article 03-01-2012

Lauren Romeo on Risk Management and Quality Small-Caps

Our 'Captain of Quality,' Portfolio Manager Lauren Romeo, talks about how risk management intersects with her search for high-quality small-caps, what sectors she's been focused on most recently, how current events have not had a huge effect on her stock-selection process, and what the key elements are in her security analysis process.


How does Royce's overall focus on managing risk intersect with your own emphasis on investing in quality companies?

At Royce, risk management is built into our investment process. The Funds in which I'm involved place particular focus on high-quality companies, which means that in those portfolios we are trying to mitigate business and financial risk by restricting our investments to only those companies with strong balance sheets and ample free-cash flow generation. Financial strength enables companies to better weather difficult business conditions and stay focused on operations. Smaller companies also typically have less access to external financing, so being able to self-fund growth helps to offset liquidity risks.

The companies we define as high quality must demonstrate a history of above-average returns on invested capital (ROIC), a metric that indicates that either the company has a solid competitive advantage or that the structure of the industry in which the company operates facilitates high returns, such as high barriers to entry.

We typically will only buy a company when it is trading at a 30% to 50% discount to our estimate of the company's intrinsic value. This, combined with the fact that we are usually buying companies when they are out of favor and their valuation already reflects negative news, provides us with a margin of safety on the downside and a favorable risk/reward profile.

We also look closely at strategic risk, meeting with not only the company's management, but also its competitors, customers, and suppliers, all of which informs our analysis of the sustainability of the company's business model and its returns on capital.

Valuation discipline is another key risk management tool. We typically will only buy a company when it is trading at a 30%-50% discount to our estimate of the company's intrinsic value. This, combined with the fact that we are usually buying companies when they are out of favor and their valuation already reflects negative news, provides us with a margin of safety on the downside and a favorable risk/reward profile.

In the Funds that you manage, the Materials sector is mostly weighted with gold and silver miners, scrap metal recyclers, and fertilizer companies. What is your investment thesis for each of these areas?

There was a period of underinvestment by miners when gold and silver prices were much lower in the early 2000s. This was followed by a subsequent ramp-up in demand for the metals from developing economies such as India and China, which created a supply/demand imbalance that drove gold and silver prices higher. We think that this situation is likely to persist in part because supply cannot quickly meet demand—it can take at least five years for a mine to move from approval to construction to full production.

We also see a side benefit to owning gold and silver mining companies—these stocks serve as a safe haven for investors seeking shelter from inflation, which is more likely to materialize in the coming years due to the aggressive monetary policies being pursued by developed countries in their efforts to revitalize economic growth.

As for scrap metal recyclers, our thought is that they should benefit as steel consumption continues to grow. We expect demand to be led both by ongoing infrastructure investment in developing countries and by more energy efficient electric arc furnace steel mills gaining market share.

Our fertilizer holdings can be volatile in the short term, but we see several trends that should support long-term growth: secular trends in population growth, rising protein consumption coincident with the growing middle classes in developing economies, low grain stock levels in the U.S., and a decrease in arable land are all developments that can sustain increased fertilizer use to improve crop yields.

How do you see the upcoming elections here in the U.S. and the still shaky economic status of Europe affecting stocks?

We don't choose stocks or investigate sectors and industries based on a top-down, macro view, but instead focus on a bottom-up fundamental analysis that leads us to high-quality small-caps trading at what we think are attractive valuations, typically due to cyclical or temporary company-specific reasons.

Most recently, we've been focusing on companies in the Industrials and Technology sectors, which were particularly hard hit during the small-cap correction in the second and third quarters of 2011. We believe these companies are poised to benefit from improving growth in the U.S., while many also have meaningful exposure to faster-growing, developing countries in Asia and South America. Several of our new technology holdings are further benefiting from growing addressable markets for both their new and existing technologies. Consistent with recent economic data, most companies with which we've spoken recently are reporting improving demand trends in the U.S. and Asia. They remain cautious on Europe in the near term and already have factored that into their guidance.

Like most macro outcomes, political events are difficult to predict, and so we don't spend a lot of time trying to do so. That said, investment research firm CSFB notes that, since 1979, presidential election years have typically been positive for small-cap stocks, with slight outperformance relative to large-caps. Historical analysis also suggests that the best outcome for the stock market is one in which neither party has control of both houses of Congress and the White House. Rhetoric, proposals, and policies from each party's candidates will no doubt depress or buoy certain industries.

Can you talk in more detail about your selection and investment process? What are some of the key elements you look for?

Our goal is to find high-quality smaller companies trading at what we think are attractive valuations. As a firm, Royce has a long-term investment horizon of at least two to five years for each stock. We refer to our portfolio management process as "planting and harvesting." Any Fund's performance today is usually a function of stocks that we bought one to three years ago, while our performance in a year or two will hopefully be a function of the stocks we are buying today or have purchased during the last 12 months. As we saw in the 2008-2009 credit crisis, many of the companies we owned not only survived the downturn, but emerged even stronger because their healthy balance sheets allowed them to take market share from weaker competitors.

Given our focus on quality companies, a key quality metric we look for is companies that have a five-year average return on invested capital (ROIC) greater than 15%. This combined with strong balance sheets gives us confidence that a company can survive difficult business conditions.

Once we've identified smaller companies with these quality indicators, our real work begins—applying Royce's core fundamental research and analysis. Our long history and strong reputation with small caps is a competitive advantage because companies often want us to be shareholders. On a typical day, managements of five to eight companies come to our offices for meetings.

As a result, not only are we able to meet with the company of specific interest, but also its competitors. When meeting with a company, we are not interested in trying to discern what next quarter's earnings will be. Instead, our focus is on understanding the economics of the company's business and key profitability drivers, management's long-term growth strategy, and its plan for dealing with current conditions that are pressuring financial results. We also want to understand management's capital allocation plans, as well as what financial metrics determine their incentive compensation.

Our ultimate goal is to determine whether the company's financial results are currently depressed for cyclical or company-specific reasons that are fixable, or whether a structural change has occurred that will make past high returns on capital unsustainable going forward.

The final piece to the process is valuation. While we may conclude that a company is high quality, a great company will not be a great investment if we overpay, which is why we want to buy at a 30-50% discount to our estimate of their true value. "Cap Rate" is the main valuation measure we use to determine this. It is essentially a pre-tax free cash flow yield calculated by dividing normalized earnings before interest and taxes by the Enterprise Value of the company. Ideally, we like to buy at a cap rate of 15% or higher, usually selling when the cap rate reaches 7-8%. Our valuation discipline is intended to give us a margin of safety on the downside and leads us to buy only when the risk/reward profile is particularly favorable.

We are solely focused on owning the best companies when they are trading at attractive valuations, even if that means not investing in certain sectors and having a heavy weighting in others. We build positions gradually, raising a holding's weighting as the valuation becomes even more attractive or as the fundamentals show signs of improving. We sell a stock when the company's valuation reaches our estimate of its true value, when we determine that our original investment thesis was wrong, when we think we should move on to better alternatives, or if the stock is acquired. That's the process in a nutshell.

Lauren Romeo serves as portfolio manager for Royce Select Fund I and for Royce 100 Fund (with Lead Portfolio Manager Charles Royce). She also serves as an assistant portfolio manager for Royce Pennsylvania Mutual Fund, Royce Premier Fund, and Royce Value Fund, as well as for Royce Value Trust, a closed-end fund.

Important Disclosure Information

Lauren A. Romeo is a portfolio manager of Royce & Associates, LLC, investment adviser to The Royce Funds. Ms. Romeo's thoughts in this piece 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).

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