Warren Buffett’s Annual Letter: Mistakes, Buybacks and Apple
Warren Buffett published his annual letter to shareholders over the weekend. The annual update, which has become one of the largest events in the calendar for value investors, provided Buffett's views on one of the most turbulent and extraordinary years for the financial markets in recent memory. Q4 2020 hedge fund letters, conferences and more Read More
Small-Cap Investing In An Election Year
- First-quarter performance
- Small-cap perspective
- Portfolio performance, positioning and outlook
- Second generation portfolios, first class results
- Q&A with Chuck, Whitney and Jack
First-Quarter 2012 Review (through 3/31/12)
- The rally that began in 2011’s fourth quarter continued in 2012’s first quarter-Russell 2000 has its best first quarter since 2006
- Performance from the October 3, 2011 market low through March 31, 2012 remained impressive for all indexes and especially small-cap
- 2012’s first quarter also saw the Russell 1000 reach a new high, while the Russell 2000 and S&P 500 indexes remained 2.5% and 1.0% below their peaks set in 2011 and 2007
- Three-year average annual total returns ended 3/31/12 were especially robust; five-year average annual returns were considerably tamer
- Non-U.S. equity indexes fared equally well during 2012’s opening quarter
- Within small-cap, growth led the way in 2012’s first quarter
- According to Bank of America/Merrill Lynch, the dynamic first quarter favored non-dividend-paying companies
- Micro-caps enjoyed especially strong first quarter performance
Second Generation Portfolios, First Class Results
In Core and Core + Dividends categories where we offer multiple funds, our second generation offerings:
- Offer greater flexibility in terms of market cap range
- Are typically smaller in size
- Have a greater percentage of investments outside the
However, portfolio manager continuity and investment approach are generally consistent across each Fund, be it first or second generation offering
Please note, we will only be answering questions about our open end funds. All performance information reflects past performance, is presented on a total return basis, and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Current month-end and quarter-end performance information is available on roycefunds.com. Please read the prospectus carefully before investing or sending money. You may obtain a current prospectus for any of the Royce Funds on our website at www.roycefunds.com/prospectus, or by calling 800-841-1180. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. The distributor of the Royce Fund and Royce Capital Fund is Royce Fund Services, Inc., a wholly owned subsidiary of Royce & Associates. This event will be recorded. I would now like to introduce Jack Fockler, Managing Director of Royce & Associates.
Jack Fockler: Good afternoon, everyone, and welcome to our twice a year conference call for investment advisors. My name is Jack Fockler. With me today is Chuck Royce, and Whitney George and David Nadel, as well.
In today’s call, we want to address first quarter performance. We want to also talk about portfolio performance, positioning and outlook. We want to spend a few moments talking about some of our second generation portfolios. And most importantly, we want to save time to answer your questions. If you have a colleague, or colleagues, who are unable to join us today, a replay of the call will be available starting later this week on the Advisor section of our website, roycefunds.com.
Let’s get started. As you probably know, 2012 has gotten off to a great start. It is, in fact, one of the best opening quarters for the Russell 2000 since the first quarter of 2006. The small-cap Russell 2000 was up about 12.4 percent through the end of March. This compares to gains of 12.6 and 12.9 for the S&P 500 and Russell 1000 and 18.7 for the tech-oriented NASDAQ Composite.
Also, in contrast to last year, volatility is down dramatically as measured by the VIX Index, down about 30 percent. Performance actually from the market bottom on October 3rd has been very dynamic, and especially for small-caps. The Russell is up about 37 percent from that low through the end of the first quarter. The Russell 1000 also made a new high in the first quarter, and the Russell 2000 and S&P 500 are trading at miniscule amounts below that level.
Three-year returns, as you probably know, have been very dynamic. They’re above 20 percent for all major indices, and five-year returns are dramatically tamer, 6 percent or below for all the major indices. And finally, non- US equities actually did quite well also. Small-caps actually did better abroad than they did in terms of large caps. So we’ve gotten off to a pretty dynamic start. Let’s go to Chuck for some thoughts on performance in the first quarter. Chuck?
Chuck Royce: Sure. We were thrilled with the overall market’s behavior. We had been sort of optimistic for this year, and remain optimistic. We had felt that there would be a gradual decline in sort of the headline activity that had kept people off balance all of last year, and that, although the major issues are not resolved, we thought the stock market would be more likely to respond positively to just the slowdown of incremental bad news. So we are thrilled with the market performance and our own performance.
Jack Fockler: Do you think this can continue, Chuck, through year-end?
Chuck Royce: Well, it certainly can continue at the rate we started off on. I think we’re going to have a bumpy but positive rest of the year, and I think the year is going to be an excellent one.
Jack Fockler: Looking out over the decade, what are your expectations?
Chuck Royce: I think we’re in a decade of reasonable returns, 6 to 9 percent, nicely better than the prior decade. I believe that without being able to point to specific reasons why we’re going to get there, but I think there’s a remarkable sort of pent-up demand for equities, and the performance of the underlying companies are certainly in excess of 6 to 8 percent.
Jack Fockler: The returns for both US indices and indices abroad were very closely correlated here in the first quarter. What’s your take on this?
Chuck Royce: The correlation continues. The directional correlation is a fact of life. It isn’t our preferred way the world works, but that’s what’s going on. There is more non-correlative, you know, within an index. Certainly sectors do well, other sectors do poorly. That’s — that is going on. Everything is not directionally correlated. But certainly, globally, it’s directionally correlated.
I do think that will separate out over time as various styles do better or worse. So I do think correlation is not permanently at the level it is, but it’s certainly a fact of life.
Jack Fockler: There’s a lot written in the professional press about large-caps being more attractive than small-caps. What’s your take on that?
Chuck Royce: Well, that’s the big thing out there. That’s the new big thing, is large-caps are inherently undervalued, and certainly you can make a statistical case for that. The issue — I think it’s way too of a generalized thought. In
the small-cap world, first place, it is multiples, 10 or 15 times bigger than the large cap world in terms of number of participants. You have very, very clear sectors and styles that are nicely underpriced relative to large-cap. In the higher quality world, which is, call it, the top 10 or 15 percent of small-caps, we believe we can statistically document that they are, in fact, underpriced relative to similar large-cap stocks.
Jack Fockler: Let’s move on, talk a little bit more about small-cap very specifically. Obviously, if you separate into style, growth had a very good quarter. Growth had actually underperformed value in each of the last two quarters of 2011. It’s led the way here in the first quarter by about a couple hundred basis points. In fact, if you look at trailing returns for the one-, three-, and five-years, small-cap growth has done better, but when you go out beyond
that, 10 years and beyond, value tends to do better.
Dividends are something we’ve talked about in the small-cap universe. It’s not something people are really focused on. Last year, dividend paying stocks outperformed. This year, dividend paying stocks have actually lagged. Non-dividend payers within the Russell were up about 15 percent in the first quarter versus a gain of about 9.5 percent for those stocks in the Russell that pay dividends.
And then, finally, the small-end, the smallish end, if you will, of the small-cap spectrum, micro-cap companies, actually were the best performers. The Russell Microcap Index was up over 15 percent. What’s your take here,
Chuck? How would you characterize the current environment for both micro-cap and small-cap events?
Chuck Royce: I think that the micro is a truly differentiated sector in the small-cap space, and I think people should pay more attention to it. They’ve had — the micro-cap world has underperformed the last five years by 400- 500 basis points. Other sectors certainly underperformed the — our premiere style funds by 400 or 500 basis points. I think micro is going to do pretty well in the next five or 10 years.
The — there is real value, though, in keeping a presence in the micro-cap world as an investor. These stocks perform differently. They’re more volatile, but they give you higher returns.
Jack Fockler: Whitney, how about your take on this?
Whitney George: Well, I think a lot of what we’re seeing is some mean reversion. I think we — it’s hard to differentiate between small and large stocks, growth, value. Equities, as a general category, have been under pressure relative to fixed income alternatives now for a year and a half at least. Certainly, I think what you’re seeing is a lot of those areas that were hardest hit as people wanted to reduce risk last year for most of the year are recovering and as that appetite comes back a bit.
I do think all equities are moving nicely in tandem right now. And at some point, as the advance matures, you’ll have a little bit more sorting, stock selection. Certainly sector selection may start to weigh more importantly. But I think, essentially, everything that we’re seeing has kind of been rising in a bit of a vacuum that was created last year as people were so obsessed with the newly discovered risks of a smaller world that we live in.
Jack Fockler: A couple of sectors that were — that actually were detractors for our performance last year, Whitney, Materials and Technology stocks specifically have done pretty nicely here coming with the start of the new year.
What’s your case, going forward, for those two sectors specifically?
Whitney George: Well, there are actually two very different cases to be made. Both are viewed as very cyclical businesses, and so, when people worried about the growth prospects or another recession last year, they were obviously very — you know, very hard hit. And as those fears diminished and the economic numbers come through, and they’ve been coming through very nicely now for a very long time since the mid-fourth quarter, people again are
In the technology area, this is a whole very dynamic sector of the economy where America has a very strong leadership position, where there are new geographic markets for companies to address their new technologies, their new applications for those technologies, and then there’s Apple Computer, which seems to be driving everything right now. In fact, you can probably pin the market’s prospects on what happens with Apple’s results and what Ben Bernanke decides to do with monetary policy, and that’s probably 80 percent of what’s going to be going on in the headlines in the next 90 days.
Materials had marched to a different drummer. They were beaten up very badly. Commodity prices were hardhit last year, recovered very strongly for the first two months of this year. But as the Fed started to indicate that maybe they did need to do more quantitative easing, maybe the economy was going to limp along and do just fine by itself. Some of that trade has come off. And so, in the last month, they actually corrected back down, so they haven’t been quite as dynamic as maybe we would have liked. But it’s an area we do remain committed to.
Jack Fockler: David, talk about outside the U.S. Where are you seeing opportunities, and what’s most interesting to you at this point?
David Nadel: Sure. Well, we’re seeing opportunities really across the board outside the U.S. The small-caps outside the U.S. are trading at about a 30 percent discount to U.S. small-caps based on P/E’s, price-to-cash flow, etc., with a much higher dividend yield. So there’s a lot to choose from.
I think, in particular, we like Japanese stocks at this point. About a year ago, we doubled our exposure to Japan following the earthquake. It’s a market which, if you think back to the late ‘80s, comprised half of the world’s market capitalization. Today it’s about 8 percent. So it’s one of the cheapest markets in the world, and there are some signs of reform happening there that are positive.
Jack Fockler: How about inside the U.S.? Were there any areas of particular notice?
Chuck Royce: Yes. I think, in the last six months, we’ve been pretty fully invested, and there aren’t any major new themes going on that we can determine. There’s some confirmation of some themes that we have thought were interesting for a while. Industrial companies are actually doing very well. And when you start to talk to managements, they’re almost euphoric about current — the current outlook. But certainly there’s not a euphoric valuation placed on these kinds of companies yet.
Jack Fockler: Let’s talk about our own performance, if we can. We got off to a very fine start, as well, across the board with all of our funds. As you would expect, some of our more opportunistic type means — or type funds clearly had a very strong first quarter. Royce Opportunity Fund was one of our leaders, if not the leader, our Royce Value Plus. Within our focus category, Royce One Hundred had a very nice start. And we also saw some significant performance from our Global and International Fund, specifically European Smaller-Companies and Royce International Smaller-Companies. So again, across the board, performance seems about what you would expect, but we had a couple of pockets of exceptional performance.
Chuck, what do you think? I mean, obviously, we got off to a great start. About what you would expect or
what’s your take?
Chuck Royce: The more beta-oriented funds did the best, and that would be expected in a fast-paced first quarter, and that’s what happened. Our dividend type funds did less well, but that’s what also you’d expect. They did perfectly satisfactorily. Our worst performing fund was Total Return, with a return of 9 percent, and I’ll take that
Jack Fockler: David, you were able to eclipse the indices with the funds that you’re involved with. What’re your thoughts there?
David Nadel: Well, I guess you can never be dissatisfied with a kind of mid-teens return for a quarter. We did come off of a year in the form of 2011 where there was a huge bifurcation between U.S. markets and non-U.S. markets, with a lot of European markets down 20 percent, some of the emerging markets down 30 percent, for the full year of 2012 when, of course, the U.S. indices were basically flat.
So we were set up for certainly a snap-back. We were expecting a pretty good first quarter, and I think, interestingly, the non-U.S. markets have not really closed much of the gap versus the U.S. markets this quarter, with just a bit of out-performance, so we may get a continuation of this trend.
Jack Fockler: Whitney, interestingly, performance was up, but volatility is down in the first quarter. You think this is the start of something new?
Whitney George: I think we’ve had unusual volatility last year, and maybe we’re in a more normal volatility kind of environment now. I think investors have to become accustomed to living in a much smaller global world. I think the notion that Greece, with an economy I think about the size of Atlanta, could somehow send us spiraling into a recession is a bit of a surprise and a wake-up call, and maybe even an over-reaction.
And so I think, as we get used to European headlines, which are always very, very dramatic, we’ll all calm down about the news flow. Maybe this year we have to learn more about how China works, but, in general, I think investors just need time to digest this new information, this new smaller world that we live in that is more interconnected, and then rational pricing mechanisms will come back into play, and that hopefully will mean not the kind of volatility we’ve seen in the last couple years.
Jack Fockler: Chuck, your thoughts?
Chuck Royce: I think the lower volatility is a very interesting positive sentiment for the current stage of the market.
It is one of the things I might look at it, and I think it is indicating a — actually a better tone to the market. So I think, in a short-term sense, it’s a positive indicator.
Jack Fockler: Question for all three of you. What are you hearing from company management teams, specifically in terms of their respective businesses, or even in terms of the economy?
Chuck Royce: I’d say in some of the areas we’ve touched on in the technology area, we have managements that are cautiously optimistic to, again, outright excited about the recovery that’s taking place. They saw a dramatic reaction
late last year, or third quarter of last year, to concerns of a slowdown. Inventories got eliminated in two months to the tune that they had for over almost a year in ‘08, ‘09. And that’s coming back.
And again, I mentioned industrial companies. If you talk to people who are manufacturing in this country, and I think there were some headlines today in the Wall Street Journal, their orders are strong. Their outlook is strong. Their business is strong. And that’s a very important part of our economy that needs to come back and be healthy in the long run, you know, for us to restore some sort of equilibrium here.
Jack Fockler: David, any thoughts?
David Nadel: I guess, just in general, export-oriented businesses I think are quite bullish, because the world is going through kind of a competitive currency devaluation cycle. So I’d cite the example of German companies, for example, that are really benefiting from a relatively weak euro compared to where they’d be with a free-floating d-mark. But, export businesses in general I think are in a sweet spot.
Jack Fockler: Let’s move on, if we can, and we’ll talk a little bit about some positioning in the portfolio and some outlook, if we can.
One of the themes that Chuck mentioned earlier was this notion of quality. There’s been some works — some interesting work done by a research colleague, Jim Furey, that’s looked at quality very specifically in sort of the same vein, same as we do, by trying to sort and look at companies based on return on invested capital.
Jim has actually published some work which looks at not only the small-cap universe as measured by the Russell 2000, but the S&P 500 is sort of representative of the large-cap universe. And he’s tried to compare the two in
terms of return on invested capital, with the top quartile companies being the very highest quality, the bottom quartile being the very lowest quality. And one of the things that’s sort of interesting that you find on the slide
we’re now looking at is that, small-cap, the lowest quality companies are trading at not only a significant premium to their own universe, but they’re trading in a significant premium relative to large-cap.
The other end of the spectrum is quite interesting because the very best small-cap companies are not only trading the discount relative to their other small-cap counterparts, but they’re trading at a very healthy discount relative to their large-cap counterparts. It’s not something people really focus on very much, so it’s an interesting thought, which we’ll come to in just a moment for comments.
The second question that’s sort of on the table that we get from time to time is what happens with regard to equity returns in an election year. I don’t know that there’s something one can pull out quite specifically in those years in which a president is being elected. But if you go back over the history of the Russell 2000, you’ll find that we’ve had eight election terms, eight election years, since the start of the Russell back in 1979. You’ve had positive returns for equities in five out of the eight years, but perhaps the more interesting aspect is the year following the election year, so 1981, 1985, 1989.
And every year following the election of a president, all returns were positive, and all were very dynamic on the up side. So it’s not clear what will come of this year with respect to the election in terms of its impact on returns, but it sure looks like the year, starting the first year of the term, it’s usually quite dynamic.
Let’s go for some thoughts for Chuck. All right, Chuck, let’s go back to this quality idea, if we can. Talk about quality just a little bit more in terms of what you’re thinking about not only in the small-cap space but maybe even broader than that.
Chuck Royce: Sure. Quality — the quality theme we have been extremely active with for some time. And quality hasn’t necessarily saved you in the financial crisis. It’s — they did slightly better, but they did not perform the way we had hoped. But I think we are evolving to a different stage in the sort of economic cycles, more maturing of — the acceleration is declining, and I think quality is demonstrably a better approach for the next phase of the economic cycle.
Jack Fockler: Talk about this whole presidential election thing. Do you see anything at all? Do you have any feeling? I mean, we get this question all the time, but—.
Chuck Royce: —Well, I think — I think — now, we’ve had a very distracting time here in the primaries, and it’s obviously not over. But I think this is just among — this is the current headline du jour, and it may or may not have the kind of market impact that people think it does.
Jack Fockler: You know, Whitney, one of the things that you’ve talked about is… what are your thoughts about why people are so skittish about stocks in here? What’s keeping people away from stocks?
Whitney George: Well, we’ve had a very difficult stretch we’ve been through going back a decade, and so confidence — it’s very hard to build confidence when you’re not making any money for that long. Certainly the volatility that
we’ve experienced makes that even more difficult. And then finally, as I mentioned earlier, the world is smaller and become truly global. That all seemed very good in sort of 2004 through 2007, but we’ve certainly had a dose in the last three or four years of what the down side of being interlinked means, and again, the markets and people don’t like uncertainty or things they don’t understand, and so it takes time for people to understand the new kind of
environment and its ramifications for going forward.
Now, at the end of the day, that’s meant that people have sought the perceived safety of fixed-income instruments. People need income, and I think they will eventually come back to equities, which can provide income through the forms of dividend, and they can grow that income. And that’s something you can’t get when you buy a 10-year or a 30-year fixed instrument.
So in addition to that, there is inflation protection, and we have a Fed now who has said they’re not going to ease anymore unless the economy starts to slow down or inflation goes below 2 percent. So you actually have a targeted inflation rate of 2 percent at the same time people are locking into a rate that’s not very different from that. And so I think equities are going to come back into the mix as people become accustomed to this new environment.
Jack Fockler: Speaking of equities, how should people think about equities, David, from an asset allocation standpoint, specifically non-U.S. versus U.S., or global allocations?
David Nadel: I mean, I suppose it varies quite a bit on your objectives, but the number is probably higher than you might initially assume that non-U.S. stocks are about 70 percent of the world’s market capitalization. So I would certainly think an allocation of 5 to 10 percent for non-U.S. small-caps is — that’d be fairly logical.
Chuck Royce: I agree. I think that the case for stocks in general is as clear-cut as it’s ever been. Stocks represent sort of compounding machines that allow the enterprise to adapt to all of these complicated economic circumstances going on. If we pick well the kinds of stocks that we seek, they will be able to compound I think comfortably over 10 percent over long periods of time, and we’ll get approximately that return adjusted for the mistakes we’ve made. And I think that is such a superior way of dealing with inflation and complications that it vastly is better than any
Jack Fockler: Let’s go on to our last section, if we can, and talk a little bit about our — what we commonly refer to as our next generation, or second generation portfolios. A question we often get is, within your asset — within your categories, your fund guide categories, oftentimes there’ll be more than one choice. How should we think about the funds that populate — how should we think about the category? And specifically, how do we pick funds when there are multiple funds in each of the categories?
I think if you think about it contextually, with respect to our — sort of our flagship offering, and then the next generation offerings, one of the things you’ll find is that there are some things that one can deduce by looking at the next generation offerings. First and foremost is that, typically, they offer greater flexibility in terms of market cap, meaning they have a little wider market cap potential from an investment standpoint. And almost generally, almost definitely, they typically operate with a higher market cap, and that’s purposeful.
Secondly, they do tend to be a little smaller in size. And third, they do tend to have a greater percentage of investments outside the U.S. So there’s definitely some differences that the next generation funds have, and — which basically translate into a little bit greater flexibility.
What’s also interesting is that there’s a fair amount of manager continuity between the initial fund and the next generation. Typically, in terms of who the manager is — for example, Chuck is very involved with Pennsylvania Mutual Fund and its successor, Heritage Fund, as he is with Total Return and Div Value. Whitney George obviously is very involved with Royce Premiere Fund, and then Royce Value Fund. So there’s definitely some continuity associated with that.
Let’s go to Chuck for some thoughts. How should advisors think about our second generation funds? How should they position them, if you will, within their portfolios?
Chuck Royce: The primary distinction will be the cap size. We have more flexibility, but, in fact, the portfolios are run with larger — in larger weighted average cap size. In the case of our Premier-type funds, Royce 100 and Royce
Value, both have larger cap sizes than Premier.
Whitney George: Yes, I think there’s one other element. First, these second generation funds, many are becoming teenagers already, so it’s not like it’s a new product. Another element is different people. Professionals like Jay Kaplan, Lauren Romeo, have been here 10 years, have come and are involved in the portfolio management — the portfolio creation idea based on the core Royce discipline. And so we are able to, I think, offer maybe a long runway in these next products with people who are very well-established running them from day one, and with added flexibility because, again, we have matured as an
Jack Fockler: Okay. Why don’t we finish here, and let’s go to Chuck, David and Whitney for any final thoughts before we open up for questions. Chuck?
Chuck Royce: Sure. I think we’re going to have a sort of — a generally positive experience for the rest of the year. I’m sure there’ll be a 10 percent decline stuck in there somewhere, but I feel extremely strong about the prospects for the equity markets in general over the next three-to-five years.
Jack Fockler: Whitney?
Whitney George: Yes, I would agree with that. I mean, I think we’ve had lots of scares. I think the market is getting used to kind of international headlines. And valuations are not stretched. Valuations got very depressed in the latter part of last year, and so we are by no means at levels where we’re finding it hard to find interesting new ideas, and again, find the opportunities to go back to some old favorites that might disappoint from time to time.
Jack Fockler: David?
David Nadel: I guess I’ve got a slightly different parting thought, which is just in terms of our non-U.S. investing, try not to make the mistake of judging a book by its cover in the sense that we have a lot of developed market companies, but they are getting — their growth is being driven by exposure to emerging markets, and their sources of both revenue and costs are often quite diversified geographically.
So it’s I guess essentially a message of it’s a complex picture in terms of currency exposure and revenue drivers. And just because you see a lot of German businesses or UK businesses, don’t think of them as solely European local businesses, because they’re often quite global.
Jack Fockler: That concludes the formal part of what we wanted to share. We have questions that have come in over the Internet. But I think, before we get to those, we’ll start with questions from those of you on the phone. So, Operator, if you’ll please open up the lines, and let’s take our first question.
Operator: At this time, I would like to remind everyone, in order to ask a question, please press star-one. Again, that was star-one to ask a question. There are no questions at this time.
Jack Fockler: Okay, we’ll start with the ones that have come in over the Internet. How can top line growth continue if consumers are hurting so much?
David Nadel: I think that’s an issue that consumer stocks face, and retailers and restaurants and things like that, and it is going to be a difficult slog. The opportunities for us are not so much finding the — you know, the fast top line growers so much as those that are taking market share and competing the good old-fashioned way. We probably are over-stored and over-restauranted still in this country, but there are some very, very well run
businesses that are doing just fine. And so, again, I think you have to pick.
Now, there are other industries where top line growth is strong. I think to get back to manufacturing; we were experiencing a recovery in manufacturing in this country before the crisis of ‘08. It was very nascent, and it has just been accelerating every time we’ve been growing in this economy, and I think people are — it’s the idea that jobs leave America to go to foreign shores where labor is cheaper is outdated and maybe even shifting. But it will take some time, I think, before the market catches on, but the results and the top lines of the companies involved in manufacturing are doing very nicely.
Jack Fockler: Someone wants to know a little more perspective on Japan at this time, David. You gave a couple thoughts. Do you have something else you’d like to share?
David Nadel: Well, not too much specifically. I mean, it is certainly statistically probably the cheapest developed market, and the businesses that we focused on in Japan are export-oriented. We think it’s a proxy for asian growth in general, and typically we feel like you’re getting the higher quality corporate management and slightly better corporate governance than a lot of Asia, usually much longer operating history with Japanese companies.
I mentioned the statistic before that Japan used to be about half the world’s market cap, and today it’s about 8 percent. Most of that market capitalization basically shifted to emerging Asia, which people were more excited about directly. But emerging Asia comes with a risk in terms of execution, and in Japan you get quite rich dividend yields, taxes — corporate taxes are being lowered a bit, and often really quite world-class businesses.
It’s not a perfect environment to invest in. Culturally it’s quite different from us, but I think, relative to other choices in Asia, it can be quite appealing.
Jack Fockler: Another question that’s come in is talk about the kind of environment that is the most difficult to work in, or one that’s the most advantageous. I’m not sure if they mean in terms of investing or in terms of
returns, or both.
David Nadel: Well, I think for us, we will shine better in a below-average return environment, let’s say, in the lowish environment. We will tend to lag in almost all of our products in a high return environment. I don’t think we’re going to enter into a high return environment other than a quarter here and there.
But in general, we — our type, our style, our risk averse style gets you extra points in a lowish return environment. So that would be my favorite environment.
Jack Fockler: Concerns about hard landing about China and its impact here in the U.S.
David Nadel: Yes. I mean, there certainly is plenty of evidence of overcapacity in China, and there is a risk of hard landing. We don’t think it’s going to be all that hard. Obviously that would be a very hard — a very hard landing would be clearly negative impact here. We’re certainly counting on some stabilization, or a less-than-dire scenario in China. But we don’t really see signs of a hard landing. We think the consumer is actually in a pretty good spot, and that is certainly supported by a lot of statistics.
Jack Fockler: What sectors do you think look most interesting in terms of M&A, potential M&A activity?
Whitney George: Well, whenever you get the largest companies in an industry trading at large premiums to the smaller companies in that industry, you have kind of the logical math that allows for M&A, because large companies get bigger by buying smaller companies.
So I’d say certainly in the materials sector, bigger companies get premium valuations to smaller so that they can make accretive acquisitions. That’s been going on probably for eight to 10 years now, and there are just some businesses that you can’t grow organically. You have to go out and acquire assets to continue to do that. Again, I would expect those areas that are depressed or challenged, certainly in the natural gas business with prices where they are, one could expect to see some opportunistic consolidation take place there.
The M&A cycle sort of shut down a bit towards the end of last year as people were very uncertain about economic outlook. And it does seem to be now just starting to come back. You’ve seen a couple of announcements here recently, and so I think it probably would make sense now for M&A activity to pick up in all sectors.
Jack Fockler: Question, dividends did particularly well in 2011. What’s your long-term take on dividends and their impact for small-cap returns?
David Nadel: Well, the interesting thing about dividends is people do not associate dividends with small-cap world, and yet we can find enough securities to build very interesting portfolios that pay 2 to 4 percent in dividend yields. I personally believe that, at the low end of dividends, the low end of yields, that the marketplace does not price in those 2 and 3 percent dividends, and you sort of get them for nothing. That’s a dangerous statement to make, but I think you can nicely improve the risk adjusted returns by using dividends and small-caps together.
Whitney George: Yes. I think we have sort of the preconditions, or the formula, to find those companies that are most likely to pay and increase their dividends, i.e. we are starting with companies with very strong balance sheets.
That just means there are no other constituencies in front of you, like banks or bond holders, to lay a claim on whatever a company makes. And we’re looking for high return businesses. They generate free cash, and ultimately that cash very often gets returned to shareholders and dividends, and growing dividends.
So just by virtue of the fundamentals that we’re looking at, I think we have a better than average chance of identifying those companies that will pay and will continue to increase their dividends down the road.
Jack Fockler: Let’s go to the operator for questions out in the — out in the field.
Operator: Again, I would like to remind everyone, to ask a question, please press star-one. You have a question from Robert Jackson.
Robert Jackson: When do you expect the leadership to move from growth to value?
Chuck Royce: I think that’ll happen in various phases. Growth has been a leader in this — in the recent advance. That’s perfectly normal to happen in a more — but there will be tremendous rotation. I’m completely convinced that value gives you a better bang for your buck in the long-term. So I do expect rotation, though, in the shortterm, and that’s what’s going on.
Robert Jackson: Got it.
Operator: There are no further questions at this time.
Jack Fockler: Couple more that have come in here. Let’s see here. Besides Germany, what other countries do you see — countries, excuse me — taking advantage of depreciating currencies?
David Nadel: Well, I mean, I think the U.S. is taking advantage of a depreciated currency. I mean, we — you know, Obama made the statement that he wants to double exports within five years, and yet we hear that we’re officially pursuing a strong dollar policy. Those two statements are not compatible for an economy that’s growing 2 or 3 percent a year.
Virtually every economy in the world is trying to — is trying to have a weak currency at this point. I mean, Brazil is taking steps to weaken its currency. Korea, to a certain extent, is a beneficiary. But Germany is the obvious example just because it is such an export machine and really relies on that structure. But other economies in Europe that are Euro-linked that are in a much stronger position than peripheral Europe are beneficiaries. I mean, Austria is a clear example of that. And obviously, the Swiss intervened last summer to set a line in the sand in terms of their currency appreciating. So really everyone’s trying to beat down their currency to stimulate exports.
Jack Fockler: Whitney mentioned in his comments about materials earlier. You want to give some additional thoughts on the — on silver versus gold?
Whitney George: Sure. Well, silver does tend to perform better in a better economy because of its industrial uses. It’s sort of sometimes a precious metal, sometimes an industrial metal, so obviously, if people are worried about the
economic global picture, they’re going to be probably using gold and not silver.
Some interesting statistics, and we did a white paper I think you can get off our website that’s got probably more than you need on silver, but there’s just — relative to its price, there’s just not that much around, so maybe there’s a couple billion ounces of silver floating around the world above ground, which is about the same as the ounces of gold, but of course the price is very different.
So it’s kind of like the micro-cap precious metal or small-cap precious metal for us with this industrial kicker. And so, if things go the way we think they might go over the longer run, it could be a lot more exciting.
Jack Fockler: Operator, go to you with any other questions. Operator: Again, that was star-one to ask a question. There are no questions.
Jack Fockler: One final question that’s come in relates to the impact of rising gas prices on equities in general.
Whitney George: You know, no one really knows where the threshold is for where gas prices shut the consumer down. I think they’re higher. They’ve been high before, so it’s not quite the same shock. Somebody else pointed out that heating prices around the country may be down in your home to the extent that people are buying natural gas, and so there’s a little bit of an offset there.
Ultimately, we pay a lot less for gasoline here than the rest of the world. And as the world gets smaller, there’ll probably be some adjustment to that arbitrage. I think it has more to do with the rate of change than it does with the actual level of prices, because if people have time to adjust their driving habits or the kind of cars they drive, then they can handle it. It’s when there are sudden changes that it becomes disruptive.
Chuck Royce: Follow up on what you said, I was in England about three weeks ago, and the price of gas over there was a little over $9 a gallon versus what we have here, which is a little under $4 a gallon. So it’s quite a differential, as you say, around the world.
Whitney George: Yes. If you’ve got a big SUV, it really hurts when they jump up. But if you have time to adjust, then it’s not so important.
Jack Fockler: Let’s go to the Operator one more time for any final questions. We’re done on our end.
Operator: There are no questions at this time.
Jack Fockler: Great. Thank you very much for your participation. We’ll look forward to speaking with you again in the fall. Take care.
Operator: This concludes today’s conference call. You may now disconnect.