The Benefits Of Being Temporarily Out Of Favor by Lauren Romeo, The Royce Funds

For quality-oriented portfolio managers such as Lauren Romeo, investor preferences for either high yield or speculative growth in recent years have put pressure on strategies that focus on strong business fundamentals. Yet this has also created potential future opportunities. The neglect of businesses that demonstrate strong earnings potential and current profitability has resulted in attractive valuations for those companies poised to resume market leadership as interest rates rise and economic growth accelerates.

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The Benefits Of Being Temporarily Out Of Favor

“Over the past couple of years it’s been a challenging environment for quality-oriented strategies, and I think a large part of that has to do with the fact that it’s really been a bipolar market where on the one hand you’ve had investors who are desperate for yield—and so they’re investing in companies such as real estate investment trusts and Utilities, which are areas that don’t meet the financial criteria that we look for in our quality orientation—and, alternatively, there’s another set of investors that have been looking for companies that have great growth prospects down the road but are not profitable today.

“Quality-oriented managers tend to invest in the middle of those two extremes, so we’re looking for companies that have the strong financial characteristics as well as highly profitable near-term operating results.

“We’re coming from a period of low interest rates and low economic growth, which has worked against quality-focused strategies. But we see signs that’s changing as we get closer to a rise in interest rates as economic growth accelerates. That should shift some of the leadership away from bond proxies and the more speculative, non-earning names towards companies that are beneficiaries of an improving economy and have improving fundamentals.

“What’s particularly attractive about the small-cap space today is that the quality area, because it’s underperformed, is on sale. The lower-quality names have really led the market higher over the past couple of years, so as a result you’ve got these very high-quality companies that have been neglected, and as a result are selling at very attractive valuations.”