Lauren Romeo: Current Opportunities Built from Short-Term Headwinds by Royce Funds
As bottom-up stock pickers who pay close attention to risk and valuation, we often see negative headlines as an opportunity to reevaluate our holdings and build our exposure to companies with long-term value at attractive entry points. Portfolio Manager Lauren Romeo provides her perspective on macro headwinds and how they affect our investment approach.
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Jeff Smith: Lauren, let’s talk about some of the headlines that are impacting the markets. The news seems to be mixed, but there’s a lot of macroeconomic and geopolitical issues that seem to be concerning investors. How does that impact our investment approach?
Lauren Romeo: At Royce, we’re bottom-up stock pickers, first and foremost. But that doesn’t mean we’re not reading the same headlines and same stories and concerns that people have from a macro standpoint and incorporating that into our analysis of both our existing holdings as well as companies that we’re currently looking at as potential buy opportunities.
When we do that analysis, the key for us is to try to determine whether these macro issues are cyclical and just an inherent part of the particular industry that’s being affected, or if there’s some fundamental change in the profitability model of that particular industry that would make past returns not sustainable going forward. If it’s the latter, those are types of companies we want to avoid. If it’s the former, where it’s a cyclical, temporary situation, those often create good buying opportunities for us given the short-term pressure that creates a situation where investors flee a sector, and that’s actually when we get interested and start to potentially be buyers.
Jeff: Can you give us an example of a company facing short-term pressure right now that looks attractive to us?
Lauren Romeo: A good example will be Valmont Industries, which is a company we’ve owned at Royce for several years. They’re a world-class diversified-industrial company that has a very strong balance sheet, consistent free cash flow generation, an excellent management team, and has averaged mid-20% returns on invested capital for the past five to 10 years.
One of the key businesses that Valmont is in is the irrigation business where they have a 40% share of mechanical irrigation. What have hurt the company’s results are much lower wheat, corn, and soy prices year over year as the U.S. is currently looking at record crop yields. And as a result that in turn is depressing farm incomes, and historically there’s been a very strong correlation between lower farm incomes and decreased spending on big-ticket items such as mechanical irrigation systems.
Jeff: So what’s the opportunity at Valmont right now?
Lauren Romeo: Well, the current fundamental situation is cloudy. The long-term trends for the irrigation business are very strong. Three key trends that we’re focusing on are the need for higher farm yields to meet global population growth, as well as to meet rising demand for more protein-rich diets as emerging market consumers see their incomes rise.
Additionally, water scarcity is an issue, and traditionally irrigation uses 70% of all fresh water. So, mechanical irrigation uses 50% less than traditional flood irrigation. It will be a big advantage in being able to ride that water consumption that’s necessary to meet these higher demands.
Jeff: What about the time frame for Valmont?
Lauren Romeo: We think the short-term macro headwinds are creating an excellent entry point from a valuation standpoint, given the favorable long-term trends. And that’s characteristic of what we try to do at Royce: take advantage of the market’s tendency to look at things on a short-term basis versus Royce having an investment time horizon of at least three to five years. And as a result we’re able to buy these high-quality companies when they’re temporarily out of favor, and instead of having to pay premium prices, we buy them when there’s a lot of negative news discounted into the stock price.