Chris Clark Discusses Current Small-Cap Opportunities with Asset.tv by Royce Funds
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President and Co-Chief Investment Officer Chris Clark discusses opportunities in small-caps for the rest of 2014 with Asset.tv’s Evan Cooper at the Morningstar Investment Conference 2014.
Evan Cooper: Chris, give me Royce’s view of a small-cap market looking ahead toward the second half of the year.
Chris Clark: Sure. It’s more obviously coming off of a very strong run in small-caps in 2013. It was also a period where it was very even in terms of the pace of returns throughout the whole year. That seems to have changed a little bit in 2014. We’ve had three pullbacks of roughly 8%. But nonetheless, we think that there are real opportunities in the small-cap space as we look out, not only through the end of this year but even out two to three years, especially in the areas that we’re very interested in focusing on.
Evan: Tell us about those areas. What makes Royce’s approach to small-cap unique?
Chris Clark: Obviously, it’s a very big, labor intensive asset class. It’s also one where the businesses tend to be more fragile. We take an approach where we invest in the highest quality businesses that we’re finding in this segment of the market. What we mean by quality are businesses that have very good balance sheets. They are not capital intensive businesses, typically. They have very high internal rates of return. We prefer to look at returns on assets and returns on invested capital as opposed to returns on equity, which obviously can be predicated on leverage. Then we look for market position. We look for companies that have a discernable competitive advantage in the areas in which they operate that distinguishes them from their competitors.
Evan: Are they in particular industries or are they all over, across the board?
Chris Clark: We’re agnostic. We look all over the market. We’re thought of as value investors because we bring an absolute standard to everything that we do. We certainly don’t overpay for what we invest in. We’ll look at all sectors, irrespective of how they might be categorized or how investors might think about them. We’re typically looking for, again, high-quality enterprises across those sectors. Certainly the balance-sheet criteria that I alluded to would preclude some sectors from our area of interest—REITs and MLPs and Utilities. Highly capital intensive businesses, commoditized businesses, we tend to shy away from and we focus, again, more on those higher-quality businesses, whether they be in cyclical or more stable industries. We’re looking for these high rates of return.
Evan: What about glamorous ones like the ones in high tech?
Chris Clark: We don’t look there. Again, we are value investors. We do think about the absolute opportunity presented in the companies that we invest in, not necessarily the relative opportunity. We like growth but we just choose not to overpay for it—obviously, biotech and social media, Internet. There are some areas in the growth sector that have become very speculative. We shy away from those areas. We typically don’t participate when they do well, but conversely we’re not subject to the dislocations when they under perform.
Evan: Are these domestic stocks only or are they international as well?
Chris Clark: Predominantly domestic, although we have a range of funds now, dating back six or seven years, that focus exclusively on the international small-cap universe. The core of our business still is domestic in its orientation, cutting up the small-cap market in a number of different ways, but really focusing on U.S. companies in that space.
Evan: Let’s go into a little more the difference between high-quality and low-quality stocks in the small-cap area.
Chris Clark: That’s a very important distinction because, generally speaking, the small-cap area of the market is lower quality in its orientation than the large-cap space. Certainly, if you think about the benchmark, the Russell 2000, close to a third of it is loss making or non-earning. That’s very different when you think about the larger-cap indices. There tends to be, at times, great disparities between the performance patterns in the small-cap space because of that composition. Because of what has gone on post-financial crisis—the zero-interest-rate environment orchestrated by the Fed, quantitative easing—it’s disproportionately advantaged lower-quality companies. Rates have come down substantially. Levered businesses have had access to capital and have been able to lower their cost of capital. Lower-quality businesses have come through a very strong period of relative performance. We think we’re in a transition right now. The Fed is clearly embarking on a tapering pattern. Rates are maybe not going to rise precipitously here but they are rising and they will be higher in the future. We think that that’s going to be very supportive for higher-quality businesses, businesses that generate their returns predicated on their own qualitative characteristics, not outside forces, influences, and certainly not because of the Fed’s intervention to support asset prices. We think it’s very important to be active in the small-cap space. The benchmark, again, is a little bit lower quality in orientation. But amongst that component of the small-cap space that have the types of qualitative characteristics that we’re looking for, we find very, very interesting companies. We can build very robust portfolios and portfolios that look good both on an absolute and on a relative strength, even as you look up towards the larger-cap companies.
Evan: Are some of these companies, in terms of quality, dividend payers as well?
Chris Clark: They are for sure. The interesting statistic is there are about 640 stocks in the small-cap space that pay a dividend of more than 2%. There is a perception that small-cap is growth-y and speculative in its orientation. There are a whole host of companies that spend their whole lives in the small-cap space because they’re addressable market is what it is. But importantly, they have capital allocation discipline like you would expect in the small-cap space. We think that there’s a real opportunity in the dividend payers and especially those dividend-paying companies that have the opportunity to raise their dividend over time. This growth bond characteristic in a world devoid of yield we think is going to be a real preference of investors.
Evan: Also, many of the large-cap stocks are sitting on so much cash. Do these small-cap companies, the ones that you like, also have a lot of cash?
Chris Clark: They do. Interesting, with rates as low as they are, that cash has been a drag on earnings. It’s been a non-performing asset. What we do see happening is an increase in M&A activity. You’re starting to see a higher pace of corporate M&A activities—companies strategically acquiring others. We think that’s going to be a real phenomenon in the market. We think it’s going to be large buying small, especially in a world that is largely devoid of growth. Companies are really going to think about their capital allocation policies and think about M&A opportunities to enhance their own growth trajectories.
Evan: It’s good while you own them and it could even be better if somebody merges with them.
Chris Clark: That’s exactly right.
Evan: Thanks very much.
Chris Clark: Thank you, Evan.