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Co-Chief Investment Officer, Managing Director

For some time, we have been arguing that higher-quality companies would lead in the market recovery regardless of market capitalization and especially as the economic recovery matures. As we have mentioned before, many high-quality stocks still look attractively undervalued, are defensive by nature, and tend to perform better as the economy migrates from recovery to expansion.

We believe a shift in market leadership to high-quality stocks is at hand, especially within small-caps. But what is quality? It may be the most overused word in the investment community today. After all, who thinks that their portfolio isn’t high quality?

Still, understanding quality is critical to our effort. We believe that finding high quality companies is paramount to mitigating risk and achieving above-average, long-term returns. It has always seemed to us that companies with sound fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices. Our rigorous search for quality includes an examination of a company’s historical returns, with a particular focus on return on invested capital (ROIC).

It has always seemed to us that companies with sound fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices.

For us, historical returns over full business cycles is one of the first markings of a quality company. Furey Research Partners in a recent research report even highlighted the fact that higher quality companies, as defined by companies with higher return on invested capital, tend to outperform on average over time (see chart below).

Small-caps’ High quality top ROIC quintile has outperformed over time

Source: Furey Research Partners and FactSet. Small-caps defined as companies possessing market capitalizations between $200mm and $3 Bn. Returns presented as cumulative difference between top and bottom quintiles’ discrete monthly returns. Data as of 12/31/10.

Another key factor in the process is looking at how a company has achieved its returns. In addition to a strong balance sheet, a record of success as a business and the potential for a profitable future are of prime importance. We engage in a disciplined, bottom-up approach that focuses on identifying companies that are generating strong or improving free cash flow and returns on capital. Our goal is to find quality companies that are trading at a discount to our estimate of their worth as a business. It is a process we repeat everyday.

While we would agree with those who suggest that now is the time for quality, it has actually been an integral part of our investment criteria for the past several decades. Over the next 10 years, alternating market leadership will likely be the norm. Yet when this decade comes to a close, a focus on quality will still be a cornerstone to achieving our desired results.

Stay tuned

P.S. A traditional definition of quality (used by Standard & Poor’s since 1956) is based on a company’s ability to generate consistent earnings growth and dividends over time. It’s probably not surprising to learn that we wholeheartedly agree with this definition. However, conventional wisdom also holds that quality is more synonymous with larger capitalization companies, whose inherent size and multiple lines of business are thought to make them less risky. Smaller capitalization companies have traditionally been considered more speculative in nature and thus lacking the greater level of safety of larger-cap companies. Here, of course we beg to differ. We believe that quality is not the exclusive province of large-cap companies, but can be found throughout the equity universe. In fact, our research indicates that there were 829 small-cap companies (those with market-caps up to $2.5 billion) that have a ROIC ratio in excess of 20%, a standard we consider to be quite high.* Put another way, these companies have an after-tax return of roughly 12%, some 500 basis points greater than the weighted average after-tax return of the Russell 2000 index. This level of return would rank these companies among the very best regardless of capitalization.

* Source: FactSet as of 3/29/11

Important Disclosure Information

Francis Gannon is an assistant 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.