Chuck Royce: Will Rising Rates Benefit Active Stock Pickers?

Chuck Royce: Will Rising Rates Benefit Active Stock Pickers? by Royce Funds.

With a rise in interest rates on the horizon, and economic recovery firmly underway, CEO Chuck Royce believes the market may be on the cusp of rewarding disciplined and risk-conscious approaches.

What, if any, encouraging signs for active small-cap approaches did you see in 2015’s first quarter?

We saw a few encouraging signs, though admittedly we still did not see a relative advantage for risk-conscious active approaches such as ours in the first quarter of 2015.

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January was a disappointing month while February saw many Royce-managed portfolios out in front of their respective benchmarks, which for most of our Funds is the small-cap Russell 2000 Index. March was more mixed, though we saw several portfolios gain an edge in the last couple of weeks of the month, when results were mostly negative.

It’s been a long and frustrating few years, but we remain disciplined and confident in the long-term value of our approach, the cyclicality of markets, and the likelihood of higher volatility and lower returns, both of which we think will be positive developments for active small-cap managers.

What consequences do you anticipate for equities when the Fed raises interest rates?

I think there will be some rockiness initially, but I don’t expect the effect to be highly dramatic. I say this mainly because the Fed has, if anything, over-explained their rationales and benchmarks for taking action—or not—on rates. The market is therefore as prepared for rate hikes as it possibly can be.

I think rising rates will ultimately benefit bottom-up stock pickers because the increased cost of capital is likely to favor companies with strong fundamentals. This should lead investors to—at long last—begin focusing on qualities such as steady profitability and returns on invested capital.

What is the case for disciplined and risk-conscious investing in the current market?

First, I believe that conditions exist for the bull market to extend itself, though with lower overall returns and a shift in leadership toward more cyclical sectors.

Other than what I would call “normal” corrections in the 5-10% range, I don’t see anything that looks likely to derail the market’s steady climb. The exception would be a wild card event, such as a major terrorist incident, but other than that the economy continues to look strong, the slower-than-expected first quarter notwithstanding.

Exclusive of energy, many companies we’ve been meeting with are going ahead with CAPEX spending or putting plans to do so in place. We’ve observed a growing confidence from management teams that the economy is healthy.

With unemployment falling, wages ticking upward, and energy prices still quite low, the all-important U.S. consumer is understandably confident and ready to spend.

These factors, along with the green shoots we saw in the first quarter among certain holdings in Information Technology and other areas where we have been finding quality, make a strong case for optimism for our risk-conscious approaches.

What is your outlook on Energy stocks?

In the long run, we are very bullish on Energy. At Royce, most of our portfolios that have a good-sized exposure to Energy are still modestly overweighted.

We are more heavily invested in service companies than exploration & production—or “E&P”—businesses. On the whole we see the sector recovering powerfully at some point—energy is simply too critical and integral to the global economy to stay down for long.

Of course, no one is able to call the bottom, just as no one really saw last year’s collapse coming. So we’ve remained invested knowing that at any time a turnaround can occur, and commodity prices will start to climb again.

What’s interesting to me is that we’re all so entangled in energy—oil and gas prices are in the news nearly every day. Companies have either seen a boost to their bottom line because of lower prices or encountered challenges because they’re involved directly or indirectly in the energy business.

For example, energy companies cut CAPEX spending with amazing speed in the immediate aftermath of the decline in crude prices, which hurt a number of tech or industrial businesses that would ordinarily benefit. In addition, any increase or decrease in Middle East tensions typically affects prices, even if only in the short run.

Our response has been to high grade holdings, trimming or selling those that look most vulnerable while holding or adding to those that in our view have so far handled the downturn most effectively.