Utilizing Emerging Quality In Investing For PENNX—Royce
article 09-15-2020

How Does Royce Define Emerging Quality?

Assistant PM Andrew Palen explains the importance of our Emerging Quality theme in Royce Pennsylvania Mutual Fund’s multi-discipline approach.


How do you define Emerging Quality?

Emerging Quality, which is one of themes we use in the Royce Pennsylvania Mutual Fund, is essentially a version of our Premier Quality approach to companies that are newer in their lifecycle, so I think it’s helpful to first highlight the key principles of that strategy. When evaluating Premier Quality companies, we closely study value chains, business models, and organizational structures in our search for exceptional small-cap companies that we believe will persistently compound their value at attractive risk-reward ratios. By routinely looking for these attributes, we’ve seen certain common qualities emerge. In first thinking about Emerging Quality, Chuck and I discussed how we might invert the process to uncover quality contenders earlier in their lifecycle.

My remit is to identify the inflection points from which companies can go on to sustain long periods of profitable growth and reinvestment. This requires an in-depth analysis as we carefully examine all of the relevant information while the company is making progress. Imagination is also important. As we dig deep into a company, we have to contemplate what might go right for the business to go from Emerging Quality to Quality. This helps to explain why the majority of companies in our Emerging Quality theme are held not in Royce Premier Fund but in Royce Pennsylvania Mutual Fund.

Why is it important to source these companies earlier?

Because that’s where we can potentially gain an advantage, at the intersection of patient ownership and intensive, rigorous examination of value creation. We often find Emerging Quality companies as they’re investing in, and scaling, their business. More and more often, this investment activity isn’t about acquiring hard assets, but instead developing intellectual assets. As a result, the company’s progress might be hidden from quantitative observation, at least for a period of time, while the additional value is being created. When intangible or intellectual value is being created, we’ve discovered that these qualities are more likely to be seen on the income statement than the balance sheet.

"We often find Emerging Quality companies as they’re investing in, and scaling, their business. More and more often, this investment activity isn’t about acquiring hard assets, but instead developing intellectual assets. As a result, the company’s progress might be hidden from quantitative observation, at least for a period of time, while the additional value is being created.” — Andrew Palen

Can you take us through the idea generation and evaluation process?

Chuck and I have talked about the fact that we don’t find these businesses solely by screening for retention rates and return on invested capital—we talk to stakeholders along the value chain to gain an appreciation of the habits of the company’s customers and what it would cost these customers to switch to a competitor. Listening to customers also allows us to understand demand dynamics in ways that numbers don’t reveal. We look for intellectual honesty from management about any strategic shortcomings as well as corporate cultures that aren’t afraid to fail. Additionally, we analyze a company’s incentive practices because poor capital allocation can easily undo a promising integration of value and strategic positioning. Finally, we examine disparate topics such as risk culture, hiring practices, product development processes, and lines of communication to the executive tier. We want to see the entire mosaic. Discord and/or damage can accumulate before they show up in results.

Innovation and ingenuity are valuable attributes, but they are also moving targets, which creates risks, as does the fact that genuinely exceptional Emerging Quality businesses can remain under-appreciated—and therefore underpriced—across years of effective execution. However, the potential rewards for identifying a high-quality business before it begins to fully reap the rewards of its success can be significant.

In what industries do you most commonly find it?

We’ve most frequently found Emerging Quality businesses in the technology, healthcare, and consumer areas. But in a world of zero marginal cost to distribute digital goods and services, a business in almost any sector can disrupt established profit pools, which is one reason we think it’s key to focus on end users, whether it’s a business or a consumer.

Internet commerce, for example, has decimated the costs of finding suppliers and the transactional costs of reaching end users thanks to search engines and social networks. Legacy models that were distributor led and focused on exclusive supplier relationships have completely changed. Supply has both been made modular and commoditized, leaving value for companies that offer integrated solutions and focus on the end user. The value of having a long-term recurring revenue stream via direct relationships with end users won’t immediately be seen in the company’s results, so this presents opportunities for small-cap businesses to participate in these scaled, global changes in ways that other investors may not currently recognize.

In recent years, we’ve seen this dynamic with our investment in Etsy, where we had a strong sense of what the business could become despite not seeing quantitative proof initially. As it happened, we built conviction and were ready to act when a new management team arrived that engaged with stakeholders, articulated where the business was falling short, and promptly redirected investment. They endured the short-term pain necessary to reaccelerate growth, triple margins, and reignite value creation. For me, it goes back to imagination—we kept our minds open about a business that could flourish in a universe dominated by Amazon.

Can you talk about another industry where you’ve found emerging quality candidates?

I would say application software, which is another industry that’s being reshaped by discontinuities in search and transaction costs. The buildout of the cloud, especially the way it’s enabled offsite, Internet-enabled application delivery, has been equally foundational to this reconstitution. Taken together, the human-heavy distribution arrangements that held sway over the past few decades have been upended, and this shift caught our attention because it’s paving the way for a new class of company that helps businesses to scale more sustainably. These companies use varied permutations of open-source, self-serve/ “freemium,” and API (“Application Programming Interface”)-led distribution models that have most recently been fueling value creation at application software companies such as Bandwidth, Elastic, and SVMK.

Can you give us an example of an emerging quality company in this industry?

Upland Software is an interesting company. It buys-and-builds cloud-based enterprise work management software that helps organizations to plan, manage, and execute projects. Over the past decade, the cloud-computing infrastructure has cratered the fixed costs of starting technology-enabled businesses. This has attracted more than $70 billion of venture capital investment in enterprise software. However, more than $50 billion of that capital lies fallow with zombie ownership groups because not all of these companies become successful.

Upland Software (Nasdaq: UPLD) 

UPLD US Equity

This is where Upland Software comes in. Historically, Upland acquired enterprise software businesses that were chasing new customers and straining to become cash-flow positive. Upland transitions a company’s focus to sustainable growth by satisfying the company’s existing customers. This typically allows for better—often significantly better—margins and cash flows. Even more important, Upland has reached sufficient scale in its target application verticals while coming out of an investment cycle that should boost growth and raise prospective returns.

Can you discuss another holding in a different industry?

Absolutely. Trupanion is an Emerging Quality holding that provides pet insurance. In an industry where access to capital creates new entrants, we think Trupanion offers considerable value to its stakeholders. For pet parents who face ever-increasing health costs, the company provides assurance with the highest-value product in the market. For veterinarians, it increases the profitability of their practice while incentivizing healthier dogs and cats. Additionally, our decades of experience with Idexx Laboratories, which operates a global network of veterinary reference laboratories, made us very familiar with this space.

Trupanion (Nasdaq: TRUP)

TRUP US Equity

Trupanion is currently at an inflection point arising from its multi-year investment in Trupanion Express, a technology-enabled product that allows pet parents to avoid big out-of-pocket expenses at checkout and irksome reimbursement issues. Also for veterinary practices, it obviates credit card fees, facilitates immediate payment, and creates a halo effect on spending by policyholders, which is significant since the average practice operates with single-digit operating margins.

We have a high regard for the experimentation, adaptability, and long-term orientation of the team at Trupanion. We also like that last year the company grew its market by more than 25% while achieving better than 35% internal rates of return on its customer acquisition spend. These are the kinds of proof points that we found below the surface, and they’re precisely the kinds of attributes that we look for in Emerging Quality businesses.

Both Trupanion and Upland are led by founder-owners who have run their respective—and quite different—businesses with credibility that allows them to sustainably issue capital at lower costs than their competitors, and this is a crucial element to sustaining value creation through the intermittent turbulence faced by any truly innovative business.

Within the Emerging Quality theme, we’re adapting longstanding Royce quality investment principles to innovative companies earlier in their life cycle, so there is typically lower overlap with other Royce approaches. We think blending our distinctive Emerging Quality approach into the multi-discipline strategy we use in Royce Pennsylvania Mutual Fund provides valuable access to innovative small-cap companies earlier in their life cycle.

Royce Pennsylvania Mutual Fund


Important Disclosure Information

Average Annual Total Returns as of 6/30/20 (%) 

Pennsylvania Mutual 24.01 -7.14 3.11 5.16 9.20 6.85 8.97 9.70 12.83
Russell 2000 25.42 -6.63 2.01 4.29 10.50 7.01 6.69 8.93 N/A

Annual Operating Expenses: 0.94

1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.royceinvest.com. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Mr. Palen’s thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Percentage of Fund Holdings As of 06/30/2020 (%)

  Royce Pennsylvania
Mutual Fund
Royce Premer Fund

Etsy, Inc.



Bandwidth Inc. Cl. A



Elastic NV






Upland Software Inc.



Trupanion, Inc.



Idexx Laboratories



Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

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