Ryan Snow, Chief Investment Officer, details how the Required Net Return on Operating Capital (RORC) helps them find quality small cap stocks in Japan.

The International Small-Cap Premier Quality Strategy that we use in Royce International Premier Fund looks for high quality companies that can sustain high returns on invested capital (ROIC) with low leverage. Many investors may therefore be surprised to learn that Japan is one of our most target-rich markets for discovering quality companies. After all, the average Return on Equity of companies listed in Japan is just 9%, trailing below that of European and American counterparts. Through our lens, however, we see a diverse and growing universe of companies with excellent businesses.

Historical Trends in Return on Equity in Japan, the U.S., and Europe

Source: Bloomberg, MSCI

Our distinctive approach to finding high-quality international small-cap companies involves a two-step process that is designed to overcome certain limits we have found when using return on invested capital, or ROIC, as a screening tool. ROIC is an excellent tool for showing how well a company is using the capital funded by the equity and debtholders to generate profits. And a company generating ROIC above its cost of capital is generating value for shareholders. However, ROIC in and of itself cannot distinguish between the quality of business activity and the quality of capital allocation.

Of course, companies rarely use all of their capital to generate profits. Profits are generated from operating capital such as working capital and fixed assets, while other capital such as cash is kept for future investments. Crucially, ROIC cannot reflect the potential return on capital earmarked for future investment. Therefore, we think the inclusion of “idle capital,” such as cash, long-term investments and other cash equivalents, can mask the underlying quality of business activity. Similarly, acquisitive businesses that enjoy high reinvestment rates may see their invested capital figures inflated—and therefore their ROICs depressed—as they recognize the intangible assets of acquired companies on their balance sheets on a “stepped-up” basis. These assets, as well as goodwill, may not directly contribute to a company’s profit generation and can thus distort the true profitability of the acquirer’s business model.

Therefore, the first step is to find companies with great underlying business models. As Charlie Munger once said, “Betting on the quality of a business is better than betting on the quality of management.” We do this by using a variant of ROIC called Return on Net Required Operating Capital, or RORC, which is defined as operating profits divided by operating capital. (Operating capital is the sum of net working capital and net fixed assets, excluding both cash and intangibles.) We use RORC because it compares a company’s operating profits against its operating capital, making it a better measure of the quality of business activity in isolation in our view.

The second step is to evaluate the future return prospects of the idle capital in order to create a picture of how a company’s ROIC can evolve over time. We see this as part of the art of the Strategy’s investment process by making a judgment based on our engagement with management teams as we seek to understand how they plan to deploy capital to support growth.

We think our two-step approach to identifying quality companies can be particularly useful in Japan. Following the bursting of the nation’s real estate bubble in 1989, Japanese companies had to repair their balance sheets, then saw potential returns on reinvestment opportunities dwindle as deflation spread and the cost of capital fell. What we see today is a universe of companies with highly capitalized balance sheets—many of which mask the underlying quality of the business.

The table below shows the impact of using RORC to build an investment universe for high quality companies in Japan. Using a 20% threshold for each metric, we looked at Japan’s ‘High ROE’ universe and found that there are more than five times more companies in our investment universe—and more than ten times more companies than there are in the country’s ‘High ROIC’ universe. What we think is most relevant about the stark differences in the size of each investment universe is how looking mostly, or primarily, at ROIC can often screen out companies with underlying businesses of comparable quality.

Number of Companies in the Japanese Small-Cap Universe With 20% or Higher Return on Net Required Operating Capital, Return on Equity, and Return on Invested Capital

Source: Bloomberg. Note: The screening criteria are (1) market cap between $100 million to $10 billion, (2) profitable in the past five fiscal years, (3) High RORC = Five-Year Geometric Mean Return on Net Operating Capital equal to or higher than 20%, (4) High ROE = Five-Year Geometric Mean Return on Equity equal to or higher than 20%, and (5) High ROIC = Five-Year Geometric Mean Return on Invested Capital equal to or higher than 20%.

The added benefit of utilizing a more holistic approach to finding quality companies is that we can purchase shares at a discount. The table below compares the valuation of a median firm across the three investment universes, screened by High RORC, High ROE, and High ROIC. Although the three investment universes contain businesses of comparable underlying quality, the median High RORC business trades at a discount on both traditional earnings metrics—trailing enterprise value over earnings before interest & taxes and price to earnings ratio—and book value. For our purposes, the 50% discount on price to book value is especially important as we think it reveals the market’s inability to value the idle capital that is not generating current cashflow.

Median Valuation Metrics Across the Japanese Small-Cap Universe

Source: Bloomberg. Note: The screening criteria are (1) market cap between $100 million to $10 billion, (2) profitable in the past five fiscal years, (3) High RORC = Five-Year Geometric Mean Return on Net Operating Capital equal to or higher than 20%, (4) High ROE = Five-Year Geometric Mean Return on Equity equal to or higher than 20%, and (5) High ROIC = Five-Year Geometric Mean Return on Invested Capital equal to or higher than 20%.

To summarize, our holistic approach to searching for high quality non-U.S. businesses using RORC gives us access to a wider and cheaper investment universe than we see when using the more traditional measures for evaluating quality companies such as ROE and ROIC. This in turn gives us an opportunity to invest in high quality yet attractively valued Japanese businesses before they are discovered by other investors using more traditional measures.