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Royce Investment Partners Commentary: Interview With Portfolio Manager Miles Lewis

How did you first become interested in small-cap stock investing?

I can trace it back to my childhood when I traded baseball and football cards with my friends. I wanted an informational advantage, which I got by scouring the newspapers and watching Sports Center every day. I'd then try to leverage that knowledge to secure the cards of the players I believed had potential upside. It's interesting--small-cap investing offers similar inefficiencies. I was then turned on to the stock market in seventh grade when we created mock portfolios for a school project. However, I didn't begin investing personally until after college, mostly by following companies I knew, which meant larger, well-known stocks.


In graduate school at Cornell, I began working for a student-run market neutral hedge fund where I started developing detailed stock pitches as part of the recruiting process. I quickly realized that to stand out, I couldn't focus on large, well-known companies because it would be difficult to add value or make an impression--who wants to hear another pitch on Apple? So, I used the fund's quant model, which was biased towards small-caps, to generate ideas. I started with retail, a sector I knew and understood, and then picked up regional banks. I steered clear of the pink sheets and tiny market caps in the hope that a portfolio manager might take action and invest in one of my ideas. That drove me to focus on the sweet spot of companies with market caps between about $500 million to $5 billion. Then in the summer of 2009 I did an internship on a small-cap value fund, which cemented my love of small-cap investing.

How would you describe your investment approach?

I'm a fervent believer in owning high-quality businesses, buying them at attractive prices, and holding them for as long as the current valuation is attractive to fair. My ideal investment is a high-quality company where the stock has lagged for transitory or cyclical reasons and looks inexpensive relative to its normalized earnings power and cash generation potential. I gravitate towards companies with a strong underlying asset or franchise, but where the narrative around the business has changed for some reason. I believe the margin of safety lies in the quality of the asset rather than in the company's valuation, and that the franchise value provides downside protection.

What other factors are important to you as an investor?

I view equity investing through a credit lens and thus focus intensely on downside protection and capital preservation, which I believe is one of the best ways of generating excess long-term returns. A credit investor can measure their return: the coupon payments are contractual. The worry is whether or not the principal will be repaid. I believe that if I find attractively valued, high-quality companies, the upside will take care of itself over time, so I tend to focus much of my attention on what could go wrong.

I also believe in high active share--to beat the benchmark and your peers, your portfolio must look different from both. To me, this means strictly adhering to a disciplined and repeatable process even when that results in occasional underperformance. Investing with a three- to five-year investment horizon assists in maintaining this discipline during shorter term periods of underperformance.

Why else is a long-term investment horizon important?

I think holding a quality company for an extended period gives you the chance to benefit from the compounding of high returns on capital compounding and the savvy capital allocation decisions of good management teams. However, in my experience the market often discounts these qualities and pulls forward years of future returns in the form of very high multiples on near-term earnings. I think it's therefore important to reverse engineer this process to understand what is priced into a stock at any given time.

What other factors or experiences helped to shape your approach?

My approach has mostly been shaped by my different experiences. Prior to graduate school, I worked in credit, primarily on distressed borrowers, which led me to emphasize cash flow, rather than earnings, and balance sheet strength. I generally do not believe in investing in commodity-driven businesses with no pricing power or in secularly challenged business models that appear statistically cheap. In addition, my focus on quality stems from the mistakes I've made. For example, my earlier attempts at investing in both of these groups resulted in losses and so buttressed my preference for owning high-quality assets that have growth potential, even when that potential seems quite modest. When investing in high-quality businesses, time is your friend; when investing in lower-quality businesses, time can often be your enemy.

Many professional investors talk about looking for 'quality companies.' How do define the term?

I define quality along three interrelated continuums, starting with the quality of the underlying business. I begin with a very simple question: is this a good business? This analysis involves examining elements such as the pricing power of the business, its industry structure, any barriers to entry and exit, the competitive advantages of the company, etc.

I then look at financial quality. If the business itself appears to be of high quality, then quality should also manifest itself in an attractive financial profile. To this end, I look for companies with attractive returns on invested capital, low capital intensity, good free cash generation, stable margins, and strong balance sheets. I place heavy emphasis on free cash flow, as this affords a company ample options including paying dividends, repurchasing stock, retiring down debt, and/or doing value-creating M&A. These attributes are not found as a result of GAAP earnings, only cash flow. I believe strong balance sheets can and should be used to create value through opportunistic share repurchases and M&A. A levered balance sheet limits a company's flexibility to create value while also introducing undue financial risk.

Finally, I focus on the quality of the management team, which is particularly important in small-cap investing. Management decisions on strategy and capital allocation can have profound impacts on the stock, both positively and negatively. If a business generates prodigious amounts of cash, but management squanders it with poor capital allocation decisions, then that cash isn't as valuable as it seems. To evaluate the quality of management, I examine their track record with an emphasis on capital allocation, the incentive structure, and management's ownership of the stock. I want managers who take the long view and whose incentives are well aligned with those of shareholders'.

How important are dividends to your investment approach?

I definitely gravitate toward companies that pay dividends. It's a practice that I think instills a sense of financial discipline in a company and often indicates a strong balance sheet and cash generation potential. Dividend-paying stocks also tend to have lower volatility. In addition, companies that consistently pay dividends often have many if not all of the important quality attributes that I'm seeking.

How do you see the current small-cap market in terms of opportunities and prospects?

I believe that the current backdrop for small-cap stocks represents a rare buying opportunity that has the potential to to deliver strong returns in the coming years. The performance gap between small- and large-caps is eye opening, while the gap between small- cap value and small-cap growth is even more so. I believe there are certain sectors, such as U.S. regional bank stocks, that represent a compelling risk/reward picture as the industry is far stronger than it was entering the Financial Crisis, yet valuations are even lower now than they were then. Given that we currently have a wider range of possible economic outcomes than we usually see, I think focusing on quality businesses with strong balance sheets is more important than ever. Not only do these companies look capable of surviving the current tumult but they also appear more likely to emerge stronger than before because they have the financial resources to invest in their businesses and/or to benefit from consolidation in their industries.

Mr. Lewis's thoughts and opinions concerning the stock market are solely their 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 performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

This article first appeared on GuruFocus.