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Market Perspective Investment Approach

Understanding Quality: The Crux of Long-Term Investing

By Francis Gannon Last updated August 08, 2013

While some experts believe that small-cap valuations are currently stretched, we see ample opportunities in what we think are high-quality smaller companies.

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The Russell 2000 Index has been making new highs over the past several weeks, advancing 7.0% in the month of July.  In fact, through the end of July 2013, the small-cap index gained 24.0% year-to-date and 34.8% over the past year. With the Russell 2000 having now advanced 223.4% from the low on March 9, 2009 through the end of July 2013, it seems sensible to ask what kind of opportunities are left in the small-cap market.

A recent article in the Wall Street Journal entitled “Big Question Hangs Over Small-Caps” attempted to do just that by comparing the performance of the Russell 2000 to the large-cap S&P 500 over recent time periods. The article’s efforts to show that small-cap valuation levels are currently quite stretched, however, missed the real opportunity set within today’s small-cap space—namely, higher-quality smaller-companies.

We have always adhered to the principle that quality is paramount to mitigating risk and achieving above average long-term returns, especially in the small-cap asset class. Over the past few years we have been suggesting—wrongly, as it turns out—that higher-quality companies would lead in the market recovery regardless of market capitalization and especially as the economic recovery matures.

We have talked a great deal recently about the ways in which the ongoing efforts to reflate the economy through numerous rounds of quantitative easing and a zero interest rate policy have had unintended consequences. To be sure, the Fed is distorting asset pricing and valuations in the equity market in a number of ways.

Many of the fundamental qualities we hold so dear, for example, seem temporarily suspended in an investment world where highly-leveraged businesses are benefiting from the ability to restructure their debt, lower funding costs, and extend maturities.

The unintended consequence of this leveling of the playing field has given lower-quality companies the luxury of time, which in a normal environment they would not have.  Look no further than the performance of lower return on invested capital businesses in the Russell 2000 Index.

Driving our investment process is a rigorous search for quality that begins with an examination of a company’s historical returns, with particular focus on return on invested capital (ROIC). For us, this metric reveals the first markings of a quality company, which can be found in its historical returns over full business cycles.

As we have mentioned before, high-quality stocks look attractively undervalued right now. The shift, we believe, in market leadership to high-quality stocks is at hand, as equities transition from their reliance on monetary policy to more of a focus on underlying fundamentals.

It is a process that should eventually reward companies with strong under-levered balance sheets, excess free cash flow generation, and the ability to self-finance. 

But how to define quality? It is, perhaps, the most overused word in the investment community today. After all, who would be willing to admit that their portfolio was not of solid quality? Yet an understanding of quality is critical to our effort—as long-term investors, we believe that companies with sound fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices.

Driving our investment process is a rigorous search for quality that begins with an examination of a company’s historical returns, with particular focus on return on invested capital (ROIC). For us, this metric reveals the first markings of a quality company, which can be found in its historical returns over full business cycles. 

Interestingly, our research indicates that at the end of 2013’s second quarter the highest quality small-cap companies within the Russell 2000, as measured by ROIC, traded at a discount to the highest quality large-cap companies. 

In fact, the discount of 14% is greater than the discount at the end of the first quarter 2013 when it stood at 12%, even with the Russell 2000 advancing 3.1% in the second quarter of 2013. At the same time, the lowest ROIC stocks accounted for virtually all of small-caps’ premium to large-cap (see the chart below).

Like all asset classes, small-caps are much larger than any one index; they are also often misunderstood. While it is easy to make blanket statements about valuations, today’s environment argues for a more active and disciplined approach when making investment decisions, one where managers identify opportunities based on sound fundamentals selling at attractive absolute valuations—the process we repeat every day.

Stay tuned…
FDG

Important Disclosure Information

Francis Gannon is a portfolio manager of Royce & Associates, LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

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. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.


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