Technology

How To Account For Risk In A High-Quality Approach

Portfolio Manager David Nadel discusses how he manages risk in his international small-cap portfolio.

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Why use a Quality at a Reasonable Price (QARP) approach?

I think that the Quality at a Reasonable Price approach makes sense because it's fully compatible with this mentality of being a business owner. If you were a business owner, if you were choosing between assets to buy, let's say, and you had only one asset that you could buy, your first question would not be how cheap is the asset?

Your first question would be how does this business work? You would analyze the structure of the business. You'd analyze the value chain. You'd understand the competitive positioning of the business. And then at the end of that process you'd say, is this price reasonable? Does the valuation give this investment the capacity to compound shareholder return at the rate that it has historically?

What is Enterprise Quality Scoring (EQS)?

So, EQS is kind of a methodical approach to analyzing quality in businesses. We're sticking to five topics, which we think are crucial to understand in businesses. And that allows us to focus in on things like competitive positioning, the operating efficiency of the business, the financial track record of the business, the sector dynamics.

It sets a track record of your conviction in the business and deliberately removes valuation, because valuation is the emotional part of investing. If price is what you pay and value is what you get, Enterprise Quality Scoring is all focused on that intrinsic value.

How does International Premier manage risk on a security basis?

First of all, we should maybe just try to debunk the notion that concentration has to be equated with higher risk. Because I think that risk, or volatility, in the international small-cap space, is a function of the investments that a fund holds.

So, then it comes down to the nature of the businesses that we're investing in. And, I think what is important about this process is we're looking at variables that are maybe underappreciated, things like cluster risk, customer concentration, supplier bargaining power, switching costs, a portion of revenue that comes from CAPEX budgets, all kinds of, I would say sort of second level topics that I think a lot of investors are a little bit less focused on.

How does International Premier manage risk on a portfolio level?

On a portfolio basis, we certainly give consideration to sector weightings. We give consideration to country exposure, but I think we're more interested in see-through, kind of cluster risk. You know, do we have too many companies that would benefit from a high oil price and therefore you would be exposed with a low oil price. I think maybe at the portfolio level, that's part of the way we're looking at it. But I really think of it as de-risking at that company level.

I think, to a certain extent, diversification by business model does help to manage risk. But again, it's what these business models have in common, and what ultimately, we're looking for, is pretty predictable reliable cash flow. We often get there by investing in companies that grow a-cyclically, companies that have a lot of recurring revenue. There are a few avenues to get there, but that's really how we think about it.

Why is active management important to international small-cap investing?

I think international small-cap is very much suited to an active approach. It's a big asset class. It's very diverse. It's under researched. These are all variables that I think allow active managers to find what are, I'm going to say three, four hundred truly exceptional, world-leading businesses, in a universe that starts with, you know, 25,000 companies. It's an enormous universe that increases the opportunity set for investors, but buying an index is, you know, giving yourself exposure to a lot of money losing businesses, a lot of businesses that are never going to achieve their potential.

What sort of environments do you expect the strategy to underperform and outperform?

We would expect the strategy to outperform based on historical results in both up and down markets, but more so in down markets. So far the strategy has captured about 108 percent of the benchmark's upside, since inception. But it's captured only 83 percent of the downside of the benchmark's since inception. So, we're getting more of our outperformance from down markets.

I think specific variables which lead to underperformance in the Royce International Premier strategy are emerging market rallies and commodity rallies. We don’t tend to invest in businesses that have no pricing power, so your classic commodity type of companies. We're underweight in emerging markets, at least as measured by domicile and so, we will tend to underperform both of those scenarios.

Article by The Royce Funds