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Market Perspective Investment Approach

Are Investors Paying More Attention to Quality Small-Caps?

By Francis Gannon Last updated October 03, 2013

Although it covers only a brief time period, recent research by Furey Research Partners showed that since the beginning of May 2013 through September 30 the lowest leveraged companies outperformed the highest leveraged companies within the Russell 2000—to us a long-anticipated reversal and an encouraging signal that suggests investors have not abandoned quality despite an environment of easy money and near-zero interest rates.

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Typically a weak month, September was far from typical this year as the small-cap equity market advanced to new highs following the Federal Reserve’s “no taper” announcement, which outweighed the uncertainty surrounding the budget and debt ceiling debates. The Russell 2000 added 6.4% in September and gained 27.7% year-to-date through the end of the third quarter of 2013.

As an active manager with a longstanding process of finding companies with a history of consistent earnings growth, strong under-levered balance sheets, and attractive absolute valuations, we have long thought that the ongoing efforts to reflate the economy through numerous quantitative easings and a zero interest rate policy would have 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 relationships we hold so dear, for example, seem to have been temporarily suspended.

Highly-leveraged businesses have disproportionately benefited from the ability to restructure their debt, lower funding costs, and extend maturities, the unintended consequence of which has been to give lower-quality companies an artificial performance edge, which would not exist in a normal environment. These structural headwinds have not been kind to active managers like us.

Recent evidence suggests, however, that a change is at hand.

As small-cap managers who keep an eye on risk, we have always sought companies with solid, under-leveraged balance sheets and the ability to generate free cash. Balance sheet scrutiny is paramount to our process and our focus on risk, as smaller companies are inherently more fragile enterprises.

To that end, we have never been fans of financial leverage, choosing rather to focus on companies with high operating leverage. Our measure of financial leverage looks at the ratio of assets to stockholders' equity, looking for a two-to-one ratio or better for non-financial companies. This is an important part of our ongoing assessment of a company’s “margin of safety.”

A conservatively capitalized company, especially a smaller company, can better weather storms because it has the necessary financial reserves to do so, while a company with too much debt on the balance sheet runs a greater risk that stormy weather will turn into a hurricane.

A conservatively capitalized company, especially a smaller company, can better weather these storms because it has the necessary financial reserves to do so, while a company with too much debt on the balance sheet runs a greater risk that stormy weather will turn into a hurricane.

We also view financially strong companies as well-positioned to grow. The assets of these companies are derived more from retained earnings than paid-in capital; i.e., they have the ability to self-fund their own success as a business.

And yet these types of companies have not benefited from the actions of the Federal Reserve, particularly in the small-cap asset class. In fact, the Federal Reserve’s actions prevented the expected Darwinian process that typically occurs following a recession, whereby higher-quality, under-leveraged businesses are able to capitalize on the missteps of those businesses that are over-leveraged, in need of financing, and struggling to access the capital markets.

A closer look at performance over the last several years reveals a clear period of time in which the market rewarded more highly-leveraged businesses at the expense of their more conservatively capitalized siblings. The former group was given a life line in an uncertain economic time.

According to Furey Research Partners, from the end of August 2011—the beginning of QE2 and Operation Twist—through the beginning of May 2013 and Ben Bernanke’s initial statement that tapering would soon commence, the highest leverage companies in the Russell 2000 Index gained 33.7% while the lowest leverage companies advanced only 15.8%, underperforming by more than a factor of two.

Interestingly, since Mr. Bernanke introduced the idea of tapering (without actually tapering) into the investment lexicon, the trend has reversed course. Furey Research Partners points out that since the beginning of May through September 30, the highest leveraged companies gained 8.6% while the lowest leveraged companies gained 15.6%.

To be clear, this is a brief period of time. From our perspective, however, it is significant as investors and corporations alike are realizing that rates will not stay artificially low forever and that quantitative easings are indeed finite.

In the face of the structural headwinds that have blown through the past several years we have not wavered and our process has not changed.

To be sure, we are in uncharted territory as the flood of open-ended quantitative easing continues to roll. We do believe, however, that the waters are likely to soon begin receding. Historically, prudently capitalized, well-managed companies have been solid investments, and we believe they will be once again.

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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