Royce: Small Cap Quality Continues To Outperform

Johnny HopkinsChuck RoyceLeave a Comment

In his latest commentary titled – The Boring, But Timely, Case for Quality, Steve Lipper at Royce explains why small cap quality continues to outperform. Here’s an excerpt from the commentary:

Encouraging investors to “buy high quality” might seem a tired, and not very useful cliché. It often carries the faint sense of an older relative offering advice, probably unsolicited, to “always buy high quality” or the aphorism of a financial advisor who recommends that clients “build wealth by owning a portfolio of blue-chip companies for the long term.” However hackneyed, there is some substance underlying these comments (as there usually is with cliches), and, at least in small caps, we see the case for quality as notably timely as well.

It may be helpful to be more precise about what we at Royce mean by quality. Like beauty, it is often in the eye of the beholder. We classify quality companies as those that can sustain high returns on invested capital with below average leverage. There are a number of critical attributes that companies need to produce those positive outcomes, including strong competitive positions, savvy capital allocation, and favorable industry ecosystems.

Yet, one could reasonably ask, since those attributes seem so obviously attractive, why aren’t the valuations of quality companies bid up so high by investors that the returns for owning these stocks are subpar? We’d offer two reasons: one is a flaw in analysis, while the other seems more like a limitation in the design of human cognition.

Regression to the mean is not only a very powerful force in financial markets, but also in commercial markets. Few companies are able to retain preeminence for extended periods of time. Indeed, all of a company’s competitors are constantly seeking to take away their leading market share, and all industries evolve over time as bargaining power alternates between buyers and sellers.

If one analyzes the valuation of leading companies, there seems to be an implied “decay curve,” which presumes that any company’s superior profitability eventually regresses back to the average for all companies. And this is the result most of the time.

However, if an investor can identify a select collection of companies that can defy that regression to the mean and persist with higher returns on invested capital, then that has historically produced superior investment results. For example, we calculated the returns for the top quintile of securities in the Russell 2000 from 12/31/92-6/30/21, sorted by a multi-factor combination of ROIC and the stability of Return on Assets.

The average annualized 10-year rolling return for this cohort was 13.0%, compared with 8.3% for the Russell 2000 over the same period. So tilting towards these high-quality metrics was highly rewarded.

You can read the entire commentary here:

Royce: The Boring, But Timely, Case for Quality

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