicators in recent months have even led economists to begin discussing when it may be time to end QE, and even possibly raise short-term rates. As investors re-focus on business fundamentals rather than financial engineering as the key to long-term earnings growth and sustained value creation, the quality portion of the small-cap universe appears poised to benefit, particularly when one considers valuation. 

Dividing the Russell 2000 into quartiles by ROIC and looking at valuations, the top ROIC quartile of companies (those that we at Royce see as the highest quality) are trading at just eight times trailing cash flow and the lowest ROIC quartile of companies (lowest quality) are valued at almost six multiple points higher.

As investors re-focus on business fundamentals rather than financial engineering as the key to long-term earnings growth and sustained value creation, the quality portion of the small-cap universe appears poised to benefit, particularly when one considers valuation.

Do you see the decline of correlation as a positive sign for quality companies?

Yes. For the past three years we've had what Yogi Berra would call "déjà vu all over again" periods in the market where macro-driven concerns such as European sovereign debt, concerns over the U.S. debt ceiling, and anxiety over the fiscal cliff drove stocks lower.

In these instances, small-cap stocks in economically sensitive sectors were tarred with the same brush, regardless of whether the companies were considered high or low quality.

Decline in correlation implies investors will differentiate among companies based on fundamentals. This type of "stock-pickers' market" should shine light on quality small-cap companies with superior business models that are attractively valued and that were previously overshadowed by macro-driven headlines.

What are the most common questions you have when you meet with a company's management?

Given our business-buyer's approach to investing, our meetings with company management focus on understanding the economics of the company's business, drivers of past returns on capital, and the sustainability of those returns going forward.

This involves a discussion of the competitive landscape, industry structure, and management's long-term growth strategy. Also, as we are often buying companies that are out of favor because of cyclical or company-specific issues that are depressing recent financial results, we want to understand the plan for managing through this period and returning to more normalized earnings power.

Capital allocation is another important topic. As quality companies typically have excess cash, it is important for us to understand the reinvestment options management is considering as well as any plans to return some of the money to shareholders via dividends or share repurchases.

A related topic is incentive compensation metrics—in general, a management team whose bonuses are tied to return on capital is likely to make more shareholder-friendly strategic and capital allocation decisions than one incentivized by growth.

How have you been positioning the portfolio lately? What sectors and industries look attractively undervalued?

We continue to have relatively high weightings in more cyclical sectors. This positioning is a function of our core bottom-up stock-selection process and is not guided by top-down views.

Over the last several years, as macro headlines have caused periodic pullbacks in the equity markets, economically sensitive sectors were particularly hard hit. As a result, it was in those areas—Industrials, Information Technology, Materials, Consumer Discretionary, and Energy—in which we were finding the highest-quality companies trading at the most attractive valuations on normalized operating income.

While the resulting cyclical bent of the portfolio has trumped the quality characteristics of our companies in terms of fund performance in recent quarters, when viewed through our lens of our typical three- to five-year holding period, we believe our companies should experience significant earnings leverage as the global economy continues to recover.

Important Disclosure Information

Lauren Romeo is a portfolio manager of Royce & Associates, LLC, investment adviser for The Royce Funds. Ms. Romeo's thoughts in this interview concerning the stock market are solely her own and, of course, there can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Royce Funds invest primarily in micro-cap, small-cap, and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). The Funds may invest a portion of their respective net assets in foreign securities, which may involve political, economic, currency and other risks not encountered in U.S. investments (see "Investing in International Securities" in the prospectus). Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index.

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