Chuck Royce On The Current State Of The Small-Cap Market by Royce Funds

The small-cap market finished 3Q15 with a double-digit decline, in many ways similar to the correction investors saw around this same time last year. CEO Chuck Royce sits down with Co-CIO Francis Gannon to discuss why he believes corrections are a sign of healthy market behavior, the importance of risk management in the small-cap space, and why he thinks a new market cycle will favor companies with earnings.

See the video here.

Chuck Royce

Francis Gannon: So Chuck, another interesting quarter in the overall market. We saw a correction in August, we saw a rally, and now we are seeing another correction in the end of the month of September. What are your thoughts on the most recent correction?

Chuck Royce: The correction is really just that—it is a very normal process. Corrections are part of the market’s fabric; always have been, always will be. We get a 10%+ correction almost every year throughout time. I don’t see anything different in this correction than just that, so I would put it very much in the kind of normal range. Even if it expands to -15% or so, I would still think of it that way.

Francis: One of the more interesting things about this correction and the correction we had last year—we had a 12.8% correction in the market last year—is it seems to be an economic growth scare. We have seen several of these over the past several years, really, driven by our own fears of a double-dip recession in the United States, fear of Europe’s problems or Greece, and now it’s Asia, specifically China. Are you finding opportunities in the market because of that?

Chuck: We get a fear of something that triggers these things, but I really put them in the context of markets are cyclical, volatility is very normal, and certainly it will be healthy to shake out some of the speculative excess, and that is what’s going on. Of course, it sets up plenty of opportunity.

Francis: One of the things we have been hearing about, especially following the Fed meeting, was almost a growth scare from a global standpoint. What are you hearing from companies today from a bottom-up standpoint about their outlooks; the growth that they are seeing from their businesses?

Chuck: I would say we see, in general, very positive responses. Of course, in an economy of our size, we have a variety of trends going on simultaneously. In the Energy sector, of course, there are large weaknesses going on, but in other sectors we are booming. Homebuilding is booming. Some of the other sectors outside of energy or industrial areas are booming.

Francis: We talk a lot about real companies and their effect and how real companies in the economy really haven’t benefited from anything that the Federal Reserve has done over the past several years, and a tightening by the Federal Reserve, at some point this year, would actually be stimulative to the overall economy and could start a new business cycle where companies that actually have profits and earnings matter—because one of the things we have seen this year is negative EBIT companies outperforming. Do you think that is going to change?

Chuck: I absolutely do. I think we are already seeing that in this third quarter. Part of this correction is about a shift of what kind of company gets favored, and I see that shift being exactly what you are talking about—towards real companies—and I am thrilled with that shift. I do think that a return to normal in this market sentiment is going to benefit the kinds of stocks we favor, the real companies, the higher-quality companies.

Francis: How important is risk management in the small-cap space at this particular crossroads in the market then?

Chuck: Risk management is critical in the small-cap space. Risk management has been underappreciated in this essentially straight-up market. We have had a six year from the lows from the spring of ’09 right through June. We had a six year almost 17-18% compound return—way off the charts. Numbers are coming down now. We are having this correction. A new cycle will set up a new favoring of what you call real companies.