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By Royce Funds

Small-caps have underperformed the broader market so far in 2014. Recent comments from Federal Reserve Chairwoman Janet Yellen only added fuel to the fire.

In her recent semiannual Monetary Policy Report in front of Congress, Yellen stated, “Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched,” further noting, “Ratios of prices to forward earnings remaining high relative to historical norms.”

The Chairwoman’s comments did not surprise us. In fact, saying that small-caps valuations are running high is an easy call to make given the Russell 2000′s returns over the past several years — the small-cap index’s five-year average annual total return through the end of June 2014 was 20.2%.

However, a closer look tells a much different story. We have mentioned it before — many high-quality small-caps still look undervalued to us. To be sure, we see quality as paramount to mitigating risk and achieving above-average long-term returns, especially in the small-cap asset class.

Understanding quality is critical to our effort — as long-term investors, we believe that companies with sound fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices.

Driving our investment process is a rigorous search for quality that begins with an examination of a company’s historical returns, with particular focus on returns on invested capital (ROIC). For us, this metric reveals the first markings of a quality company, which can be found in its historical returns over full business cycles.

Interestingly, our research shows that the highest quality small-cap companies within the Russell 2000, as measured by ROIC, now trade at a discount to the highest quality large-cap companies, while companies with the lowest ROIC account for virtually all the small-cap premium (see chart below).

The upshot is that the small-cap space continues to have plenty of quality companies — and many look attractively priced to us.

Median LTM1 EV/EBITDA2 by ROIC Quartile as of 6/30/14

1 Last 12 months
2 Enterprise value/earnings before interest, taxes, depreciation, and amortization
Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock). The portfolio calculation is a simple weighted average that excludes all non-equity securities, investment companies, and securities in the Financials sector with the exceptions of the asset management & custody banks and insurance brokers sub-industries. The portfolio calculation also eliminates outliers by applying the inter-quartile method of outlier removal.

Source: Russell Investment Group and Bloomberg

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Source: Yellen's Recent Statements Notwithstanding, Many High-Quality Small-Caps Still Undervalued