Royce Funds – The State of Small-Cap Valuations

Royce Funds – The State of Small-Cap Valuations
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Q&A with Jay Kaplan Last updated October 07, 2014

With the U.S. economy and employment rate slowly improving, small-cap valuations may not see a correction significant enough to offer attractively discounted share prices any time soon—at least at the levels that Royce typically seeks.

Portfolio Manager and Principal Jay Kaplan discusses how he’s been managing his portfolios in a market environment that’s been largely unkind to value investors and talks about some names he likes going forward.

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As someone who buys stocks with a business-buyer’s perspective, what have been your biggest challenges through the first nine months of the year?

I think the biggest challenge is the state of small-cap valuations—as a whole they look high enough to me that even an additional decline in the 5-10% range would probably not create a plethora of great bargains unless, over time, we see earnings grow at a more robust pace than stock prices, which would change multiples and thus create some opportunities. (Watch Jay discuss adjusting to an expensive market with Consuelo Mack on WealthTrack.)

However, given that the economy continues to chug along at a modest pace and employment numbers continue to slowly improve, I’m not sure that we’ll see small-cap share prices drop to attractively discounted levels anytime soon.

Of course, there could be a shock—a geopolitical or other event that triggers a significant sell-off. Otherwise, however, very few companies look undeservedly cheap right now—most low-multiple stocks look cheap for very good reasons.

An accommodative Fed and a growing economy make it hard for me to see the valuation picture shifting much over the next several months. So I’ve been staying with old favorites at higher valuations than I would normally like.

But today, it’s an easy choice to make between holding a high-confidence pick and rooting around in the bargain bin where very little looks good.

Can you give two examples of high-confidence picks that have done well so far in 2014?

Two Energy companies—Helmerich & Payne and Unit Corporation.

Both were terrific performers in the first half. Each corrected a bit in the third quarter when oil prices were slipping, though they remained among Royce Value Fund’s top performers year-to-date through the end of September.

Helmerich & Payne is an old Royce favorite that provides contract drilling of oil and gas wells and operates land and platform rigs. New orders for its technologically advanced rigs continue to come in at an accelerating rate—the opposite of what happened in 2013.

With business booming, the company continues to take market share while attracting customers who don’t mind paying a little more for Helmerich’s higher-quality products. The company also has a great reputation for quality in terms of its crews and drilling efficiency. It’s a perfect example of a high-confidence company.

Unit Corporation is another great example. It goes against the grain in terms of its business model because it is both an oil and gas producer and an energy services business.

Wall Street traditionally looks at these businesses separately, so by doing both Unit has always been an anomaly. We’ve liked the company for many years because it has historically been successful across all of these related business lines.

So far in 2014, its E&P (exploration & production) business has recovered nicely, its midstream business that transports and processes natural gas has been doing very well, and its drilling business, like Helmerich & Payne’s, has improved. In addition, Unit’s new BOSS rigs have seen a pick-up in demand.

But today, it’s an easy choice to make between holding a high-confidence pick and rooting around in the bargain bin where very little looks good.

Can you talk about a company that has struggled a bit this year but that you still think has strong long-term prospects?

The first name I thought of was Atwood Oceanics because it’s also an Energy company, but it hasn’t yet enjoyed the kind of success that Helmerich & Payne or Unit have so far in 2014.

It’s a good example of why we generally don’t make sector bets at Royce—not every stock in a sector or industry is going to perform the same way.

So first and foremost we’re stock pickers who prefer to look at companies from the bottom up. And on that fundamental basis, I see a lot to like about this company in spite of the fact that it’s lagged some of its small-cap sector peers this year. (Learn more about Jay’s investment approach in WealthTrack Web Extra: Jay Kaplan on Translating His Early Experience with Bonds into Small-Cap Stock Analysis.)

Unlike Unit and Helmerich & Payne, Atwood is an offshore drilling contractor that specializes in deep-water drilling. That area of the drilling business has suffered from an oversupply problem that has put pressure on pricing for both rigs and drill ships.

The company’s rigs that are currently under customer contracts provide for a very solid 2014 and go a long way toward providing visibility into 2015’s results. However, the company is also taking delivery of two large new drill ships in 2015 for which it does not yet have contracts, and this has the market worried.

I think most of this anxiety is reflected in the stock’s price. I also think it is reasonable to assume that Atwood will find work for these state of the art, high-quality ships (although the pricing could be pressured), which should boost the stock price.

Finally, I like that the company has recently initiated a dividend with a stated goal to increase it over time.

Another company that I think has promise is Convergys Corporation, which is based in Cincinnati and runs a global call-center business. Earlier this year, it acquired a competitor—Stream Global Services—that gave Convergys a greater presence in Europe and Latin America while also bringing in new customers.

The roster now includes AT&T, Comcast, DirectTV, and Microsoft. I like the way the new business has been integrated.

Revenues were challenged in the most recent quarter following the loss of the U.S. Postal Service as a client and some weakness across its communications customers.

However, the profit outlook for 2014 remains solid because the company has cut costs and gained some synergies via the acquisition. Convergys has also increased its dividend, bought back stock, and continues to generate free cash—all things that we like.

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