3 Reasons We Like Small-Cap Machinery Stocks
article 03-22-2019

3 Reasons We Like Small-Cap Machinery Stocks

With strong results so far in 2019, Co-CIO Francis Gannon discusses three other notable characteristics that we like in small-cap machinery.

TELL US
WHAT YOU
THINK

Most of our portfolios have larger exposures to at least two of the following four sectors—Financials, Industrials, Information Technology, and Materials, giving them a distinctly cyclical tilt.

So far in 2019, we’ve been very pleased to see many of these cyclical stocks bounce back, along with most of the small-cap market, as stocks have enjoyed a vibrant and welcome rally through the year’s first quarter after the dramatic downturn at the end of 2018. Through the end of February, four of the five top-performing sectors in the Russell 2000 Index were cyclicals.

“Machinery has been among the sector’s best-performing industry groups so far in 2019. It’s also an industry that regularly attracts our attention, with the result that many of our portfolios have large weightings in this group.” — Francis Gannon

In our portfolios, some of the most compelling bargains in 4Q18 and strongest rebounds in 1Q19 have come from holdings in the Industrials sector, a wide and diverse area that covers companies involved in everything from manufacturing to logistics, construction to staffing services, and machinery to transportation. (The sector also has the third-lowest percentage of non-earners in the Russell 2000, behind only Financials and Utilities.)

Machinery has been among the sector’s best-performing industry groups so far in 2019. It’s also an industry that regularly attracts our attention, with the result that many of our portfolios have large weightings in this group.

What is it that we like so much about machinery stocks, in addition to their benchmark-beating results so far in 2019? While each of our portfolio managers could give detailed reasons on a company-by-company basis, there are also some common features across our small-cap strategies that help make the group a near-perennial area of interest.

1. Market Leaders with High ROIC
We can often find machinery companies that have a dominant niche in their space that at the same time is not overly capital intensive, as high capital intensity could potentially leave the business more vulnerable to larger-scale, and costly, CapEx than we prefer. Their position as market leaders also frequently allows them greater pricing power, particularly when demand is high, which makes them even more attractive in our view. In addition, market leadership in a less capital intensive specialty often results in these companies having high returns on invested capital, or ROIC. (An important quality metric for us, ROIC is the return a company makes above the average cost it pays for its debt and equity capital.) A high ROIC shows that the company is efficiently allocating capital into profitable investments—a key element in running a business with long-term sustainability.
 
2. Recurring Revenue Streams
Among these market leaders, we look for businesses that also have more regularly recurring revenue streams. This usually occurs because the company manufactures consumable parts, provides related services, or makes devices or components that need to be replaced or upgraded. This makes their business cycles a little easier to predict, allowing us a better chance to take advantage of lower share prices when demand slackens before heating up again.
 
3. Current Valuations Look Attractive to Reasonable—Especially Relative to the Index
YTD 2019’s high returns notwithstanding, many machinery stocks still sport reasonable valuations, especially when compared to the Russell 2000 as a whole, as measured by our primary metric for examining valuations, median EV/EBIT (which is the ratio of enterprise value to earnings before interest and taxes-our calculation excludes companies with no earnings).

Small-Cap Machinery vs. Russell 2000; Median EV/EBIT1 (ex. negative earnings)
From 2/2/04 to 2/28/19

machinery-r2k-ev-ebit

1 Enterprise Value/Earnings Before Interest and Taxes

While machinery companies within the index outpaced the index as a whole through the end of February (+20.0% versus +17.0%), the chart shows that the industry’s current median EV/EBIT sits comfortably below that of the Russell 2000—which suggests ample room for further growth.

Although (and in some ways because) it has grown in market cap to $5.4 billion, making it a mid-cap stock at this writing, Lincoln Electric Holdings is a wonderful historical example of the profile we like in machinery stocks. The company is the world leader in arc welding, robotic welding systems, plasma and oxyfuel cutting equipment, and brazing and soldering alloys. It’s been held in some Royce portfolios for more than 30 years.

We have always seen it as a well-managed business that has innovated effectively and efficiently over the years. This allowed the firm to expand its niche and become a small-cap company with global reach. Among other actions, regularly reinvesting in its business has allowed Lincoln Electric to remain profitable through many different economic, market, and business cycles. It exemplifies in many ways the fundamental qualities that we seek, not just in machinery stocks but throughout the small-cap universe.

Stay tuned…

More Small-Cap Perspectives

 

Important Disclosure Information

Mr. Gannon’s thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.

The performance data and trends outlined in this video are presented for illustrative purposes only. All performance information is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Percentage of Fund Holdings As of 12/31/2018 (%)

  Lincoln Electric Holdings

Royce Dividend Value Fund

0.9

Royce Pennsylvania Mutual Fund

0.6

Royce Premier Fund

3.4

Royce Small/Mid-Cap Premier Fund

2.5

Royce Total Return Fund

0.7

Royce Value Trust Fund

0.8

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

Cyclical and Defensive are defined as follows: Cyclical: Consumer Discretionary, Energy, Financials, Industrials, Information Technology, Materials. Defensive: Consumer Staples, Health Care, Real Estate, Telecommunication Services, Utilities.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization-weighted. The Russell 2000 Index is an index of domestic small-cap stocks that 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.

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. (Please see "Primary Risks for Fund Investors" in the prospectus.)

Share:

Subscribe:

Sign Up

Follow: