Whitney George on 4Q13: Market Shows Resilience In Spite of Macro Headwinds

Director of Investments, Portfolio Manager, and Managing Director Whitney George comments on the market’s strength in 2013, sectors where he is seeing compelling long-term opportunities, positive developments in China, and companies in which he has high confidence heading into 2014.

Are you still seeing compelling long-term opportunities in the Energy, Industrials, Materials, and Technology sectors?

I think there’s a lot of potential in these sectors, which tend to be more economically sensitive and are thus well positioned to benefit from the faster-growing economic cycle we seem to be entering.

What remains particularly attractive to me is that many of our portfolio holdings in these sectors look strong to us on both an absolute and relative basis when it comes to balance sheet strength, returns on invested capital, and P/Es. In addition, many companies that we like in these sectors, such as Canadian energy services businesses, have not yet seen, or have only recently begun to see, share price recovery.

What do you make of the market’s strength in 2013?

The market enjoyed a tremendous year in the face of potential headline risk that could have led to a domino effect similar to what we saw in 2008-09. Yet we avoided the cascade from the Cyprus banking situation, the sequester and government shutdown here in the U.S., ongoing concerns since May about tapering, elections in Germany, etc. The market has been able to roll with each of these potentially upsetting events, showing a remarkable and encouraging amount of resilience.

What are the most interesting stories outside the U.S. right now?

I would have to say China. While there are certainly pockets of excess, it seems to me that its economy is healthy—it’s in a current account surplus, for example. I also think it’s a positive development that the government is concentrating on two key areas.

First, they’re comfortable with slower growth in exchange for quality growth—that is, with less pollution and more efficiency. They’re also making internal consumption a priority. There’s less emphasis on cheap exports and more about improving things domestically.

Can you talk about a couple of companies in which your confidence is relatively high as we head into 2014?

Two stand out to me—Myriad Genetics and Cirrus Logic. In 2012, we held good-sized positions in Nu Skin Enterprises and GameStop even as many other investors were convinced that both businesses were no longer viable.

In Nu Skin’s case, there were doubts about its direct marketing distribution set-up while GameStop’s video game business was allegedly destined to go the way of Blockbuster Video. Much of the criticism was coming from the hedge fund community, especially those with a much shorter-term investment horizon than we have here at Royce. There was also considerable short interest in both stocks.

We have noticed an emerging theme in the last couple of years. Large short sellers and their research support people have taken negative positions in some companies that we see as well-managed with strong long-term fundamentals. As alternative strategies such as long/short have grown in popularity compared to active small-cap management, we have witnessed some extraordinary opportunities develop.

We are reminded of the Ben Graham quote, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” At the end of 2012, the market had voted for a price of $37.05 and $25.09 for Nu Skin and GameStop, respectively. At the end of 2013 these two stocks weighed in at $138.22 and $49.26. While there are no guarantees, I see a number of similar misperceptions surrounding Myriad and Cirrus.

Myriad Genetics is a molecular diagnostic company specializing in genetic testing for cancer. It received a mixed ruling from a Supreme Court decision in June 2013 when it was decided that human genes can’t be patented.

This led its stock to fall, and its price has been highly volatile but mostly falling ever since. Short sellers represented about 45% of its float in mid-December because so many investors feared that the company can no longer compete or be profitable.

This seems odd to me because the firm remains a leader in its field, has recently delivered great financial performance, has introduced new products, and announced important business partnerships. Yet the perception persists that because the ruling threatened its near-monopoly in genetic tests for cancer risk, the company can no longer be successful.

Needless to say, we have an extreme contrarian view rooted in its ongoing success, its free cash-flow generation, and management’s practice of buying back stock.

Cirrus Logic supplies analog and mixed-signal semiconductors for several applications. After selling my position in the portfolios I managed during 2012, I began to re-establish a stake in 2013 when its stock price began to decline considerably. Concerns persist over how much of Apple’s business it can hold on to going forward—the consumer tech giant represents more than 80% of Cirrus’s business.

While we understand these anxieties, we like the company’s ability to innovate and lead in areas such as sound quality, voice recognition, and LED lighting controls. The short interest in the stock was hovering around 20% for much of December on the idea that less and less business would be coming from Apple, but we think this is a high-quality business that looked very attractively valued at the end of December.

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