article , video 08-29-2016

How Are Leading Companies Adapting to a Low Return World?

Portfolio Manager Steven McBoyle explains why he likes high-moat businesses with sustainable earnings power that have the capacity to reinvest.

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Steve Lipper: As you've been researching companies, you've noticed a common trend that's different than what we've seen before. Can you tell us more about it?

Steven McBoyle: A hallmark to our investment approach is we invest in high-moat businesses with sustainable earnings power that have the capacity to reinvest and really it's this dynamic, the capacity to reinvest, that has been capturing our attention more and more.

So take the reinsurance industry for example. Currently, the reinsurers are having a very hard time putting capacity into the marketplace at adequate returns on a per risk basis. The reinsurance industry currently is struggling with a soft and structurally unattractive market, so really what we're seeing here now are players having to act in rather creative ways to put capacity into the market.

Recently, you saw a very unique transaction that took place between two leading players in the industry. In this example you had a leading reinsurer, who historically only wrote business on a direct basis team up with a leading competitor that allowed them to address the brokered reinsurance market, effectively allowing them to be able to put capacity into the marketplace in a productive fashion.

Steve: So intelligent capital allocation in an oversupplied world, we're seeing it take the form of actually retracing from certain markets, making smaller rather than larger acquisitions to amplify some of the growth opportunities, and shrinking the capital base.

Steven: That is entirely all true. So we have a classic holding in Lincoln Electric. We have grown up with this business; a classic franchise, premier-like business.

They are retracting capital from the Asian market. They had at one point in time a Chinese strategy that ultimately over time they concluded, and rightfully so, that the returns were not appropriate.

Capital comes back to North America. They are also aggressively buying back stock for the first time in quite some time and had been doing so for the last number of years.

Steve: As we look to research, this doesn't seem to be a topic that's widely covered. Do you think investors are appreciative of this limited ability to reinvest capital and managements adapting?

Steven: I certainly know from our perspective, we're paying more attention to it recently. We are eight years into a recovery and we continue to grow at very low rates so companies and managements have had to adapt to that environment.

You can benefit from compounding if you can identify a high return on capital business, but also one, critically, that has the ability to reinvest back into the business.

On the margin, I would say that the ability to invest in the core business has diminished in certain industries, and that’s where you're seeing a lot of creative-type corporate strategies that are taking place that I think are new and differ from past practices and patterns.

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of July 12, 2016 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.

As of 6/30/16, Lincoln Electric Holdings was 2.6 % of Royce Premier Fund's assets, 0.3% of Royce Heritage Fund's assets, 0.0% of Royce Special Equity Fund's assets, and 2.8% of Royce Special Equity Multi-Cap Fund's assets.

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.

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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