Royce Funds - Is Quantitative Easing Distorting Asset Prices?

Principal and Portfolio Manager Francis Gannon provides thoughts regarding the economy, the markets and small-cap investing. Francis, a former panelist on Louis Rukeyser's Wall Street, has 19 years of investment management experience and joined our team in 2006.

Over the past four years investors have become accustomed to one constant in the equity markets—when the Federal Reserve acts, stocks move, at least for a little while. Stocks soared through the summer months in anticipation of another round of liquidity from both the Federal Reserve and the European Central Bank.

The small-cap Russell 2000 Index, for instance, gained 17.8% from its most recent low on June 4, 2012 to its most recent high on September 14. However, the markets have so far greeted the announcement of the latest round of quantitative easing more than a little skeptically—the Russell 2000 has fallen 5.2% from September 14 through the end of October. For the moment, decelerating earnings growth, particularly from some of the market's best-known names, is trumping easy money.

We have long thought that the ongoing efforts to reflate the economy through successive rounds of quantitative easing and a zero interest rate policy would have unintended consequences. One has to look no further than the year-to-date performance for the major equity indexes to see how the Fed's 'Zero Interest Rate Policy' is distorting asset pricing and valuations in the equity markets.

At Royce, we seek companies with solid, low-debt balance sheets and the ability to generate free cash. Balance sheet scrutiny is where most of our company evaluations begin.

We place a great deal of emphasis on managing risk, which is why we avoid businesses with financial leverage and choose instead to focus on companies with high operating leverage. Our measure of financial leverage examines the ratio of assets to stockholders' equity, where we want to see a two-to-one ratio for non-financial companies.

This is an important part of our ongoing analysis of a company's "margin of safety." If a company is carrying too much debt, it is likely to struggle (or fail) to meet the challenge of out-of-left-field occurrences, such as lawsuits and overseas currency crises.

A conservatively capitalized company, especially a smaller company, can better weather these storms because it has the necessary financial reserves to do so. A company with too much debt runs a greater risk that stormy weather will turn into a hurricane.

We also view financially strong companies as well positioned to grow—their assets are derived more from retained earnings than paid-in capital, which gives them the ability to self-fund their own success as a business.

In today's zero interest rate environment, the market has been rewarding more highly leveraged businesses, many of which are benefiting from the ability to restructure debt, lower funding costs, and extend maturities. In essence, low-quality companies are being given the luxury of time, which they would not enjoy in a more historically typical environment.

According to Furey Research Partners, the lowest leverage companies in the Russell 2000 have gained only 9.5% year-to-date, while the highest leverage companies have advanced 19.9% year-to-date through the end of the third quarter 2012 (see chart below).



At the same time, we have suggested that higher-quality companies across asset classes would lead in the market recovery and, especially, as the economic recovery matures to anemic expansion. We still maintain that high-quality stocks look attractively undervalued; they are also defensive by nature and tend to outperform in periods of heightened volatility.

From our perspective, company quality is a key component both in trying to mitigate risk and achieving above-average long-term returns. Our conviction on this score remains firm.

At the end of September 2012, the highest quality small-cap companies within the Russell 2000, as measured by ROIC, traded at a significant discount to the highest quality large-cap companies.

However, in today's zero interest rate environment low-quality companies are outperforming and benefiting from the open-ended policies of the Fed that are distorting asset pricing and valuations. In fact, according to Furey Research Partners, of the Russell 2000's 14.2% gain year-to-date return through the end of September, five industries accounted for more than half the return.

Interestingly, these top five performing industries also possess the lowest median ROIC (return on invested capital) within the Russell 2000. Unsurprisingly, at the end of September 2012 the highest quality small-cap companies within the Russell 2000, as measured by ROIC, traded at a significant discount to the highest quality large-cap companies, while the lowest ROIC stocks in the small-cap index accounted for virtually all the small-cap premium to large (see chart below).



Source: FRP and FactSet

So while volatility seems likely to increase over the next several months as the market digests the election results and turns its focus to January's fiscal cliff, we are staying focused on high-quality, under-levered companies—and the potentially profitable opportunities they present for disciplined, active managers like ourselves.

Stay tuned…

FDG

Important Disclosure Information

Francis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon's thoughts in this essay 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.The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

The Royce Funds invest primarily in micro-cap, small-cap and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). The Funds may invest a portion of their respective net assets in foreign securities, which may involve political, economic, currency and other risks not encountered in U.S. investments (see "Investing in Foreign Securities" in the prospectus). The 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. Russell 2000 Index 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. Distributor: Royce Fund Services, Inc.

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