Dont Sweat the Small Stuff

January 2013

Despite lingering economic uncertainty, small-cap companies are getting their finances in order, and this potentially bodes well for returns over the next few years, says the Royce Funds Frank Gannon
Although U.S. economic growth remains anemic, most small-cap corporations are in good health. They have cleaned up their balance sheets, built up free-cash flow and taken advantage of widely available debt, says Frank Gannon, assistant portfolio manager of the Royce Dividend Value Fund. He is taking advantage of this great disconnect, he says, by picking up companies that remain undervalued. In an exclusive interview for Morgan Stanley Wealth Management, Gannon recently shared his views about the renaissance of U.S. manufacturing and why leverage is an important indicator when it comes to small-cap companies. The following is an edited version of the interview. Question: U.S. economic growth has muddled along at a pretty tepid pace. How much cyclical exposure does your portfolio have? Frank Gannon: Our firms specialty is smaller companies, so we don't do a lot of top-down research. Everything is built from a bottom-up perspective, [although] we do hear an awful lot from our companies. I would say that the portfolios have a very strong cyclical bent to them these days, given the opportunity set that we've been given over the past several years. Over the past three years, weve had what I would call a growth correction. In that corrective phase of the market, the more economically sensitive, or cyclical, areas of the market have gotten hit quite hard. As we've been building our portfolio over the past three years, that's where we've been finding the opportunity set. So from our perspective, that is one of the more exciting areas of the market right now. Question: Theres been a lot of talk about a renaissance in U.S. manufacturing. Are you a buyer of that theme? Gannon: I think it permeates our portfolio. We've seen a lot of companies that are bringing manufacturing back here to the U.S. It's funny, because a lot of people don't equate large manufacturingor manufacturing outside of the U.S.with small-cap companies. I think one of the beauties of the small-cap space is that there are so many misconceptions. One is [the lack of knowledge about] the fact that these companies do generate revenue outside the U.S. Bringing this manufacturing back to the U.S. has been a big theme we've seen, especially in some of our machinery-industry companies within the industrial sector. We think it's an area that is going to continue to grow over the next several years. Question: What investment themes are you most bullish or bearish on? Gannon: We think the biggest opportunity set is within the highest-quality area of small cap. If people think about small cap, they think of it as being very expensive in general. But if you lift up the hood, if you will, and you look in the smallcap world, what you find is that the very low-quality companies are extremely expensive in today's world. Highquality companies tend to be very cheap. We've done several

studies looking at that, and what we found is that the highest-quality small-cap companies sell at a discountnot only to larger-cap companies but also to their small-cap brethren. So we think it's an enormous opportunity. We define quality as [getting] high return on invested capital. Companies that can generate a lot of free-cash flow invest that free- cash flow to grow their business and then demonstrate return on that free-cash flow. It's very much a Warren Buffett idea of trying to find companies that have large economic modes. So the quality theme I think is one that is, perhaps, the most important and interesting from our perspective in today's market. Areas of the market that we've tended to avoid are ones that we always seem to avoidbut also ones that have done extremely well so far this year. We're not big fans of real estate investment truststhey don't fit our investment models. Obviously, they've done quite well this year, but they also have very low return on invested capital, which is one of our major metrics of quality. We're not big fans of utilities, also an area of the market that has done extremely well this year. We're not big fans of the banks within small caps. While we think their valuations are interesting, we're still nervous about the balance sheets. Question: Where, specifically, are you finding the best opportunities in small caps? Gannon: Today I'd say it's within the more economically sensitive, or cyclical areas, of the market. Industrials would be one of the areas in which we're finding great opportunity. You've had several times over the past year when these great macro headlines have driven a great disconnect between what we're hearing from a micro standpoint with a lot of our companies. Industrials are another area thatas people were worried about economic growth in Europe, China or even here in the U.S.have been hit quite hard. We've been able to take advantage of that. Within industrials, we think some information-technology areas are at the crossroads of what we would say is quality in valuations, which is pretty exciting from our standpoint. Question: Can you talk a bit about the implications of U.S. monetary policy and its impact on security values? Gannon: In the small-cap market, we are seeing the 0% interest-rate policy of the Federal Reserve distort some of the valuations in many respects. We did a study, and we looked at leverage, which is one of our factors. We try to

find companies and balance sheets that are extremely underlevered, focusing on operating leverage and financial leverage. We tend to buy our companies when they're out of favor, so [their] having a strong balance sheet gives us a little hope that they'll be able to make it through these difficult times. In today's world, through the end of the third quarter, the highest-leveraged companies within the Russell 2000 are those that have had the best performance this year. The lowest-levered companies have actually underperformed the overall market. Part of that is because they [highestleveraged companies] have been given the beauty of time here, the luxury of time, if you willwhich, in a normal environment, they probably wouldn't have. Now they can extend maturities, they can refinance, they can do a lot of things to bring down their interest cost, all of which is very good. But the market is paying for that right now. Question: Can you tell me what you're hearing from the companies in your portfolio? Gannon: I'd say in general they have done better than the market has thought they would, given some of the macro concerns we've seen so far. Our companies in general are telling us that we are still in a pretty anemic economic environment, that things are kind of bumpy along the bottom, but that there is business to be had. You have to fight for it, but business is still there. By the same token, they're generating an enormous amount of free-cash flow. They're optimistically buying back stock when they can. They're returning cash to shareholders through dividends, and they're making acquisitions, either geographically or through product extensions. When the economy does continue to grow or resumes its growth, they potentially will be in a much better position to produce topline growth. It's a little different picture than what you might hear on a day-to-day basis. But from a bottom-up standpoint, our companies are actually quite positivewhich I think is interesting given the high amount of uncertainty going into the end of the year and into the first quarter. Question: What else should we know about your portfolio? Gannon: The dividend value portfolio tends to focus on companies that generate dividends within the small-cap space. I think it's an area of small caps that people don't typically talk about. As I like to say, people don't use the word dividends and small caps in the same sentence. But dividends within the small-cap space represent a very interesting area. Dividends help mitigate volatility in the overall market. They tend to be a marker of quality. We kind

of have a pet theory that [if you get] a dividend within the small-cap space, you actually start the year off with a couple of nickels in your pocket. Then you get the potential for multiple expansions as things go on. These tend to be companies that are generating a lot of free-cash flow, and yet, for the moment, I think the market is not truly recognizing their potential. But we hope we'll get paid on that over the next three to five years.

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