Small-Cap Investing Today: Perspectives from Our PM Roundtable by Royce Funds
Chuck Royce, Francis Gannon, Whitney George, Buzz Zaino, Charlie Dreifus, Jay Kaplan, and Jack Fockler in an in-depth discussion about third-quarter and year-to-date performance, small-cap investing in the current environment, positioning and current outlook, the importance of process and discipline, and more.
The following is an edited transcript of The Royce Funds’ semiannual webcast and conference call held on October 1, 2014. Managing Director Jack Fockler was the moderator and Chief Executive Officer Chuck Royce, Co-Chief Investment Officer Francis Gannon, and Portfolio Managers Whitney George, Buzz Zaino, Charlie Dreifus, and Jay Kaplan shared their thoughts on third-quarter and year-to-date performance, current positioning and outlook, the importance of discipline, our perspectives on both the market and small-cap investing, and more.
Please note: The thoughts expressed are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.
Observations from the Quarter
Jack Fockler: Chuck, were you at all surprised by the higher level of volatility and specifically, what do you make of the current correction?
Chuck Royce: The volatility was of course largely on the downside. We believe that these cyclical forces where sometimes small-cap leads, sometimes it lags, is very much in the normal course of things.
This correction has been in people’s minds for some time. And in many ways, it’s come later than we thought it would. So I’m not surprised by this, and it seems well within a normal corrective phase.
Jack Fockler: Do you anticipate the large-cap stocks will continue to outperform through the end of the year or maybe even longer?
Chuck Royce: Well, I think that’s probably the big question on everyone’s mind is now that large-caps are doing very well, is this a short-term phenomenon or a longer-term phenomenon? There is not a clear answer on this. But I do believe for the same reasons that small-caps are down sharply now, they will return to leadership.
When it’s time to have a bottom, which I personally doubt is more than a month away, I think the reverse will be very sharp and swift.
Jack Fockler: Has large-caps’ relative strength been mostly a matter of reversion to the mean, or are there other factors at work here?
Whitney George: I think there’s some of that, as small-caps had a nice lead last year and are maybe taking a breather, certainly than large-caps. I just wanted to point out that the one-year spread between large and small is as large as it was back in the crisis, ’08 and ’09 period.
Charlie Dreifus: It’s inconclusive that some large part of this is reversion to the mean. What is unknown and makes it a little more difficult to assess is it really shouldn’t have happened now, given everyone wants to own U.S.-centric names.
The interesting phenomenon the true measure is how well or poorly Europe does, and other parts of the world, and how the large-caps react to that. Because they also have obviously as the dollar strengthens, the large-caps have a huge headwind in terms of translation profits because they earn so much overseas.
Jack Fockler: When we do see a reversal, if you will, or an up-period, where do you see market leadership, Chuck?
Chuck Royce: I do think market leadership after a bottom will actually come through small-caps. When the shorting of small-caps is reversed it may come swiftly and sharply.
Jack Fockler: Charlie, can we expect the U.S. economy to continue to gain momentum, even in light of more recent performance here?
Charlie Dreifus: The U.S. economy continues to be incredibly attractive. And that backs into what Chuck said about small-caps being favored because again they’re much more U.S.-centric. There’s a reason that Airbus is building a plant in Alabama and more recently there has been $58 billion worth of acquisitions by German companies of U.S. companies. Everyone wants to be here and earn profits here. The U.S. economy has no equal these days.
And so our position vis-à-vis the rest of the world continues to grow dramatically. Now what we’re currently seeing is that some economic data points are coming in softer than they were. But that’s the ebb and flow of the economy. The point is that we’re still in an improvement phase while the rest of the world isn’t.
Jack Fockler: So Jay, what can we expect from fundamentally sound small-cap companies?
Jay Kaplan: I think fundamentally sound companies are still performing okay. The U.S. economy continues to be fine. It’s not robust. But it’s nevertheless fine. Balance sheets are in great shape. Profitability remains in great shape. But some people have been worried that margins have peaked and are coming down, but we haven’t really seen any evidence of that yet.
And in the event that we actually get any kind of revenue growth, there is an opportunity for margins perhaps to even expand. So fundamentally, I think of most of what we look at is in pretty good shape.
Francis Gannon: Just building on the opportunity that’s being created today, the numbers that we have seen of late is that it’s roughly 40% of the companies in the Russell 2000 were down more than 20% from their peaks within the past 12 months, compared to about 6% for the S&P 500.
So as these big economic trends that Charlie and Jay are talking about continue to play out, the valuation and opportunity set in our asset class is significant.
Jack Fockler: Buzz, you tend to do a lot of work in the micro-cap area. It’s obviously been extremely hard hit. What are you seeing and what are your thoughts here?
Buzz Zaino: What you see is selling pressure. However, we’re also seeing a number of companies being bought out. There are attractive companies and there’s so much cash around simply sitting fallow in large corporations’ bank accounts that the temptation to acquire these companies is there. And it’s been happening certainly in our portfolio, and I would expect that that would perhaps increase in the days to come.
Jack Fockler: Chuck, as you alluded to, we are clearly on the path to a 10% correction. We obviously haven’t had one in more than two years, which is hard to believe. Are we on the way to a 20% correction?
Chuck Royce: Well, we’re past having a 10% correction as of today. This is the third sort of 8% plus of move from highs to lows, not necessarily from ultimate highs.
To me, this is just part of the normal process that will go on. And I think it too will run its course. I do not think we will have a 20% correction.
The Role of Active Management in Small-Cap Funds
Jack Fockler: You all have sort of touched on this, but does anybody want to add to the notion of the case for active management?
Chuck Royce: Well, there are five hands in the room that just went up. We have a long-term view, of course, that active management will have a significant payoff. We believe there are truly factors why it has not in that last five years or so. And that relates to the extraordinary run from the bottom, and the extraordinarily low interest rates.
In very high-return periods, as risk managers, we are going to have lower returns, because we’re sort of not designed to have very high returns. So we feel we’ve done fine since the bottom. Risk management I think is a key to what we all are doing. And risk management in the one case means lower or stronger financial companies. They’ve been disadvantaged in this inferior company rally. That too, is expiring.
Rates will be returning to normal. And I think that will start sooner rather than later. And I think we will have, in general, a very strong ability to deliver outsize relative returns in the next couple of years.
Whitney George: I think the idea that equities represent a share in a business has sort of left the general investment lexicon. And we may be old-fashioned, but we are buying into businesses with managements, and trying to select good businesses that we can own over a very long period of time, with very low turnover, which certainly helps with expenses and taxes, that we think will give us a great long-term absolute return.
But I think in the long run, we are investing in businesses. I take comfort that recently Berkshire Hathaway hit an all-time high after noting in their annual report that they failed to beat the S&P 500 for five years for the first time ever. So that’s kind of my bellwether for quality active management in businesses.
Charlie Dreifus: Well, what Whitney just said echoes loudly. The last five years have been an anomaly. They just don’t happen. You don’t get 20% or whatever the return is over the past five years that often, if at all.
So off the bottom, it’s a very different experience. And it manifests in so many ways in terms of correlation and volatility.
So I daresay that the active manager universe in the next five years will look very different compared to this past five years.
The idea that equities represent a share in a business has sort of left the general investment lexicon. And we may be old-fashioned, but we are buying into businesses with managements, and trying to select good businesses that we can own over a very long period of time, with very low turnover, which certainly helps with expenses and taxes, and actively select those companies that we think will give us a great long-term absolute return.
Current Positioning and Outlook
Jack Fockler: There is no denying, of course, that macro headlines unduly influence equity market sentiment and performance. I think Whitney alluded to it earlier when he called what’s been going on the Yellen correction.
More defensive sectors, as we suggested, like Health Care and Utilities and industries like REITs, have clearly been performance leaders this year. As you would expect, because we subscribe to a bottom-up approach, it means that our sector weights can be at odds with the market, and therefore in the short term, you can have performance differentials that can be quite great, either positive or negative.
Our portfolios in general tend to have a bit of cyclical bias. And in general tend to have a quality bias, as we’ve suggested. So let’s go to some comments. What are you guys hearing from company management teams in terms of either the business or the economy?
Buzz Zaino: Well, certain segments are doing very well. We’re seeing a lot of those companies now showing bigger backlogs and greater sales.
I think retail is going to be pretty good this year, just on a comparative basis. It was so terrible a year ago that it’s a pretty easy comparison, especially with higher employment.
So we’ve got a lot of things going for us.
Charlie Dreifus: I agree with what Buzz said. But a little more like in this Goldilocks, not too hot, not too cold advance in the economy, you have interesting things happen that the entire supply chain is lean. The inventory-to-sales ratios all over the place are very low.
There’s a lot of concern about margins peaking and are they going to revert to the mean. And I don’t think so. Based on my conversations with companies and my deep dive into the financial statements, I’m seeing that companies have reduced their breakeven points.
And in some cases you’re seeing very high incremental operating margins. And in other cases, you’re not seeing that yet. Because the cumulative advance of these small fits and starts of increasing revenues have not gotten to the critical point to kick in.
But if we continue to have the Goldilocks environment, earnings levels are going to get higher as we improve the top line.
Jack Fockler: What’s going on in the energy zone?
In the third quarter, the Energy sector within the Russell 2000 actually entered a bear market, and was down 21%. It actually fell 17% during the month of September alone, so it was a pretty powerful correction.
Whitney George: This has been an area of focus for us, and probably overweight in many portfolios, particularly mine. And what I think the market may be discovering is that there is an opportunity for a real renaissance or change in energy policy, certainly in North America, and maybe even in this country.
Lower energy costs, which seems perplexing given what’s going on in the Middle East, and all of the other issues in the world, really caught people by surprise. But if you think about it, if there is a policy change to become more pro-production and actually export energy from North America, it solve a lot of problems. It’s clearly good for consumers.
So it’s something we all ought to be rooting for. We own a lot of Energy. But we tend to focus on service companies, not the ones that have the hydrocarbons in the ground. These companies are positioned to benefit from a renewed policy in this country, and certainly expanded efforts in Canada and now Mexico, which clearly seems on its path to make some major strides inviting international capital into their country to develop its vast resources.
So on balance it’s a good thing. The change in the price has created, as Frank pointed out, a correction across the board. But by actively sorting through the entire industry, there are definitely winners and losers that can be picked out and that’s what we’re doing right now.
Jack Fockler: Whitney and Buzz, you both have a keen interest in technology. What are you hearing from companies in that zone?
Our opportunity set is growing every day as the market continues to come down.
Buzz Zaino: Well, the reality is that the consumption of integrated circuits has just been exploding. If you think of all the advantages that are provided for us in automobiles and mobile communications, it’s not stopping. It’s continued to grow, and it is exhausting our capacity to produce them. So we’re seeing an increase in capital spending, or projected increases, especially next year. As the volumes grow, the profit margins grow.
Whitney George: I’d echo Buzz. I’d say there still remains a huge valuation discrepancy between hardware and software in the industry. Of course you need both. But hardware stocks, whether they make disk drives or various forms of analog chips, look to be incredibly reasonable, while software, particularly if you’re in the social media space, looks quite extreme.
Process and Valuation Are Crucial in This Stock-Picker’s Market
Jack Fockler: As everyone knows, we have had multiple rounds of quantitative easing. We’ve had the Fed’s zero interest rate policy. And these have clearly had a disproportionate benefit as it relates to lowering the cost of capital for most businesses.
There’s also, as we’ve suggested, been a pretty significant preference for a passive strategy in ETFs. This has clearly come at the expense of active management. There’s also an expectation that rates will rise over time, and as a result, perhaps fundamentals will become even more important, especially as we move forward.
Clearly, economically sensitive sectors have been attractive in terms of either balance sheet strength or returns on capital. And one of the themes that a couple of guys have touched on is this productive use of corporate cash. Thinking about those in the context of what we do. We have a lot of experience in the room.
What gives you the confidence to continue to execute your discipline, despite you have all of these things going on around you?
Charlie Dreifus: Well, I think the discipline is rooted in economic watching. It’s not only as a business manager would think, but it’s based on the laws of economics.
If you buy companies where the cap rates, the return to the buyer, is greater than the cost of capital, and it’s a great business and does all of this in a professional, credible manner with good accounting and everything like this, you’re—it’s like trying to hold a balloon underwater. It will eventually rise to the surface.
You don’t know the time of when that will occur. But it will occur.
Jay Kaplan: One of the best ways to compound wealth is to own a portfolio of high-quality, well-run businesses that generate cash, earn good returns, that are managed by good people who try to do the right thing with the generated cash as an asset for the benefit of shareholders, while trying to ignore the gyrations and the noise of the stock market.
And over time in market cycles, the compounding of the earnings from that business will compound your wealth. So I’m hanging my hat on that. And I think as a group we have proven that over time that can be very successful.
Final Thoughts from Panelists
Chuck Royce: I think the next three to five years will see the return of active management. I can see it coming, and I can feel it coming. So I’m looking forward to that day for all of our benefits.
Whitney George: I agree with Chuck. Certainly the market is a little uneasy about what’s going on in Europe.
There isn’t a sign of a recession. So this should not turn into a bear market. And we will use this correction, as we always have, to refresh the portfolio and prepare for the next three years.
Jay Kaplan: If you considered the fact that the Russell 2000 has gone virtually straight up for the past five years, a 10% dip, although it feels bad now, is really not that big of a deal. So let’s not panic, and let’s focus on investing in really good businesses.
Buzz Zaino: Well, we’re in a business, and we like to buy things with proper valuations and sell them at excessive valuations. And these corrections give us the opportunity to exaggerate that.
Charlie Dreifus: Well there’s always a black swan event that can be out there. It’s not the Fed’s policy, because that’s embedded in the market. In fact, what I think which we haven’t touched upon and is not in our skillset, but I’ll take the plunge and say that inflation is dead. I mean inflation is not going to be an issue for quite some time.
And this has to do with our domestic energy situation. It has to do with the rising dollar. The consumer has gotten a lot more cautious. They’re not borrowing the way they used to.
All of this means that at some point consumers are going to come back with a vengeance.
Francis Gannon: Our opportunity set is growing every day as the market continues to come down.
We have seen a definite change in the performance of the market going back to the low of May 2013. And while it hasn’t been a straight line for higher-quality businesses, we have faith that our process across all our different disciplines will continue to work.
Finally, we believe in active management, especially in the small-cap asset class.