article , video 11-04-2014

Building a Database of Quality Businesses

Small-cap equities form the largest domestic equity universe, accounting for approximately 80% of all publicly traded companies in the U.S. In such a large and diverse space, how do we attempt to identify companies with the quality characteristics we typically seek? Portfolio Manager Steven McBoyle explains how we uncover and monitor businesses within our chosen asset class based on three key investment tenets and careful due diligence. 

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Francis Gannon: Steve, one of the more interesting things you’ve been working on here over the past several years with Chuck has been expanding our definition of quality and building a better business model database. Can you tell us more about that?

Steven McBoyle: At The Royce Funds, we have three key investment tenets. We invest in companies with strong balance sheets, we invest in companies that have high return on capital measures, and we pay an awful lot of attention to valuation. It’s really the second tenet, return on invested capital, that is the most indicative, we believe, of the underlying quality of a given business or franchise.

We call it the enterprise conviction framework, and it’s effectively a mental model that allows us to look at the overall market map of a given industry and look at the underlying structural attributes of a given company, how it operates within that industry, and ultimately we’re looking for the sustainability, or it may be even the improvement, of the underlying return on invested capital attributes of that company.

What falls out of all of that is obviously a database, or a collection of businesses that arguably are the best-of-breed businesses within our small-cap zone.

Francis: Can you give us an example of some of the qualitative things you’re looking for?

Steven: So I mentioned the market map before. In terms of the framework analysis that we do, we begin with the market. First and foremost, is it a large and growing market? Is the market mature? Does the market as a whole provide pricing power up and down the value chain?

We look at the constituencies within the market. How do they interact with one another, and where does this company position itself relative to those other constituencies, constituencies being suppliers and customers.

So once we have an appreciation for that overall market, we look at the underlying company itself. What competitive advantages, structural attributes does it bring to the marketplace? Do they benefit from switching costs? Do they have a positive network effect at work? Do they have the low cost production position within the industry?

And so, again, this is a framework that almost in a predictive method allows you to determine how a certain company should evolve, what certain strategies a company should have if you believe that they have that certain competitive advantage that they’re providing to the marketplace.

Francis: How important are the management teams in that discussion?

Steven: Managements are obviously important, but in no means are we betting on the management. It’s fair to say that over time the company, and the position of the company, dictates the underlying return metrics of a business.

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. 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. Investments in securities of small-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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