Small-Cap Investing Today: Perspectives from Our PM Roundtable by Royce Funds
Chuck Royce, Francis Gannon, Whitney George, Buzz Zaino, Charlie Dreifus, Jay Kaplan, and Jack Fockler in an in-depth discussion about third-quarter and year-to-date performance, small-cap investing in the current environment, positioning and current outlook, the importance of process and discipline, and more.
The following is an edited transcript of The Royce Funds’ semiannual webcast and conference call held on October 1, 2014. Managing Director Jack Fockler was the moderator and Chief Executive Officer Chuck Royce, Co-Chief Investment Officer Francis Gannon, and Portfolio Managers Whitney George, Buzz Zaino, Charlie Dreifus, and Jay Kaplan shared their thoughts on third-quarter and year-to-date performance, current positioning and outlook, the importance of discipline, our perspectives on both the market and small-cap investing, and more.
Please note: The thoughts expressed are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.
Observations from the Quarter
Jack Fockler: Chuck, were you at all surprised by the higher level of volatility and specifically, what do you make of the current correction?
Chuck Royce: The volatility was of course largely on the downside. We believe that these cyclical forces where sometimes small-cap leads, sometimes it lags, is very much in the normal course of things.
This correction has been in people’s minds for some time. And in many ways, it’s come later than we thought it would. So I’m not surprised by this, and it seems well within a normal corrective phase.
Jack Fockler: Do you anticipate the large-cap stocks will continue to outperform through the end of the year or maybe even longer?
Chuck Royce: Well, I think that’s probably the big question on everyone’s mind is now that large-caps are doing very well, is this a short-term phenomenon or a longer-term phenomenon? There is not a clear answer on this. But I do believe for the same reasons that small-caps are down sharply now, they will return to leadership.
When it’s time to have a bottom, which I personally doubt is more than a month away, I think the reverse will be very sharp and swift.
Jack Fockler: Has large-caps’ relative strength been mostly a matter of reversion to the mean, or are there other factors at work here?
Whitney George: I think there’s some of that, as small-caps had a nice lead last year and are maybe taking a breather, certainly than large-caps. I just wanted to point out that the one-year spread between large and small is as large as it was back in the crisis, ’08 and ’09 period.
Charlie Dreifus: It’s inconclusive that some large part of this is reversion to the mean. What is unknown and makes it a little more difficult to assess is it really shouldn’t have happened now, given everyone wants to own U.S.-centric names.
The interesting phenomenon the true measure is how well or poorly Europe does, and other parts of the world, and how the large-caps react to that. Because they also have obviously as the dollar strengthens, the large-caps have a huge headwind in terms of translation profits because they earn so much overseas.
Jack Fockler: When we do see a reversal, if you will, or an up-period, where do you see market leadership, Chuck?
Chuck Royce: I do think market leadership after a bottom will actually come through small-caps. When the shorting of small-caps is reversed it may come swiftly and sharply.
Jack Fockler: Charlie, can we expect the U.S. economy to continue to gain momentum, even in light of more recent performance here?
Charlie Dreifus: The U.S. economy continues to be incredibly attractive. And that backs into what Chuck said about small-caps being favored because again they’re much more U.S.-centric. There’s a reason that Airbus is building a plant in Alabama and more recently there has been $58 billion worth of acquisitions by German companies of U.S. companies. Everyone wants to be here and earn profits here. The U.S. economy has no equal these days.
And so our position vis-à-vis the rest of the world continues to grow dramatically. Now what we’re currently seeing is that some economic data points are coming in softer than they were. But that’s the ebb and flow of the economy. The point is that we’re still in an improvement phase while the rest of the world isn’t.
Jack Fockler: So Jay, what can we expect from fundamentally sound small-cap companies?
Jay Kaplan: I think fundamentally sound companies are still performing okay. The U.S. economy continues to be fine. It’s not robust. But it’s nevertheless fine. Balance sheets are in great shape. Profitability remains in great shape. But some people have been worried that margins have peaked and are coming down, but we haven’t really seen any evidence of that yet.
And in the event that we actually get any kind of revenue growth, there is an opportunity for margins perhaps to even expand. So fundamentally, I think of most of what we look at is in pretty good shape.
Francis Gannon: Just building on the opportunity that’s being created today, the numbers that we have seen of late is that it’s roughly 40% of the companies in the Russell 2000 were down more than 20% from their peaks within the past 12 months, compared to about 6% for the S&P 500.
So as these big economic trends that Charlie and Jay are talking about continue to play out, the valuation and opportunity set in our asset class is significant.
Jack Fockler: Buzz, you tend to do a lot of work in the micro-cap area. It’s obviously been extremely hard hit. What are you seeing and what are your thoughts here?
Buzz Zaino: What you see is selling pressure. However, we’re also seeing a number of companies being bought out. There are attractive companies and there’s so much cash around simply sitting fallow in large corporations’ bank accounts that the temptation to acquire these companies is there. And it’s been happening certainly in our portfolio, and I would expect that that would perhaps increase in the days to come.
Jack Fockler: Chuck, as you alluded to, we are clearly on the path to a 10% correction. We obviously haven’t had one in more than two years, which is hard to believe. Are we on the way to a 20% correction?
Chuck Royce: Well, we’re past having a 10% correction as of today. This is the third sort of 8% plus of move from highs to lows, not necessarily from ultimate highs.
To me, this is just part of