article 07-24-2014

Janet Yellen's recent statements notwithstanding, many high-quality small-cap stocks still look undervalued to us.

Small-caps have underperformed the broader market so far in 2014. Recent comments from Federal Reserve Chairwoman Janet Yellen only added fuel to the fire.

In her recent semiannual Monetary Policy Report in front of Congress, Yellen stated, "Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched," further noting, "Ratios of prices to forward earnings remaining high relative to historical norms."

The Chairwoman's comments did not surprise us. In fact, saying that small-cap valuations are running high is an easy call to make given the Russell 2000's returns over the past several years—the small-cap index's five-year average annual total return through the end of June 2014 was 20.2%.

However, a closer look tells a much different story. We have mentioned it before—many high-quality small-cap stocks still look undervalued to us. To be sure, we see quality as paramount to mitigating risk and achieving above-average long-term returns, especially in the small-cap asset class. 

Understanding quality is critical to our effort—as long-term investors, we believe that companies with sound fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices.

Driving our investment process is a rigorous search for quality that begins with an examination of a company's historical returns, with particular focus on returns on invested capital (ROIC). For us, this metric reveals the first markings of a quality company, which can be found in its historical returns over full business cycles. 

Interestingly, our research shows that the highest quality small-cap companies within the Russell 2000, as measured by ROIC, now trade at a discount to the highest quality large-cap companies while companies with the lowest ROIC account for virtually all the small-cap premium (see chart below).

The upshot is that the small-cap space continues to have plenty of quality companies—and many look attractively priced to us.

Median LTM1 EV/EBITDA2 by ROIC Quartile as of 6/30/14


1
Last 12 months
2 Enterprise value/earnings before interest, taxes, depreciation, and amortization
Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock). The portfolio calculation is a simple weighted average that excludes all non-equity securities, investment companies, and securities in the Financials sector with the exceptions of the asset management & custody banks and insurance brokers sub-industries. The portfolio calculation also eliminates outliers by applying the inter-quartile method of outlier removal.
Source: Russell Investment Group and Bloomberg

Important Disclosure Information

Francis Gannon is Co-Chief Investment Officer and Managing Director of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Gannon's thoughts and opinions expressed in this piece are solely his own 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.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It 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.

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