Chuck Royce on Positioning for a Normalizing Economy

Chuck Royce on 4Q14: Positioning for a Normalizing Economy by Royce Funds

Chief Executive Officer and Portfolio Manager Chuck Royce discusses the spread between large- and small-cap returns in 2014, the current case for active management in the small-cap space, the valuation picture as we enter 2015, and the impact lower energy prices are likely to have on stocks.

Why do you think large-cap stocks did so much better than small-caps in 2014?

Chuck Royce: I think much of large-cap’s outperformance was related to reversion to the mean.

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Although most stocks have been doing well since the bottom in March 2009, small-caps have been out in front—often by a sizable margin—throughout most of that period. That began to change in 2014, particularly in the second quarter when both the S&P 500 and Russell 1000 outpaced the Russell 2000 by a decent-sized spread. This didn’t surprise us.

Small-caps had been ahead for so long and had held such a substantial edge from that trough coming into 2014 that a shift in leadership for equities seemed imminent. What’s interesting to me is that small-caps gave up leadership mostly during downdrafts, which were barely noticeable for larger stocks in 2014.

Small-caps experienced losses between March and May and, more seriously, between July 5 and October 13, and these declines really set the stage for the leadership rotation we saw for the year as a whole.

Considering the lower returns for small-caps in 2014, were you expecting better relative results for many Royce Funds?

Chuck Royce: Absolutely. We were expecting quality stocks—those with strong balance sheets, solid cash flow characteristics, and high returns on invested capital—to emerge as leaders within the small-cap asset class.

We still see, especially among cyclicals, a number of profitable, conservatively capitalized businesses that have either been ignored or have lagged. We expect this to change.

Related to this was our thought that many stocks in economically sensitive cyclical sectors would also do well considering what we see as their financial and operational strengths and relatively lower valuations. After a solid first half for many small-caps that fit these descriptions, things went south in a hurry.

During most of the second half of 2014, almost nothing we did as a firm worked. It wasn’t simply that quality small-caps didn’t do well—our more opportunistic and GARP-oriented portfolios were also out of sync, as were our dividend-paying portfolios. Some portfolios were overweight in Energy stocks, but we have a number with very low exposure to Energy that didn’t fare much better.

What is the current case for active management in the small-cap space?

Chuck Royce: The case hasn’t really changed—it’s still the same argument that we’ve been making for decades. The only thing that’s different is that we’ve gone through a long period in which nearly all actively managed small-cap funds have failed to beat their respective indexes.

But I believe strongly that in an inefficient area such as small-cap, trying to understand these inefficiencies and identifying qualitative factors should make a difference over long-term and full market cycle periods.

We remain completely committed to this idea. We will continue to look for what our analyses tell us are high-quality companies and try to buy them when they’re temporarily out of favor and attractively discounted.

How do small-cap valuations look to you as we enter 2015?

Chuck Royce: I think the valuation picture is somewhat tricky. For example, looking at trailing 12-month earnings for many companies suggests that small-cap share prices are on the high side. But if you believe, as we do, that the economy is going to keep growing, that credit spreads will continue to expand, and that a more robust CAPEX cycle is in the offing, then valuations seem pretty reasonable, if not attractive in certain areas.

We still see, especially among cyclicals, a number of profitable, conservatively capitalized businesses that have either been ignored or have lagged. We expect this to change.

What impact do you think lower energy prices are likely to have on stocks?

The market was initially rattled by the decline in energy prices, though for most consumers, lower prices for gasoline and heating oil is like getting a pay raise. But of course it wasn’t just the sinking commodity price that spooked the markets, it was also concerns over currency stability in Russia, and the ruble was in trouble almost immediately.

It also raised concerns over terrorism and political stability in the Middle East and the economic prospects of certain regions in the U.S. So the ripple effects of falling oil prices run wide. But we remain bullish on the long-term prospects for Energy, especially for services companies.