How Operating Margins and Capital Allocation Affect Small-Caps

Chuck Royce and Co-Chief Investment Officer Chris Clark talk about operating margins being at or near peak levels, increased M&A activity, and the absence of any real CAPEX activity.

See Chuck Royce on how operating margins and capital allocation affect small-caps video here.

Chris Clark: One of the big shots that I think investors are taking besides valuation is this concept around operating margins being at a peak level in the market. They’re certainly very high in the small-cap space. Do you think there’s an inevitable decline in margins going forward from here, or is there something else going on that could lead to even higher margins and, commensurately, higher earnings going forward?

Chuck Royce: There’s no doubt that corporations made job one improving margins under existing sales conditions. They were fearful coming out of the crisis and they worked hard on their margins, and margins have absolutely come to a peak, but several things can happen.

Margins could come down as companies expand. We have not had the big CAPEX cycle. We’re clearly starting an M&A cycle, though that’s in the paper every day here. So margins could come down as CAPEX kind of picks up. Or we could get a surprise on the upside in sales growth where margins might even go up some more.

Chris: Do you worry that now we are seeing an increased backlog of IPO activity that, again, bodes sort of poorly for the future of the market? Is that just companies being opportunistic at a high moment here, or is there something else to it?

Chuck: I think IPO as a sort of capital market phenomena is a healthy one, and many of the IPOs that come out today we will look at in a serious way six months, a year, two years down the road when, perhaps, the IPO enthusiasm has settled down.

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About the Author

Royce Funds
For more than 40 years, Royce & Associates, investment adviser to The Royce Funds, has used a disciplined, value-oriented approach to select micro-cap and small-cap companies.

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