Great commentary from Royce Funds

Volatility in the equity markets, as measured by the Volatility Index (VIX), fell dramatically during the month of October, yet daily volatility, driven by macro news, remains on an upswing as the world searches for new clues in the seemingly endless debate over the future shape of global economies. After pricing in a severe recession that, at least for the moment, does not seem to be on the horizon, small-cap equities recovered a bit in October after falling close to 29% from the highs of late April.

October’s 15.1% gain for the small-cap Russell 2000 Index was a toxic mix of constantly reversing positive and negative rumors regarding the European debt crisis, laced with fears of continued economic weakness in China, and spiked with surprisingly positive third-quarter earnings. For the moment, the risk trade is back on, though sentiment remains decidedly negative. To be sure, investors are positioned for the worst. Yet one has to wonder when sentiment and headlines will finally take a back seat to fundamentals.

From our perspective, this is a near-perfect environment for active managers with an absolute orientation like us.

From our perspective, this is a near-perfect environment for active managers with an absolute orientation like us. Expectations are low, valuations are attractive and corporate cash continues to build. As we have seen and heard in many third-quarter earnings reports, fundamentals are clearly better than the dire daily headlines.

The markets need only a whisper from a few catalysts for the “glass-half empty” sentiment to reverse quickly and fundamentals to come into focus. Interestingly, there are several trends in the market that are worth highlighting because they could be these very catalysts. First, we think it’s generally a good time to invest when the people closest to the businesses we are buying are also investing. It should come as no surprise then that insider buying activity is spiking back to levels last seen in 2008-2009, according to JP Morgan. Second, a major trend coming out of third-quarter earnings is that the amount of corporate repurchases is on the rise.

While we don’t yet have official numbers for the third quarter, JP Morgan reports that “buybacks totaling $19 billion by Russell 2000 companies occurred in the second quarter of 2011.” We suspect that number increased dramatically in the third quarter as the market collapsed. Finally, merger and acquisition activity continues to rise. We have often viewed the strategic consolidation of a particular industry or sector as a positive. A recent JP Morgan report highlighted the fact that merger and acquisition activity in the U.S. has risen 140% to $1.3 trillion during the last twelve months. The report went on to say that “even during August, with markets gyrating, M&A activity rose 30% during the month on a year-over-year basis.”

While there is no easy answer to the question of what happens next, we have always believed in the critical importance of focusing on what we know and not worrying about what we cannot control. At the end of the day, we are risk managers first and foremost.

So while many investors continue to focus on economic volatility, seizing on every piece of macroeconomic or political news to gain a sense of the overall shape of the economic future—and position their portfolio accordingly—we remain focused on individual companies and the opportunity each presents. It should be noted, however, that as business buyers, we are struck by the strategic actions of corporations in this uncertain environment.

Stay tuned…
FDG