Francis Gannon: Capital Allocation and Risk Management by Royce Funds

Companies with little or no debt on their balance sheets can focus on capital allocation decisions that help the business to grow and/or return free cash back to shareholders. Especially during uncertain periods, a low-debt balance sheet also helps us to assess risk, which is crucial in the small-cap universe, where companies are often fragile.

Francis Gannon: We tend to focus on companies that have a lot of cash—at least as of late—especially on their balance sheets. How important is capital allocation for these businesses?

Steven McBoyle: Capital allocation is paramount. There’s actually a wonderful book called The Outsiders written by Thorndike which I think actually is a poignant piece that speaks to just how important capital allocation is over time.

We as shareholders, and shareholders of Royce Funds, have an implicit and explicit contract with management. So day in, day out, we come in to assess whether management is making the appropriate capital allocation decisions over time.

The tools that management has are obviously buybacks, dividend policy, mergers and acquisitions, and perhaps most importantly—to the extent that we at The Royce Funds look at the entire business cycle—what they do with their own cash. Do they actually build it at the appropriate points in time in the business cycle, and do they invest it at the trough portions of the business cycle?

Francis Gannon: So how does that all fit into our view of risk management?

Steven McBoyle: Risk management is critical. We are risk managers, first and foremost. We’re obviously dealing with small-caps. They are fragile businesses, for sure. We at The Royce Funds are attracted to those companies that are profitable.

Interestingly enough, upwards of a third of the underlying index are businesses that don’t make money. In addition to that, we obviously are quality focused. So again, we’re attracted to businesses that have strong business moats and differentiated business models. These are time-tested, self-funding businesses.

So if you take those two overlays in terms of how we look at risk management, and you apply a very strict valuation parameter on top of that universe, in addition to having the downside protection in terms of strong balance sheets, we think all in all that’s a wonderful way to manage risk within the zone.

Francis Gannon: Capital Allocation and Risk Management