A Deep Dive into 2 Quality Value Holdings
article 09-19-2023

A Deep Dive into 2 Quality Value Holdings

Lead Portfolio Manager Miles Lewis and Assistant Portfolio Manager Joe Hintz detail the investment thesis for 2 Quality Value holdings in Royce Small-Cap Total Return Fund.


Barrett Business Services (Nasdaq: BBSI), which is in the Industrials sector, has completely changed its business model, and we are really seeing the benefits of that shift shine through. Barrett is a Professional Employer Organization, or PEO, that allows small businesses to essentially outsource Human Resources. While it has competitors, most focus primarily on white collar industries. Barrett, on the other hand, has always focused on what they call more “gray collar” industries, that is, a mix of white- and blue-collar industries. Its direct clients are small businesses, and the company serves approximately 125,000 employees across these businesses. These workers represent around $7.5 billion worth of wages and benefits, and BBSI receives a fee from each business based on a percentage of that total wage and benefits bill.

“The bond insurance industry appears poised for meaningful inflection—and AGO has been capitalizing on the recovery. Higher rates are driving increased demand for Financial Guaranty products, with 2Q23 being AGO’s best quarter for new business in a decade. All of this could enable AGO to be a growing enterprise again, possibly resulting significant multiple expansion over time.”
—Miles Lewis

Barrett employs a “high touch” model that essentially combines PEO with a consultative approach. This combination leads to higher success rates for its clients, as well as lower churn rates for Barrett—which has market leading customer retention rates in the 90% range. In addition, small businesses that hire a PEO will usually grow faster, have lower employee turnover, and be 50% less likely to go out of business. And Barrett’s high retention rates imply a highly recurring revenue business model. Barrett’s target market of businesses with fewer than 100 employees is only 15% penetrated, leaving ample room for future growth opportunities, while its referral network for new business leads to both lower customer acquisition costs and nearly pre-vetted candidates, resulting in high new business win rates. As a capital light business, Barrett can quickly and efficiently launch expansion opportunities while enjoying short earnback periods. This helps Barrett generate a lot of cash, with its most recent cash balance representing 20% of the company’s total market capitalization.

Barrett’s current CEO, Gary Kramer, joined the company as CFO in 2016. After being promoted to CEO in early 2020, he instituted multiple changes that have drastically improved the firm’s business model—which we have gone largely unnoticed by the market. Historically, investors have shunned Barrett due to its gray collar end markets and the fact that it self-insured workers comp insurance offerings, creating higher risk. Under its new CEO, however, the company moved to an outsourced insurance model in which Barrett incurs no downside risk from policies, but still receives the upside benefits if claims come in lower than modeled—a significant shift in the company’s risk profile that we believe has not yet been recognized other investors.

Kramer has also implemented strategies and policies to better serve larger customers, increase Barrett’s marketing reach, and improve retention rates. All of which has led to a more robust growth model. Most important, the company began a beta trial of a health insurance offering for clients in 2023, with a system wide launch coming in 2024. This effort is also structured in the zero-downside risk model while also offering has two large benefits. First, it considerably expands the company’s addressable market as potential clients who need a health insurance offering for their employees historically would not have been able to utilize Barrett’s services. Second, Barrett receives a fee for acting as the insurance broker, and this incremental revenue will drive significant earnings growth as there are few incremental operating costs to service this new revenue. We think that this new health insurance offering could increase earnings power by 25-50% over the long term, which is on top of an already attractive growth model.

One other highly attractive element to this opportunity is its potential for a very asymmetric return profile. Once adjusted for the significant cash balance, the stock trades at a price earnings ratio (“PE”) of only 10.0x FY2 EPS (earnings per share growth in the fiscal year after this one), which is both cheap on an absolute and relative basis. Barrett’s peers currently trade in the 16.0-25.0x P/E range. We therefore see limited downside risk. In fact, with earnings power set to potentially accelerate growth on the back of the health insurance launch, we think there is considerable upside potential both from growth in earnings and from multiple expansion.

We see Assured Guaranty (NYSE: AGO) as a great example of the diversity of our holdings in the Financials sector. It has a niche business insuring bonds, predominantly U.S. municipal debt instruments, and is known as a “Financial Guaranty” or “FG,” meaning that if a borrower (i.e., the municipality) misses an interest or principal payment, AGO pays it so the bondholders are unaffected. Bond insurance adds value for AGO’s customers and, in our view, the bondholders as well. AGO is rated AA, but its capital levels are at AAA standards, and the company has an excellent reputation that comes with being the largest player in the industry. The industry has essentially been a duopoly since the Great Financial Crisis, which wiped out most other industry players. AGO now has a roughly 63% market share to go with the strongest balance sheet and best brand name. The municipalities—AGO’s direct customers—benefit from lower costs of capital and lower interest payments, which creates additional benefits, such as being better able to invest in their communities. Bondholders benefit from improved liquidity, the assurance of timely interest payments (thus reducing their risk), and professional underwriting, as each AGO insured bond is underwritten by the company.

We also especially like the company’s admirable capital allocation record. Since 2013, AGO has retired 73% of its shares outstanding, or nearly $4.7 billion worth of stock, though it remains in a sizable excess capital position. AGO has also grown its book value per share (“BVPS”) at 14% a year for a decade. Even with its record of effective execution and position as the industry leader, we think its valuation is quite attractive—its shares have recently been trading at roughly 60% of BVPS. We see three significant implications of this attractively inexpensive valuation: it gives AGO a sizable margin of safety; the company looks less risky than it did a few years ago, as legacy risks from 2014’s Puerto Rican bond crisis have largely been resolved. We expect to see meaningful share repurchases in in the second half of 2023 or early 2024.

Much of our thesis is rooted in the prospects of an industry rebound. Until recently, the bond insurance industry had been the victim of low interest rates, as lower rates meant less money for bond issuers, which made it less economical for AGO to write new policies. Lower rates also resulted in tighter spreads, which were similarly less economical for AGO’s business. In addition, the low default environment engendered a reduced appetite for credit protection. The upshot was a more than 50% decline in the amount of debt that AGO insured over the last 14 years.

But this is all changing due to the current higher interest rate environment. In fact, the bond insurance industry appears poised for meaningful inflection—and AGO has been capitalizing on the recovery. Higher rates are driving increased demand for FG products, with 2Q23 being AGO’s best quarter for new business in a decade. All of this could enable AGO to be a growing enterprise again, possibly resulting in significant multiple expansion over time. To be sure, we believe that the stock could double in the next 2-3 years. At roughly 60% of BVPS, and with the company likely to continue aggressively repurchasing shares over the next 6-9 months, we see limited downside as well.

Important Disclosure Information

Average Annual Total Returns as of 6/30/2023 (%)

NET               GROSS
Small-Cap Total Return 6.50 9.42 14.29 5.81 7.76 9.97 12/15/93  1.26  1.26
Russell 2000 Value
3.18 6.01 15.43 3.54 7.29 9.17 N/A  N/A  N/A
Russell 2000
5.21 12.31 10.82 4.21 8.26 8.54 N/A  N/A  N/A
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. Lewis’s and Mr. Hintz’s thoughts and opinions concerning the stock market are solely their 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.

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.

Percentage of Fund Holdings As of 6/30/23 (%)

  Small-Cap Total Return

Barrett Business Services


Assured Guaranty


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.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing Foreign Securities" in the prospectus.)



Sign Up