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How Royce Defines Small- and Mid-caps ---------------------------------
WHITNEY GEORGE: We're looking at companies typically with market caps between 500 million
and ten billion. And that's sort of an interesting spot; it's, you know, not small-cap, which
we are typically defining as up to two and a half billion. I think the definition for
mid-cap would probably take you from the two and a half billion up to maybe 15 billion.
So it's sort of a no-man's zone in the style box world, which creates some interesting
opportunities.
STEVEN MCBOYLE: There's no standard way that smid-cap is defined. Most utilize the Russell
2500 which is effectively a composition of the full Russell 2000 in addition to the smallest
500 companies within the mid-cap index with Russell. The ever-so-slight variation between
smid and small is we are of the general view that larger cap companies have a better ability
to withstand economic and business stresses, and so therefore we apply effectively a less
stringent test on the balance sheets of these larger capitalization companies. I think it's
very important to emphasize the fact that we're not reducing in any way our emphasis
on small-cap companies. This is a natural extension of that which we've done successfully
within small. We're just merely migrating that up into the market cap spectrum of mid.
Why Smid-Caps? ---------------------------------
WHITNEY GEORGE: I think it's a very natural extension from what we've been doing for years.
What has happened over time is some of our most successful portfolio companies have grown
out of the small-cap range, and we would like to continue to invest in those companies,
some of which we know best, in some cases we have 25-year histories with. It gives us
an opportunity to continue to work with some of the companies that have been most successful,
kind of made the transition from micro-cap to small-cap and now are kind of at their
debutante moment in terms of the investment world because the next step is the S&P 500.
STEVEN MCBOYLE: The most obvious advantage to smid is the larger investable universe.
So, the greater the universe, obviously the greater opportunity set that we have the ability
to play within. The second advantage to smid is the ability for us to continue to hold
our small-cap winners, even though they migrate out of the small-cap universe. When you think
about it, there's no good investor rationale as to why we ought to forfeit our institutional
knowledge, given the fact that a small company is no longer small and has grown to become
a mid-cap company. The other advantage of smid is latitude. At different points in time
the valuation differences between the two different asset classes, whether it be small
or mid, can oftentimes be quite large. At this point in time, as we sit here today,
the market, the correlations couldn't be any tighter, but historically that's not always
been the case. So with the flexibility of being able to invest up and down the cap spectrum,
one has the ability to find the greatest absolute valuation opportunities at a given point in
time. I may also point out, too, that over time the Russell 2500, again the proxy for
smid, has outperformed the Russell 2000, again, the proxy for small. And with this outperformance
over long periods of time, I would also point out that it has done so with less volatility.
So the combination of strong performance with less volatility certainly, I believe, is a
strong combination as to why an investor should have exposure to smid.
Advantages of Mid-Caps ---------------------------------
BRENDAN HARTMAN: When Royce researches a small-cap stock in a certain industry, by definition
you've got to look at the mid-cap and the large-cap stocks in that industry to really
understand what's going on and the competitive dynamics. Therefore, there's a lot of synergies
in using the big research organization that we have to look at an industry and pick not
only the small-cap stocks but the mid-cap stocks as well. If you look at the mid-cap
space compared to the small cap space, oftentimes you have very high-quality small-cap companies
that naturally graduate to the mid-cap space as they grow their earnings and cash flows
and become larger-cap companies. Investing in that space allows you to continue to own
these high-quality companies that are going to outperform the market over long periods
of time. And then, I think at the high end we look at the mid-cap space as probably advantage
to the large-cap space because you can be much more targeted in taking a rifle shot
at the end markets you want to invest in, rather than owning a larger-cap conglomerate
like a General Electric or something of that nature that has five or six different business
units.
Mid-Cap Efficiencies ---------------------------------
BRENDAN HARTMAN: Without a doubt the mid-cap space is more heavily followed by Wall Street.
There tends to be more analysts covering a mid-cap company, particularly when you get
into six, seven, eight billion dollar market caps. However, Wall Street still maintains
a very short-term focus on quarterly earnings and, you know, next year's earnings, whereas
at Royce we take a three- to five-year view, and have a longer time period, so we're not
trying to outsmart Wall Street in the mid-cap space, but we think we can be more patient
than the typical Wall Street investor and use market dislocations to buy securities
at attractive price, which is very crucial to our process. It's the entry point at which
we buy stock is going to determine ultimately the returns on that security.
Current Opportunities ---------------------------------
WHITNEY GEORGE: We're actually seeing some absolute valuations in mega-cap companies
that are equivalent to what you're finding in some micro-cap stocks. So after the turmoil
and recovery of the last few years, there's sort of a mixed bag of where we're finding
value right now. One would expect, under normal circumstances, that the larger the market
capital of the company, the higher valuation you might expect to see, and just because
of the liquidity advantages that larger companies have. But right now it's really a stock-by-stock,
industry-by-industry sort of situation. There are some industries where the big companies
are traded much more richly than the small companies, and then there's the reverse true
in other sectors of the market. So it's hard to generalize right now. It really gets down
to the stock-by-stock selection process.
STEVEN MCBOYLE: Sitting here today as we look at the market, we're actually finding a lot
of value within the quality smid-cap portion of the market. And again, that's exactly our
sweet spot in terms of where we invest. I also would point out that we've gone through
a spectacular small-cap performance period. And I think we're beginning to see quite definitively
at this point in time in the year, leadership rotation towards quality in addition to larger
capitalization companies. As we sit here today, year to date mid is outperforming large, and
outperforming small. I continue to think that that is a trend that will continue and on
to serve smid-cap quite well.
International Exposure ---------------------------------
WHITNEY GEORGE: I
think one of the advantages of these larger companies, smid-cap companies, is that even
the domestic companies tend to have more of an international business opportunity and
exposure. So we don't think about it so much as where the company is physically domiciled
as to where their end markets are. And I would guess that well more than half of the revenues
generated by the portfolio companies are coming from outside of North America.
BRENDAN HARTMAN: We're seeing a lot of attractive opportunities that are really sector-specific,
particularly in technology as well as industrial materials. And, you know, a lot of that has
to do with what's going on on a global basis, not just here in the United States. Clearly,
the global demand drivers in the emerging countries, Brazil, Russia, India, China, the
BRIC countries, that's a big driver for a lot of the mid-cap companies. And I think
that's an advantage that some of these larger mid-cap companies have is that they are more
global in their end markets and in their supply chains than some of the smaller-cap companies.
The Debutantes ---------------------------------
WHITNEY GEORGE: I think one of the interesting things about the zone is that it's kind of
our portfolio of debutantes. And those are companies that are now growing into a size
where the audience for those companies increases so dramatically. And so you often get a revaluation
as a company becomes bigger, becomes eligible for the S&P 500. The sums that are invested
in just past index products alone, you know, have an enormous effect once a company is--interests
the S&P 500 or approaches that size. So it really is kind of an interesting time for
companies, and to watch them evolve, be successful and then grow up and have a whole new audience
discover them. So it is very important for us, it's a very rewarding part of what we
do in terms of the companies that we own. So I think we have a competitive advantage;
we knew the companies better as they entered the zone than all the new mid-cap players
or even large-cap players that might be looking at the companies for the first time.
Smid-Caps and Merger and Acquisition Opportunities ---------------------------------
STEVEN MCBOYLE: We're looking for small- and mid-cap companies that have strong balance
sheets, high return on invested capital, and strong free cash flow generating abilities.
Now, having said that, beyond that we spend an enormous amount of time trying to determine
the business franchise of a different company. And so the attributes within any small- or
mid-cap company that would perhaps indicate the potential of such a business franchise
would be whether the company has a leading market share position in the industry that
it serves, whether it has pricing power, and whether the industry framework, if you will,
is favorable to that given company. And what I mean by that latter point is, we look for
limited to no supplier concentration, customer concentration, and, more specifically, customers
that priced inelastic. Those are the attributes that once we assess, typically will tell you
whether you're beginning to look at a quality franchise smid-cap company.
WHITNEY GEORGE: One of the other interesting features of the kinds of companies that we
own in smid-cap is they are more often acquirers of businesses as opposed to being acquired
by larger companies. That makes them very interesting, you know, particularly when you
talk to managements about capital allocation, that strategy.
Traditionally our investment approach has been very similar to the way companies invest,
in terms of, you know, what they're looking for, either corporate acquisitions or leveraged
buyouts (LBO). And so we have had more than our fair share of companies acquired. In the
smid-cap space, though, more often than not they are the acquirers as opposed to the acquirees.
So, A, that requires careful attention to things like capital allocation. We need to
make sure that managements are appropriately allocating, not overpaying for businesses,
not getting too far off track in terms of strategy or in terms of what they're trying
to grow. It makes for, you know, very interesting discussions with management teams, and it's,
you know, it's a slight variation on what has--we've typically experienced in the M&A
world. I think it's a great time to be doing acquisitions.
You know, capital is very cheap; borrowing costs are very low; typically most of the
companies we own have very strong balance sheets, often excess cash so that they can
put that cash to work in an operating business, the market is now rewarding them. So one can
do very well whether you own the acquirer or the acquiree in this kind of environment.
BRENDAN HARTMAN: A lot of the mid-cap stocks that we look at and that we own have great
balance sheets right now with record cash levels, very little debt, and they are looking
to do acquisitions as Warren Buffet talked about in his letter. They've got their proverbial
guns loaded and they're looking for opportunities, and what we're looking for in that scenario
is a company with a clearly-defined M&A strategy. We're not looking for the company that's going
to go out and buy the third or fourth leg to their business. We want somebody who is
focused on the end markets that are growing and they have a competitive advantage, and
are looking to use M&A to drive that advantage forward. We're not paying for that M&A potential
today in our valuation work. We're not assuming they do acquisitions and grow the earnings
that way. That's upside. We don't like to pay for something that's maybe two years down
the road that's, you know, there's a fair amount that can go wrong between now and then.
But it's certainly a source of upside for stocks in our portfolio.