Francis Gannon: Are We Witnessing A Market Rotation? by Royce Funds
Here at The Royce Funds, we are long-term investors. Yet as active managers who always keep our eyes on risk, the three-month period ending April 30, 2015 seems noteworthy, especially with the Russell 2000 Index hitting new all-time highs.
Many investors have shown a preference for stocks with bond-like yields or with long-duration growth assets over the last few years, to the point that each has been sporting substantially stretched absolute valuations. Traditional defensive sectors, such as Consumer Staples, have also become quite highly valued.
It’s interesting to us that these groups increasingly appear inversely correlated to interest rates. Many companies in these sectors stumbled recently as 10-year Treasury rates rose nearly 50 basis points since the bond’s most recent low in late January.
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Two other areas typically sensitive to interest rates, such as real estate investment trusts (REITs) and Utilities, declined 5.5% and 2.7%, respectively, for this same 90-day period while small-cap biotech declined 6.9% in April after a multi-month march upwards. Cyclical sectors dramatically outperformed their defensive peers for the three-month period, as investors focused more on “real” businesses and “real” economic growth, with the Energy and Information Technology sectors leading the way. Even at this admittedly early stage, it looks very much to us like a rotation toward more cyclical sectors, where we have been finding both very attractive to reasonably attractive valuations and consequent room for long-term growth.
As we have mentioned before, the last few years have been incredibly difficult for most active managers, and there is no shortage of evidence that the number of outperforming actively managed portfolios has reached long-term lows.
Many active managers, including ourselves, have been stymied by the perplexing market dynamic in which defensive areas, including Consumer Staples, Health Care, Utilities, and REITs in particular, have mostly been rallying. It’s not surprising, then, that we have often been asked over the last couple of years if we have considered abandoning our time-tested and disciplined approach.
Our reply is a resounding “No!” It seems to us that the more relevant question is, are active managers about to reassert their performance advantage relative to their passive competitors as we’ve seen in this recent short-term period?
To be sure, one three-month period does not make a trend. With that firmly in mind, we continue to believe that the current environment argues for more active and disciplined approaches, those driven (as ours are) by fundamentally sound companies selling at attractive valuations.
As business buyers using approaches that examine quantitative and qualitative factors, we build our Funds stock by stock. We do not begin the investment process with an eye toward replicating a benchmark. Rather, we look for well-run companies with histories of high returns on assets and on invested capital that are trading at what we think are discounted prices.
To that end, we see tremendous earnings power waiting to be unlocked in many of our portfolio holdings as the U.S. economy continues on the “road to normalcy,” with the inherent operating leverage in many of our companies potentially continuing to propel earnings.
As we have seen in the market of late, improving fundamentals are a lure for investors, which in turn should drive valuations for our companies. This is how our contrarian investment approach has worked in the past. And while taking longer than we expected, we believe there is a structural case to be made for substantial rotation in the market toward the kind of investments in which we see both value and long-term growth potential.