Small Cap Market Talk: Positioning The Royce Funds For 2016 by Royce Funds
Portfolio Managers Chuck Royce, Buzz Zaino, Charlie Dreifus, Chip Skinner, and Jay Kaplan each use distinctive investment approaches for the Funds they manage. How are they positioning their respective portfolios, and what are their expectations for small cap stocks in 2016?
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What is your take on the small cap market?
There are a number of mixed signals out there right now. Housing, employment, and auto sales are strong here in the U.S. while at the same time many investors are understandably anxious over the “4 C’s” of commodities, currency, credit, and China —and those worries were pretty strong even before the massive sell-off that opened the year.
Of these, I’d say the state of the credit markets is probably of greatest concern for small cap investors, especially in the near term. Historically credit crunches have created trouble for small caps as a whole. But I expect companies with low leverage, high returns on invested capital, and other elements of financial strength to have a marked advantage in a more challenging or difficult credit environment.
I think this is particularly true for the bulk of our own holdings in more cyclical areas. There may be pain for nearly all small caps in the initial phase of a significant credit event, but we think financially self-supporting companies should ultimately emerge as leaders.
We’ve seen how badly the market wants higher commodity prices, as does the Federal Reserve. That would certainly help the distressed sectors of the world economies and currencies in emerging markets while also harnessing the strength of the U.S. dollar. Frankly, though, it is still difficult to see why commodity prices should advance on a sustained basis. The subpar growth rates from the only major economies (U.S. and China) make it likely that commodities remain weak. In fact, China’s situation also makes further currency turmoil more likely as it weakens its currency.
The possible test next year, and further out, is whether current P/E multiples are sustainable without aggressive monetary policy. If not, can earnings growth compensate for declining multiples? The answer to these questions will determine the investment rate of return going forward.
On both the economic and equity fronts, things seem even more uncertain than usual to me. As of mid-January, stocks were down 20% from their 2015 highs, meaning that we’d officially entered bear market territory. When I go on to factor in the increasingly troubled junk bond market and geopolitical risks, I see a number of serious issues. Historically, credit disasters have often created trouble for stocks, especially more vulnerable small caps that need access to capital markets.
However, my pessimism about the near term makes me more confident in the long term. Valuations are beginning to look better for a number of names that I haven’t looked at or reexamined for a long time. The number of potentially investable names is growing. In addition, a number of holdings are being punished right now well in excess of their performance as businesses.
So while the short-term pain is hard to take, the long-term risk-reward scenario looks positive for these companies. With rates rising, it also looks very much like we’re at the end of the leverage-is-good era, which should benefit the kind of conservatively capitalized, free-cash-flow-generating companies I usually look for. In addition, there’s been some activist noise in a handful of my holdings recently—something I haven’t heard for a long time.
Portfolio Manager—Royce Smaller-Companies Growth Fund
I’ve been hearing a fair amount of fatalism about the U.S. economy lately, but I think we’re still in pretty good shape. We’re certainly in better shape than our peers in Europe and Asia. I expect the economy to continue growing in much the same bumpy, slow-growth way that it did in 2015—and I feel the same way about stocks. I think a recession is unlikely, but we have lost one of our growth engines, the energy industry, which is now in recession. China remains a wild card, of course, but considering the increasingly strong condition of the U.S. consumer, I’m fairly optimistic.
The current downdraft has been painful, but that’s when long-term opportunities are created for disciplined investors—and even before 2016 stumbled out of the gate, we were seeing what we thought were good prices for stocks in a wide variety of industries.
I think the increased spending and business tax credit plans passed in anticipation of the 2016 elections to boost the pace of growth in the U.S., and that should help areas such as nonresidential construction, defense, consumer, and technology.
With all the attention on China, it’s important to remember that the U.S. remains by far the world’s largest economy, so sooner or later I expect improvements here at home to ripple out to other parts of the globe. However, I think the greater domestic focus of most small cap stocks will be a positive while we wait for a stronger, steadier pace of economic growth.
How are you positioning your portfolios for 2016?
I expect reversals in a number of trends that have disadvantaged the Funds I manage. From the perspective of economic cyclicality, we are comfortable with a contrarian, pro-cyclical bias for the portfolios. Moreover, I believe that the protracted leadership of growth over value stocks is likely to reverse in 2016 and that companies with better balance sheets will do well in an environment of elevated corporate bond spreads.
We expect the combined effects of these reversals to put the market’s focus squarely on the attributes we emphasize, which have been largely neglected in the current cycle.
We remained significantly overweight in both Information Technology and Industrials at the end of the year while also having substantial exposure to Consumer Discretionary. Our positioning is consistent with our view that valuations for the majority of our portfolio holdings look highly attractive to us and are poised to benefit from ongoing U.S. economic growth.
I expect this not only in those areas I mentioned previously—nonresidential construction, defense, consumer, and technology—but in individual companies in other areas where improvements in earnings, margin expansion, or new management looks capable of driving stock price appreciation.
2015 offered a potent reminder of how humbling this business can be. I’ve always ordered pencils with erasers to account for our mistakes knowing that my process does not work in all markets—it is not the Rosetta Stone. However, against the backdrop of tepid demand for equities, particularly from individual investors who have endured two major market declines in the past 15 years, wide-scale multiple expansion looks unlikely. In my view, this highlights the case for the kind of bottom up, granular security selection that has always distinguished my disciplined and contrarian approach.
In my small cap portfolio, I remained overweight at the end of 2015 in Consumer Discretionary, Industrials, and Materials while I had significantly less exposure to Financials and Health Care. In my large-cap fund, my largest weightings were in Consumer Discretionary, Industrials, and Information Technology. I held nothing in Consumer Staples, Energy, Financials, Telecommunication Services, or Utilities and had low exposure to Financials and Health Care.
Our positioning in Royce Smaller-Companies Growth Fund has not changed dramatically. Carl Brown and I scaled back on a number of Health Care companies in the second half of 2015, mostly in biotech and, to a lesser degree, in pharmaceuticals as it became clear that that these areas were under a lot of pressure, and the portfolio was overweight, in part due to strong performance in the first half of 2015.
However, we still see a lot of growth potential in areas such as drug development, medical devices, specialty pharma, and genetic testing. I think spending on technology is set to increase in 2016, which gives me confidence in the fundamentals for a number of industries. In particular, I’ve been focusing on areas such as cloud storage and data management, analytics, and cybersecurity. These are in addition to those industries in which I still see room for growth—Big Data, machine-to-machine technologies, and semiconductors, which has been more of an industry consolidation play.
I also see some opportunities in Financials, particularly in banks, which should be helped by the recent rate increase. Finally, with consumer confidence high, I’m staying with certain consumer names in spite of a rough 2015.
As for positioning in Royce Small Cap Value Fund, I’m content to wait for many underperforming retail holdings to turn around, so at the end of 2015 Consumer Discretionary remained a significant overweight, as did Information Technology and Industrials— two sectors where I was diversified across a number of industries at the end of the year.
I’ve also been adding a few trucking companies—a depressed area where valuations look good to me—and a few smaller community banks that trade at low price-to-book, earn reasonable returns on equity, are overcapitalized, and have high credit quality.