An Encouraging Market Turn For A Disciplined Contrarian by Jay Kaplan, The Royce Funds
Portfolio Manager Jay Kaplan talks about this Royce Fund enjoying one of the best relative quarters in its history, why he has confidence in his core holdings, and how the shift toward a more normalized environment has so far rewarded profitability.
An Encouraging Market Turn For A Disciplined Contrarian
What do you think contributed most to the success of your disciplined contrarian approach during 1Q16?
Mostly, I think it was the market slowly returning to what I would call normal.
We went through three or four years of underperformance versus our small-cap benchmark, the Russell 2000. During this period, especially through the end of 2015, I made some mistakes— I held a little more in consumer and energy stocks than was probably best, for example.
However, the larger reason was that the market simply did not reward the kind of investments that contrarians like me typically make. Conservatively capitalized companies with steady profitability were not in high demand, especially in cyclical areas.
With investors favoring, at various times over the last few years, defensive, high-yield, and/or fast-growing businesses, our more measured approach suffered.
Of course, this isn’t unheard of. Before I joined Royce in 2000, I saw the same thing happening in the late ’90s to similar companies that I liked—profitable, free-cash-flow-generating businesses that most investors were ignoring in favor of hot dot.coms.
So I’ve been through periods like this before—I think every veteran contrarian has. There will always be times when disciplined, long-term strategies that focus on valuation and quality are out of favor.
When did you first notice a change in the market?
I began to see signs of a shift last summer. As equity prices fell and credit started to get tighter, the kind of companies I own started performing better, little by little, starting in the third quarter of 2015.
Increasing uncertainty about the economy seemed to lead more and more investors to begin rethinking their preferences.
Then stocks really began suffering in January and February of 2016 while most of my holdings defended very well.
So while there were signs of this shift as far back as last summer, it wasn’t until this year that I saw more consistent outperformance for my portfolios and the kind of companies that I like to purchase. In fact, 1Q16 was the best relative quarter for Royce Small-Cap Value Fund in 10 years and the second-best in its history.
There’s been a lot of conflicting noise about the state of the economy and markets lately. What have you been hearing from the CEOs and management teams you’ve met with about how the next several months seem to be shaping up?
I’m still hearing a lot of uncertainty because the global economic backdrop is not great—it’s not terrible, but it’s not terrific, either. The outlook from the Fed and other observers remains measured at best.
So there are even more unknowns than usual, which understandably makes corporate management teams a little nervous. However, the vast majority of the companies I own have not revised guidance down.
I think in addition to the “leverage is good” era ending, we may also be entering a period, at least in the short run, in which “not too bad” is good enough. Outlooks have certainly not been buoyant by any stretch.
That’s not the greatest news for the economy overall, but as an investor who owns a lot of companies where expectations were very, very low, with valuations to match, who’s now seeing these companies being reevaluated by other buyers, I like the results so far this year. But sooner or later, the earnings picture has to improve for growth to be sustainable.
What has driven the recent recoveries for a number of the trucking and transport companies you hold?
Valuations for a number of trucking and transport companies started to look inexpensive to me in the spring of 2015.
Volumes were low, and there were new regulations coming into effect. Expectations, even for the most fundamentally sound businesses in the industry, were very low, which put them right in my wheelhouse.
Things then grew appreciably worse through most of the rest of last year because of concerns about a possible recession. I was okay with these subsequent declines because I knew the recovery might take a while.
Then, earlier in 2016, it seemed clear that we weren’t headed for an imminent recession, and investors seemed to realize that certain companies in the industry were trading at prices that had already priced in that possibility, so we’ve seen some recovery so far this year.
Have fundamentals for these companies also recovered?
The industry is just starting to improve a bit—and improvement does not always run in a consistently straight line up. That’s why patience and discipline are so important to what I do.
For me, the key is that between the spring of 2015 and January of 2016, I invested in what I think are terrific businesses at prices I don’t see very often, with the potential for some of these companies to gain market share as a result of a new regulatory environment.
I have a long-term outlook for these companies. I don’t get too excited about short-term moves in any direction. I recently talked about some of these companies in more detail.
Can you discuss a couple of retail holdings and detail what you like about their prospects?
The overall industry is kind of all over the place, with a small number of businesses doing well, others struggling mightily, and a lot of companies in between.
Competition remains fierce. We’re also arguably “over stored” here in the U.S., which is another, related challenge for the industry. Most of my holdings are clothing or footwear retailers, where overall spending has fallen, though a warm spring may go a long way toward solving that problem.
That said, the pattern is the same one I described in more general terms—outlooks in most cases have not been revised markedly down, valuations at the end of 2015 were very low, and four of my largest positions, Shoe Carnival, The Buckle, DSW, and Deckers Outdoor, have each rebounded a little in 2016.
Can you tell us more about why you like these four holdings?
Sure. The business of Shoe Carnival remains solid—they’ve upgraded some of their women’s brands in order to try to gain business from the moms who are in their stores buying for back-to-school and holidays. I like the way they’re trying to grow the business in the face of some major challenges.
The Buckle is still facing some pricing pressure—the company has always resisted discounting—and slowed mall traffic, but its long-term success, measured by solid margins, particularly during difficult periods for apparel retailers, gives me confidence.
DSW is more of a long-term play. The company sells discounted designer shoes and boots, so the warmer winter hurt its business badly, which pushed it even further out of favor.
I think of it as a high-quality company. I like that it pays a dividend and that management was buying back shares at what look to me like significantly discounted prices.
Deckers Outdoor, which is best-known as the maker of Uggs, is working on broadening its product line away from winter footwear to more fashionable, all-season wares.
Its shares tend to move around a lot based on seasonal holiday sales, so its stock was hit hard by the warm winter and slower 2015 holiday sales cycle. Even as its shares have bounced back a bit, the Street still doesn’t seem to be expecting a lot in the near term from the company. I like its long-term potential.
Royce Small-Cap Value Fund remained overweight in Energy at the end of the first quarter. What is one of your key holdings in the sector?
It’s an interesting question. Energy is not a focal point for me in the portfolio—the sector’s weighting at the end of March was 6.0%, which was not much larger than the benchmark’s.
I also tend to think of my largest holding in Energy, Matrix Service, as more of an industrial engineering and construction company than a pure play energy business. Given that view, my weighting looks even smaller to me.
Matrix is has a sizable exposure to energy, but it also serves a number of other industries, such electrical power. In addition, its exposure to energy is focused on large-scale construction projects, such as above-ground storage tanks, and on engineering, retrofitting, maintenance, cleaning, and other services.
So while it often trades in tandem with oil and gas price sentiment, its business is not as directly tied to commodity price swings the way, for example, an exploration & production or rig services company would be. I see it as a large-scale construction company.
Its stock has been down with the decline in oil prices and a series of write offs it did for project overruns. However, the company has a strong backlog of business in both infrastructure and physical plant projects that I think will help investors ultimately recognize the value of this company.
In what sectors or industries have you been looking around in most frequently?
I’m always casting a wide net because it’s about the companies more than sectors or industries.
Most recently, I’ve been looking at Alliance Fiber Optic, which makes high performance fiber optic components such as interconnect systems and couplers and splitters.
There’s been a resurgence in the fiber optical business lately that hasn’t yet been fully reflected in the share prices of many companies, so I like the opportunity there.
I also like Ensign Services, which operates nursing homes and rehabilitative care services centers, often by buying underperforming facilities and vastly improving them.
It looked mispriced to me because most of its revenue stream comes primarily from Medicare, so there’s ever-present pressure on the business to do things better, faster, and cheaper. I think they’ve been really good at that, so I see a lot of potential for the business going forward.