4 Premier Quality Small-CapsRoyce Funds
PM Lauren Romeo describes the potential advantages of increased volatility and details what she likes about four current holdings.
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How have you been taking advantage of the increased volatility in the US market so far in 2018?
Unlike many who equate it with high risk, we always view increased volatility as an opportunity.
While most of Wall Street focuses on how a stock is going to perform over the next six months, we’re focused on the return on capital the underlying business looks likely to generate over the next several years. This time arbitrage is a key component of our Premier Quality approach, and increased volatility allows us to buy names that have been on our radar screen for some time or add to existing holdings in our premier quality strategy when short-term fears are weighing on their stock prices.
What factors do you think account for some of the lagging performance in cyclical industries over the last year or so?
While most of Wall Street focuses on how a stock is going to perform over the next six months, we’re focused on the return on capital the underlying business looks likely to generate over the next several years.
Performance for cyclicals began to pick up in the latter half of 2017 in concert with the broadening and accelerating of global industrial growth. Through the first half of 2018, increasingly positive sentiment from managements across key cyclical sectors such as industrials, materials, and energy has been justified by robust sales and order trends.
At the same time, however, investors have grown more cautious in 2018 about the sustainability of economic growth. We’re seeing this with the emergence of tariffs, threats of trade wars, inflationary pressure, and rising interest rates.
In which sectors are you seeing the most interesting opportunities?
One consequence of lagging results for cyclicals is that many quality companies in those industries continue to trade at valuations we find attractive on both an absolute basis and relative to defensive sectors: based on their last twelve months enterprise value divided by earnings before interest and taxes, cyclicals as a group were cheaper than defensives at the end of March compared to their long-term average discount.
Cyclical Relative Valuation Looks Cheap vs. Defensive Sectors
Cyclical vs. Defensive Stocks Within the Russell 2000 Median Relative LTM EV/EBIT¹ Ex. Negative EBIT through 3/31/18
1 Last Twelve Months Enterprise Value/Earnings Before Interest and Taxes
Cyclical and Defensive are defined as follows: Cyclical: Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Telecommunication Services, and Utilities. Source: FactSet
With Premier’s focus on the intersection of quality and value, it’s not surprising, then, that seven of the nine names we added to the portfolio in 4Q17 and 1Q18 come from cyclical sectors. These companies are diverse, ranging from a specialty chemicals maker to a healthcare software and data analytics firm. Yet they share the high-quality business characteristics that we emphasize in our quality strategies.
What are the most important quality attributes that you need to see in a company?
From a quantitative standpoint, we look for companies with high returns on invested capital (ROIC), good free cash flow generation, and strong balance sheets.
Key business attributes that drive these outputs include a sustainable competitive advantage, the ability to profitably reinvest free cash flow, and shareholder-friendly capital allocation. A company typically produces and sustains a high ROIC because it has attractive business economics based on a unique competitive advantage—for example, pricing power due to strong brand equity, high customer switching costs, and economies of scale—or because it operates in an industry that has a favorable structure such as high barriers to entry.
Our task as portfolio managers is not only to identify the competitive advantage, but also to understand the likelihood that this edge will prove durable in the face of potential challenges such as an evolving competitive landscape, changing industry dynamics, or the emergence of disruptive technologies.
We characterize businesses that can sustain high ROICs as compounders. They grow intrinsic value year after year as the cash reinvested in the business maintains this high level of profitability.
Most quality businesses generate strong free cash flow—that is, excess cash beyond what is required to be invested to maintain the business’s competitiveness. The ideal premier company is one that has high return, incremental reinvestment opportunities for free cash flow—for example, internal such as geographic expansion, or external such as strategic acquisitions. If it does not, management can still reward shareholders—and avoid destroying value—via dividends and/or share repurchases.
Can you talk about two companies that have lagged this year that you think have strong prospects?
Genworth Canada is that country’s largest private residential mortgage insurer. With about one-third of the market, it operates in a duopoly with a rational government-owned competitor.
Mounting concerns about an overheated Canadian housing market has pushed the stock down by as much as 10% this year.
Genworth has capital well in excess of statutory requirements and a stellar underwriting and risk management track record. Its astute and veteran management team has adeptly steered the business to underwriting profitability in prior peak loss years. Significant regulatory changes instituted over the past two years, along with mortgage reforms implemented after the Global Financial Crisis, should also provide some protection against a severe spike in mortgage defaults.
At 0.9x tangible book value, a secure 4.7% dividend yield, and the ability to continue to generate average annual returns on equity in the 12%-13% range, the stock is a compelling example of what we think is a high-quality business selling at an attractive valuation.
Another year-to-date laggard is Sun Hydraulics, which makes hydraulic and electronic valves, controls, and instruments for industrial machinery and off-highway vehicles. Its shares have declined more than 20% since December. Despite robust sales growth, margins and earnings have been weaker than expected due to operating inefficiencies incurred by a ramp up to meet strong demand as well as higher materials and commodity costs.
We think that these margin issues should prove temporary, possibly abating in the second half of this year, as the impact of management’s corrective actions—which include price increases, new supply agreements to ease constraints, and reduced temporary and overtime labor—take effect.
Our view is that looking only at its near-term prospects overshadows strategies the company is implementing that could lay the foundation for high single-digit organic sales growth—and a doubling of revenue and operating profit over the long term.
If Sun can successfully expand its addressable markets via new product development, geographic expansion, and acquisitions while also sustaining 20%-plus operating profitability, the returns on incremental invested capital should prove highly attractive.
Can you also discuss two companies that have done well so far this year?
Bio-Techne was up about 16% through the end of May. It is one of the world’s largest producers of reagents (which are specialized proteins) used in drug research and development and clinical diagnostics. It’s a strong free cash flow business given the high incremental margin and annuity-like nature of the sales of these consumable products.
Equally important, the CEO has transformed the company in the five years since he came on board, taking a steady cash cow and turning it into a compounding growth machine by reinvesting in previously untapped opportunities such as faster and broader new product development, geographic expansion, salesforce growth, and acquisitions that supplemented its core business or enhanced its presence in the analytical instruments market.
The payoff from these actions has been evident in Bio-Techne’s robust financial results, and the market has rewarded the stock with valuation multiple expansion.
Cabot Microelectronics supplies high-performance chemical slurries and pads used in semiconductor manufacturing that remove excess material deposits, flattening and smoothing the surfaces of the layers of chips. It is the global leader in slurries with a 36% market share.
The stock was up about 20% through the first five months of 2018 as Cabot continues to benefit from the secular trend of increasing semiconductor manufacturing complexity. Additional steps in the manufacturing process means more polishing and thus more slurry usage.
Additionally, Cabot’s entry into the polishing pad market a few years ago, bolstered by an acquisition, opened up a large new addressable market, and Cabot is growing its pad business at a 20% annual clip as it continues to win share in an expanding market.
What gives you confidence in the prospects for quality small-caps going forward?
We believe strongly that Premier’s portfolio represents a collection of businesses with superior economic models and enviably high ROIC.
As long as our regular analyses reveal no significant erosion in, or threats to, the durability of each company’s economic moat, we’ll continue to own them—and potentially benefit as they keep compounding value for, and return excess cash flow to, shareholders.
It’s easy to forget because the post-Financial Crisis decade has been so anomalous, but over the long term the stock market has been pretty efficient at capitalizing businesses with above-average profitability at multiples that reflect the true intrinsic value they’ve generated. In the near term, we’ll continue to try to take advantage of price volatility or negative sentiment to add to existing holdings or establish new positions in what we believe are great businesses at attractive valuations.
With small-cap growth having outperformed value in seven of the last nine years, we also see Premier as well poised to benefit from a reversion to the mean that we’re expecting here at Royce.
Article by The Royce Funds