Royce's "Captain of Quality" Talks About Identifying and Investing In High Quality Small-Cap Companies

Lauren Romeo

You serve as Portfolio, or Assistant Portfolio Manager on a number of Royce Funds. You are also known as Royce's "Captain of Quality". How do these two roles work together, and what does it mean to be part of the "quality team"?

A specific focus on identifying and investing in high quality small-cap companies is the link between the two roles. At Royce, all portfolio managers are also analysts. Our Co-CIOs Chuck Royce and Whitney George have created a structure that maximizes individuals' efforts in a particular investment approach rather than specific industry coverage.

My main portfolio management roles are on Royce's "Focused" Funds, in which the strategy is to construct limited portfolios—generally less than 100 positions—of what we deem to be high quality small-cap companies trading at attractive valuations. I work closely with Chuck and Whitney on many of these products. 

Even for the more diversified "Core" Funds in which I'm involved, such as Royce Pennsylvania Mutual Fund, my mandate is the same—invest in quality companies for that portion of the portfolio that I manage. As a result, my stock idea generation and daily research efforts are focused on finding small-cap companies with durable business models and then leveraging those ideas across the Funds I work on.

How do the quality names get disseminated among Royce's Portfolio Managers?

One of Royce's most valuable investment assets is the cumulative company and industry knowledge of its 25 investment professionals, including 17 portfolio managers with at least 15 years of investment experience. Collaboration is a hallmark of our research process, and it's how we leverage our knowledge. It starts with something as basic as our work environment; rather than being walled off in offices, we have desks in an open working area that facilitates a free flow of ideas and frequent interaction. It is common for portfolio managers to work together on a particular stock idea.

In our meetings with company management teams, there are usually several portfolio managers in attendance. Afterwards, we reconvene to discuss key takeaways from the meeting or debate the bull and bear cases for investing in the stock. We also use technology to share knowledge, such as an online centralized research repository for company notes to which we all have access, or by disseminating our research notes, thoughts or articles of interest via group e-mail.

How do you define "quality"?

We define quality as companies with strong balance sheets, solid free cash flow generation and a sustainable business model that generate high returns on invested capital. These favorable quantitative traits are usually a function of a good industry structure with rational competition, or the result of a company having some enduring strategic advantage that makes it difficult for competitors to dent its dominant market position and high returns.

Quality companies also have management teams with a good track record of capital allocation. The investment universe is littered with examples of "deworsification" in which a great business was rendered an average one as a result of poor capital investment decisions by management, such as an ill-advised acquisition.

The "quality" subset of the small-cap and smid-cap universe remains quite broad. Today, there are almost 1,200 U.S. non-financial companies with market caps up to $5 billion, many of which could potentially meet our quality metrics. This investable universe is roughly four times larger than the universe of companies with market caps higher than $5 billion.

We also look for "emerging quality." These are companies that have the potential to improve their returns on invested capital to above-average levels as a result of a change in either their industry's structure—consolidation leading to a more rational competitive environment, for example—or at the company level, such as a new management team, or divestiture of an underperforming asset or exiting an unprofitable line of business.

What are some disqualifiers?

We typically avoid capital intensive businesses that regularly require external financing, especially debt, to grow. These are also often commodity businesses producing products that are relatively indistinguishable from competitors' so that companies can only compete on the basis of price. The pulp and paper industry or airline industry are examples of this.

Poor industry structure, including factors such as high degrees of competitive rivalry, low barriers to entry, high threat of substitution, strong bargaining power of customers and/or suppliers, also results in low return profit models. We also avoid highly regulated businesses like utilities, where returns are typically limited. Finally, Real Estate Investment Trusts (REITs) often do not meet our "strong balance sheet" test since they regularly need to raise debt and/or equity to grow because of the requirement that they pay out most of their income in exchange for favorable corporate tax status.

When you meet with a company's management team, what questions do you ask?

After identifying what appears to be a quality company based on its financial metrics, our real work begins—applying our bottom-up, business-buyer's research approach. Meetings with the management team, as well as speaking with its competitors, customers, suppliers and industry experts, are core to our due diligence process.

Given Royce's strong reputation in the small-cap market, companies want us to be investors and as a result we have excellent corporate access, with an average of five to eight companies coming to Royce for meetings on a typical day. Our main focus is on understanding the company's business model and what drove past high returns on capital. We also look at its future growth opportunities, the factors that are currently depressing the company's financial results or its valuation, management's strategy to address the business challenges or threats, and management's long-term capital allocation priorities, as well as the company's key incentive compensation determinants.

Ultimately, we are trying to discern whether the stock is out of favor for cyclical or temporary company-specific reasons that are fixable and will allow the company to return to normalized earnings power over time, or whether there is a structural change that has permanently altered the company's business model so that past high returns may not be sustainable going forward.

How does valuation factor into the equation?

Valuation is a critical part of our investment and risk management process. A great company will not be a great investment if we overpay. Market myopia and situations where investor perception about a company's business headwinds is worse than the reality can cause a company's stock market valuation to decouple from its intrinsic value. We try to buy companies when they are trading at a 30%-50% discount to our estimate of their true worth. Royce's long-term investment horizon of at least three-to-five years allows us to be contrarian and buy when a company is out of favor. This gives us a margin of safety as the stock price reflects both bad news and low expectations rather than being priced for perfection.

If a high quality company is outside your valuation range, does that preclude you from doing evaluation work? 

No. Investment success is often a function of the intersection of preparation and opportunity. Even the highest quality companies at some point experience valuation multiple contraction, whether due to a macro-driven market sell-off, a cyclical rotation by investors out of certain industries, or company-specific issues. We can't predict when these events will happen, but we can be prepared to quickly capitalize on the buying opportunities when they arise by having done our homework on the companies in advance.

In addition to the names we currently own or are researching, we also maintain and regularly add names to a quality watch list of more than 300 companies. These are companies that have track records of generating high returns on invested capital and strong free cash flow, but otherwise aren't exact fits for us at the moment. They may be trading at premium valuations, modestly above our investable market cap range, may not meet our balance sheet strength test, and/or may be in the "show me" stage of transformation from an average to a high quality company. We review the database weekly and can quickly scan for decreases in valuation or market cap, or improvements in the balance sheet, any of which can put a quality company in our target range.

Why is quality important when investing in small cap stocks? 

First, unlike many large-cap companies that are in multiple businesses, many small-cap companies operate a single business or are dependent on a few customers or products. To manage this risk, it makes sense to invest in companies with the most durable business models and sustainable returns.

Second, small companies have less access to financing. One way to offset this risk is to invest in companies with strong balance sheets that generate sufficient cash flow to self-fund their growth. This strong balance sheet requirement really showed its worth during the credit freeze in 2008. Many of the quality companies we owned were able to use their balance sheet strength to take market share from or acquire financially weaker competitors, such that they emerged from the recession in an even stronger position. Finally, the small-cap market has historically been a target-rich hunting ground for larger companies as well as private equity buyers looking to make acquisitions. By focusing on quality and taking a business-buyer's approach to investment analysis, we are looking at many of the same business characteristics and valuation measures as strategic and financial buyers, so many of our companies wind up on acquirers' radar screens.