Portfolio Manager Steven McBoyle describes the attributes at the heart of his quality approach: businesses that possess a moat-like franchise, sustainable high returns on capital, and the capacity to reinvest.

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Premier Small-Caps
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What's your view of the small-cap market?

Well, certainly 2016 was a strong year for small-caps and value. Not entirely surprising to us just given the many factors that were at play. Most importantly, the fact to what extent growth outperformed value, order of magnitude and duration.

So, a reversion to the mean was inevitable. Now, by the end of 2016 the market had really priced in a lot of successful political fiscal outcomes and didn't really discount, if you will, all the implementation risks.

So, as we're sitting here today, I think the market is now grappling with this transition, if you will, from monetary support to fiscal support. I think this is a transition that is likely not going to be smooth and for that reason I think the market is grappling with that and for that reason we've seen a pause and a reversal, if you will, in the first quarter.

Similarly, not all that surprising in light of the dynamic that we witnessed favorably in 2016 as it relates to small-cap and value.

What's your outlook for the rest of the year?

If we can paint a very positive picture where this baton is successfully passed from monetary to fiscal, we will have positive cyclical reflationary forces that are going to benefit a lot of our cyclically highly profitable US-domiciled small-cap companies.

The overarching governor to everything that I've just said, of course, is valuation. And to the extent that the cap rates have declined cost of capital is now increasing. By definition, the spread has narrowed.

So, we do have a very favorable general economic background. A lot of positive indications that the economy is doing well, even on a global scale.

People often ask about corrections. Corrections come by way of price and/or time and so if the economy has the ability, which I think it does, to effectively earn its way into valuation, this will just simply be that continuation of pause, a consolidating moment.

What are the common attributes you are looking for in stocks in Premier?

A Premier company is one that possess a moat-like franchise, has sustainably high return on invested capital, has exhibited prudent capital allocation over a long period of time, and has this ability to reinvest back into the business.

We don't invest thematically. Again, we're bottom-up managers. We go as far as to say that risk management begins at the stock level. Now, having said that, we will on the margin be attracted to companies and industries that are direct beneficiaries of what we like to call a-cyclical growth, or where growth in the addressable market is structurally improving, particularly where we deem that the market has not identified that fact.

One thing that can be very powerful from a compounding effect is where you identify a structurally growing addressable market. So, take for example, factory automation is an ongoing and important theme within industrials today.

We own a company named Cognex, which is a leading machine vision software company that addresses this theme by way of introducing software algorithms and cameras to the factory floor. It all but effectively addresses defects and scraps, which are lower, traceability is improved. Throughput increases and, of course, we reduce labor costs, which is an important dynamic in manufacturing in the US today.

Even Lincoln Electric, within the Premier Fund is benefitting, as well, from this trend towards factory automation as they provide automated solutions to the factory floor within the welding cells. This is what we call a-cyclical growth. It doesn’t matter at what point you are in the industrial production cycle, we know that factory automation is going to increasingly a larger slice of the pie. That's a dynamic that we like.

Article by Steven McBoyle, The Royce Funds