The Market And U.S. Economy From A Small-Cap Perspective by Royce Funds
Portfolio Manager and Principal Jay Kaplan discusses current market and economic conditions and what he’s hearing from company management teams, the effect energy prices are having on some of his holdings, and Royce’s competitive advantage within the small-cap space.
See the video here.
Francis Gannon: So Jay, many of the trends we saw in the market in the fourth quarter of last year continued in what has turned out to be a really interesting first quarter from an economic perspective as well as a market perspective. I wonder if you could give us a bit of an update on your thinking and what you’re hearing from many of the companies.
Jay Kaplan: The economy remains OK. Unemployment keeps coming down, which is good. Wage growth, however, is kind of stagnant, so that’s not so great. And labor participation remains not so great. There’s no inflation, which, you know, cuts both ways, and we can talk about that as it relates to short-term interest rates. And when you talk to companies, by and large I think the message we’re receiving is that business is OK. So companies are sort of muddling through.
Francis: How are you thinking about Energy in the portfolios?
Jay: We think the companies that we own are pretty high-quality companies. If you look at the industry, there are a lot of companies that are over-levered. If energy prices stay low for long, there’ll probably be M&A activity. But from where we sit, we like what we own. So within Energy I think we’ll be OK. The stocks have come down a lot as the commodity prices come down. We think there’s good book value support in a lot of our companies. We feel pretty good about that with a historic valuation perspective.
When you start to look through to the industrial companies, a lot of them ultimately supply into the energy services industries. So we have industrial companies that maybe have 5-10% of their business somewhat tied into oil. On the other hand, in consumer companies, one could argue—though we really haven’t seen it yet in a big way—that the savings at the gas pump ought to translate into good retail sales. That hasn’t been totally true. Some folks think that individuals are saving some of this windfall, which is really good. I just heard the other day that with the cold winter we had here, a lot of that gas went into heating. So that’s kind of mixed. So I’m a little disappointed that we haven’t seen that flow through.
Francis: The other big topical thing from an economic, say, top-down perspective has been rates. Interest rates, specifically. How is that going to affect the portfolios?
Jay: I think a couple of things will happen. There’s kind of a macro-micro, as there always is. If you think about it on a macro level, I think when we get that first uptick in short-term rates the market will not be very happy about that. So you’ll see a kneejerk reaction. The market will be unhappy. With low inflation and no wage growth and low labor participation, the Fed’s in no hurry to raise rates.
From a micro perspective, there’s been a lot of speculation in the small-cap space. So we’ve seen, over the past two, almost three years, biotech stocks that don’t make any money be the best performers. We’ve seen Internet companies, software companies, small-cap pharma companies, a lot of companies with no earnings and no returns on capital really benefit from the kind of market environment we’ve had, driven by really low interest rates and free money.
When rates start to go up, a lot of that speculative activity may start to come back down to Earth. That would be good for our portfolios, since we generally are not invested in non-money making companies.
Francis: One of our, I think, clear competitive advantages as a firm is that we have many people here who have been investing within the small-cap space for a long period of time: our institutional knowledge base. How does that help in our underlying process in looking at a business?
Jay: I think it helps a lot. I could cite examples of companies that I have owned for 20 years on and off: companies that I’ve owned, have sold, have come back, owned and sold a number of times. You get to understand the businesses very well, you get to understand the executives very well, and it helps you make really good decisions over time.
One of the dirty little secrets about small-cap investing is we recycle the merchandise a lot. It’s not that often that small-cap companies grow up to be big-cap companies. They make an upward move and they stumble and come back again, and then there’s another cycle.
The other thing that happens is sometimes if we’re fortunate, the companies start to get a little bigger and they get taken over. That’s really good as well. But it’s really unusual to see one of our companies move to the S&P 500, so we have that opportunity to revisit things again and again. And I think our experience level and that institutional knowledge that we have is really helpful.