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Royce Funds Commentary - Drawing Parallels Between Company Quality and Economic Strength

August 06, 2014 | About:
Holly LaFon

Holly LaFon

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First-half results were mildly bullish, and included a brief period where higher-quality companies reasserted themselves during the more volatile months of April and early May. Co-Chief Investment Officer Francis Gannon talks about how the market has responded to the Fed's monetary stimulus, the economically sensitive characteristics that populate most of our firm's portfolios, and where we have been finding opportunities.

As August begins and markets move further into 2014, it's interesting to look at first-half results in the broader context of the last five years.

Recently I was given the opportunity to present at a conference in London. Joining me were more than a dozen experts who discussed the global economy, market opportunities, investment strategies, and more.

I spoke to peers and clients not only about the opportunity set within the small-cap universe, but was also able to reflect on our disciplined value approach, our preference for self-funding, quality companies, what we've seen in the markets since the financial crisis of 2008-09, and how the markets affect what we do on a daily basis.

To be sure, we aim to find stocks trading at a significant discount to our estimate of their intrinsic worth, focusing on those companies with high returns on invested capital and strong balance sheets.

To us, these two characteristics are the first markers of what we define as company quality. We often find ourselves moving beyond the confines of our benchmarks, most commonly the domestic small-cap Russell 2000 Index, which currently includes a significant portion of non-earning companies.

Where have we been finding quality, then, especially in an environment of ongoing—though slowing—monetary stimulus from the Fed, near-zero interest rates, soaring valuations, and subdued economic growth? The answer, at least to us, is somewhat unsurprising (and somewhat out of vogue, at least over much of the last 18 months). Specifically, we have been finding quality in more cyclical, economically sensitive sectors, namely Industrials, Energy, Information Technology, and Consumer Discretionary.

The past five years have been largely unkind to active managers such as ourselves. Fed intervention has greatly distorted asset prices and, in a way, provided a lifeline to more leveraged, lower-quality companies.

By contrast, our main area of interest is in conservatively capitalized smaller companies with little-to-no debt. We believe these companies are better positioned to grow and survive stormier weather.

The low-quality reign has cast a dark cloud over these types of companies, as their attractive attributes have drawn little interest from investors hungry for high yield and/or fast growth. Conservatively capitalized smaller companies have always been our primary area of interest, no matter what is happening in the market.

We uphold our discipline with integrity and high standards. We will not change our approach when it is out of sync or out of favor. In more than four decades of investment management, we have never succumbed to that temptation.

Since May 2013 there have been a few periods in which low quality took a back seat to fundamentals. (I talk about that here and here.) These early moves toward higher quality were highly encouraging. While we do not pretend to know where the markets may be headed or how to time market cycles, we do believe that high-quality companies are well positioned to lead.

As the economy continues to strengthen and interest rates rise (as we believe they will), the U.S. will be far less Fed dependent.

Low-quality companies will no longer have the easy access to capital they've been granted, and investors should begin to see the advantages of owning fundamentally strong and financially independent businesses.

Small-cap is an area that is ripe for these developments.

Stay tuned...
FDG

Important Disclosure Information

Francis Gannon is Co-Chief Executive Officer and a Managing Director of Royce & Associates, LLC, investment adviser to The Royce Funds. Mr. Gannon's thoughts and opinions in this piece concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

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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