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Lauren Romeo Takes Advantage of Uncertainty in Selecting High Quality Small-Caps: Royce Funds Commentary
Posted by: Holly LaFon (IP Logged)
Date: September 4, 2012 12:35PM
How would you describe the current small-cap environment?A lot depends on your perspective. From a strategic standpoint, investor sentiment toward equities – both small and large – has become increasingly negative over the last couple of years and, in a repeat of 2010 and 2011, macroeconomic news has increasingly dictated the short-term direction of trading.
Ongoing eurozone woes, the upcoming presidential election and looming fiscal cliff here in the U.S., and decelerating growth in China, along with other important emerging economies, have all increased the level of "FUD" – fear, uncertainty, and doubt – in the stock market. From a stock picker's perspective, however, this high "FUD factor" can make for an attractive investment environment.
In a 1979 Forbes article, Warren Buffett described fear and investors' perpetual desire for clarity in this way: "Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values." Equities today are perceived to be far riskier than they actually are and therein lies the opportunity.
Are high-quality small-caps expensive?No, quite to the contrary. High quality small-cap companies—those with high returns on invested capital (ROIC), strong balance sheets, and high free cash flow generation—look particularly compelling today. Not only are they trading at attractive absolute valuations, which is the measure that we prefer, but they also sell at less than half the valuation multiples of "lower quality" small caps, that is those with low ROIC, leveraged balance sheets, and non-earners, and at an 18% discount to the highest-quality (top quartile ROIC) large-cap companies based on firm value-to-cash flow multiples.
Traditionally, high-quality companies have traded at premium valuations given their superior business models, so we are thrilled when negative sentiment, cyclical concerns, or temporary company-specific factors depress the share price to a point where we are able to buy a position in an above-average company at a below-average valuation.
Not all segments of the market look compelling, however. Some areas that do look expensive are the more defensive sectors such as Consumer Staples, Healthcare and Utilities, which have all benefited from investors' risk aversion.
Where have you been finding the most attractive valuations in smaller companies?Economically sensitive sectors, such as Industrials, Technology, Materials, and Consumer Discretionary, continue to be fruitful hunting grounds for us. Investors have fled these sectors on multiple occasions over the last 18-24 months when fears escalated over the state of the global economy and the perceived impact that a slowdown or recession would have on near-term earnings prospects. We have buying in the face of that fear.
This somewhat contrarian posture is rooted in the recognition that as investors seek the safety of Treasuries, or reach for yield in REITs and Utilities, they are shunning many excellent small-cap companies that hold dominant, often global, positions in their niches.
Many are poised to benefit from favorable secular demand trends, have significant earnings power to be unlocked by margin expansion as growth eventually re-accelerates, and have solid balance sheets that will enable them not only to weather a downturn, but possibly emerge even stronger relative to their more leveraged competitors.
We are also finding value in the Energy sector in light of the plunge in natural gas prices and the resulting dislocation in drilling activity in North America. Our focus remains primarily on energy services companies that continue to advance technologies that improve the economics of extracting oil and gas resources from unconventional formations.
What does the recent performance of economically sensitive companies say about current business trends?In general, most of the cyclical companies we've been meeting with have indicated that business conditions are better than the daily headlines reflect. While Europe remains difficult and China's deceleration is tangible, the situation does not resemble 2008, when demand essentially disappeared.
Political gridlock in Washington is definitely causing some companies to postpone growth-oriented capital expenditures until healthcare, tax policy, and regulatory issues are clarified. However, were business conditions to deteriorate further, many companies expect to fare much better given the aggressive actions taken during the recession to eliminate excess costs, improve productivity, and raise their "trough" margin targets.
Finally, corporate balance sheets for both small- and large-cap companies are as healthy as they have been in years, providing an additional cushion, as well as firepower to take market share or pursue acquisitions.
What might spur a comeback in cyclical companies' stock prices?Just as negative macro data points have driven investors out of economically sensitive stocks, positive news should likely lead to a rotation back into these names.
The influx could be powerful given that many institutional investors, guided by shorter-term investment horizons, have positioned their portfolios quite defensively with above-average exposure to Consumer Staples, Healthcare and Utilities. Also, since many of the higher-quality companies we own have meaningful sales outside the U.S., a re-acceleration of growth in developing economies, especially China, should give a boost to near-term sentiment.
It's possible that increasingly attractive valuations in the more cyclical sectors may refocus investors, as well as strategic and financial acquirers, on the long-term positive fundamentals of the individual companies. It was encouraging to see that, as many of our companies reported results for the quarter that ended in June, their stock prices reacted favorably, even in cases where managements offered a cautious outlook. It appears that the sharp price declines in the preceding months reflected overly pessimistic assumptions.
When you talk with management teams, what do they plan to do with their cash on the balance sheets?"Returning excess cash to shareholders" is increasingly part of the vernacular of small-cap management teams. Especially for those that saw their stocks swoon in the second quarter of 2012, many of our companies have increased their stock repurchase activity.
We have also recently seen several companies materially increase their dividends after reporting quarterly results, further signaling confidence in their financial strength and long-term business prospects despite all the near-term uncertainty. Some companies are also keeping some powder dry to fund acquisitions that may make sense to either enhance or expand their market positions.
What would you say are the biggest risks to your portfolios today?In recent quarters, the negative macroeconomic environment has been a significant headwind for our portfolios, particularly given their more cyclical bias, which has more than offset their high-quality attributes.
So we have been finding ourselves somewhat out of sync with the market in the short term. Importantly, these moments are not uncommon for us and are a natural byproduct of Royce's contrarian, value-driven, benchmark-agnostic approach.
As has been the case historically, we will continue to let the attractiveness of the long-term economics of individual companies and their absolute valuations guide our portfolio construction, not the short-term whims of the market. The consistent application of this discipline has served us well over time, and we are confident that it will continue to do so in the future.
What advice would you give to investors in terms of how to manage their purchasing power risk?I'd refer them to Chris Clark's insightful piece on the topic "The Real Debate: Preservation of Capital vs. Preservation of Purchasing Power".
In that piece, Chris notes that in addition to hard assets such as commodities, "investments in high-quality companies that have embedded pricing power and high returns on their invested capital look to us to be some of the best investments to protect and grow purchasing power, and we believe they need much broader representation in investors' asset allocation."
One reason for investors' current aversion to equities is their elevated volatility. Investors have a tendency to associate volatility with risk when that may not be the case.
Another key attribute in preserving purchasing power is the importance of being disciplined about price and valuation. A great company will not be a great investment if one overpays.
As Charlie Dreifus likes to put it, "Rate of return is a function of entry price."
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