When we talk about quality at Royce, we’re talking about companies that have high returns on invested capital (ROIC), excess free cash flow, strong balance sheets, and little debt. Another sign of quality that we look for is shareholder-friendly capital allocation, which can include the practice of paying dividends or reinvesting in the business.
According to Portfolio Manager and Principal Francis Gannon, the Fed’s multiple rounds of quantitative easing and the near-zero interest rate environment have given lower-quality companies space to refinance their debt or, in some cases, take on more debt with very little consequence.
“What we’ve seen over the past several years is companies not really investing in their business,” says Francis. “We’ve seen an awful lot of financial engineering” he adds.
In response to whether Royce would ever change its approach based upon what might be working in the overall market, Francis believes that there is evidence—most notably between the middle of May and the middle of June—of a change in market sentiment that might favor the fundamentals Royce looks for and has never abandoned.
“Our goal at the end of the day is to be able to find high quality small-cap companies that are selling at a pretty significant discount to what we believe their intrinsic net value might be, and that approach hasn’t changed,” says Francis. “It’s an approach that is rooted in finding under-levered businesses that are generating a lot of free cash flow, that have high ROIC; and in today’s world sometimes that hasn’t worked over the past several years where over-levered businesses have actually been the beneficiaries of what’s going on with the Federal Reserve’s policies,” he adds.
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