Portfolio Manager and Principal Francis Gannon discusses how we define quality at Royce, shifts in market performance due to Fed intervention, and our resolute confidence in higher-quality small-caps, especially in an environment of ongoing economic uncertainty.
“As an active manager we have long thought there were going to be unintended consequences of what the Federal Reserve has been doing over the past several years, and it goes back to our definition of quality and especially the way we look at the world in the small-cap space.
We focus on high-quality small-cap companies that are, most importantly, underlevered. Leverage is key to our definition of what a high-quality small-cap company is. We look at leverage in a very simplistic way, but it’s all encompassing and focusing on the balance sheet. We take total assets of a company, we divide it by its shareholder equity, and that number has to be less than two for non-financial companies. It’s that old Graham and Dodd idea of trying to find companies that own more than they owe.”
“We went back and we looked at the performance of the markets over the past several years in really an effort to better understand not only our performance but the performance of some of the higher-quality business that we love, and we noticed that there was a clear shift in the performance of the market at the end of August of 2011. And at that time, you had the Federal Reserve really begin their push to try to reflate the economy through additional quantitative easing, specifically the Twist program, LTRO, and then QE3, eventually.
From the end of August of 2011 through the end of April of 2013 there was a clear shift. In that period of time we noticed that lower-quality businesses, especially those businesses that were highly levered, actually did extremely well, while high-quality businesses, especially those businesses that are conservatively capitalized, tended to underperform. And it goes back to a lot of what the Federal Reserve was doing at that time to keep rates low or push rates even lower through various quantitative easing programs.”
“We did notice a clear distinction in the performance of low-quality businesses, especially those businesses that were highly levered. In that period of time they were able to extend their maturities and they were almost given a lifeline by the Federal Reserve where they were able to refinance their debt, all of which fell to their bottom line, and the market rewarded that from an earnings perspective.
That has changed over the past several months, where high-quality businesses have actually started to perform again. And part of the reason they’ve performed again is because the Federal Reserve has introduced this idea of tapering, even without actually tapering. Markets and corporations are actually thinking differently about debt on their balance sheets.”
“Rates are not going to go back and revisit the lows that we saw a year or two years ago. The pressure on rates, if anything, is going to be heading up, not down from here. But it’s changed the way corporations are thinking, and in our world that’s extremely important. Access to capital is extremely important. Higher-quality companies don’t need that access to capital typically. Lower-quality companies, or highly-levered businesses, need that access to capital on a continuous basis.
And that’s what we’ve seen over the past several months, is that those better businesses—those business that are conservatively capitalized—are the ones that are going to be able to benefit from the fact that they don’t need that access to the capital markets. They can continue to grow their business and invest in their business. And you're starting to see that take place in the marketplace today.”
“The biggest opportunity set we have in the small-cap marketplace today is higher-quality small-caps. It’s an area of the market that investors have completely ignored over the past several years. It’s an area of the small-cap marketplace that we think we has several years of runway ahead of us in terms of performance as the market gravitates back to those companies that are conservatively capitalized, that use the strength of their balance sheet to grow their underlying business, especially in an environment of continued economic uncertainty.”
Important Disclosure Information
The thoughts and opinions in the video are solely those of the person speaking 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.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Micro-cap, small-cap, and mid-cap stocks may involve considerably more risk than investing in larger-cap stocks (please see "Primary Risks for Fund Investors" in the prospectus).
