Positioning A Deep Value Strategy For Further Success by Buzz Zaino, CFA & Bill Hench
Portfolio Managers Buzz Zaino and Bill Hench discuss the factors that impacted Royce Opportunity and Micro-Cap Opportunity Funds in the strong third quarter, current holdings, and their outlook going forward.
Deep Value Strategy
What factors helped both Royce Opportunity and Micro-Cap Opportunity Funds to do so well in 3Q16?
Bill Hench: We’ve had the most success with companies that have simply been executing more effectively.
Many value investors have given up on their strategy over the last 15 years amid concerns that value investing no longer worked. However, some made small adjustments to their strategy but remained value investors to the core. Now all of the value investors who held fast to their investment philosophy are being rewarded as value Read More
GDP growth has been sluggish, so there’s been a premium for companies that have improved margins, expanded their business, spun off non-performing assets or segments, cut costs, etc. while still operating at a high level. These kinds of moves have captured a lot of attention from investors because of the current slow-growth environment.
Buzz Zaino: It’s also been the culmination of a lot of work that we’ve been doing over the last couple of years as we tried to position the portfolio for success once the market was set to reward the sort of deep value stocks that we like. So really it’s been a maturing of the portfolio as the share prices for many companies that we bought 12-24 months ago began to appreciate.
We bought the bulk of them when their valuations, based on P/B (price-to-book) and P/S (price-to-sales) ratios, were very attractively low. It always takes a lot of patience because many of these businesses have new managements or are otherwise working to turn things around—and these improvements take time.
What sectors and industries have you been focusing on over the last several months?
Buzz: In general, we’ve moved away from a few of the industries that were a major part of our focus over the last year or two, such as housing and non-residential construction, because prices have risen since we began to build our positions in those industries.
With the big move in the Russell 2000 since February, we’ve also been a lot more selective because small-caps aren’t nearly as cheap as they were last year or earlier this year. I’d say with a few exceptions, we’re looking far more on a stock-by-stock basis these days, as opposed to the last few years when we often found a number of opportunities in several industries.
Bill: Some interesting things are happening in a couple of technology industries. There have been some announced increases in Capex from large semiconductor makers Applied Materials and Lam Research that are helping the prospects for many smaller component and semiconductor makers.
We’ve also seen a lot of M&A activity on the electronic device side, where pricing and inventories also remain very solid. So we’ve been actively looking around in those areas of technology. But as Buzz said, the bargains are no longer spread out across multiple industries.
In each of your portfolios, Information Technology and Industrials make up close to half the assets, which is pretty consistent with each Fund’s history. What is it about these sectors that makes them a perennial source of your investment focus?
Buzz: Both sectors are very diverse, and most of the companies are in highly cyclical industries that have great growth potential. That’s a really attractive combination, one you don’t always find elsewhere. The challenge for most of the companies, then, is to manage quarterly growth effectively.
It’s not easy to run their respective businesses in a way that consistently meets expectations, which are always for more growth. Even a slight earnings miss or operational hiccup can be very costly.
And these kinds of problems are often magnified for smaller industrial or tech companies that often receive little analyst coverage, aren’t always that well understood, and/or have a limited number of customers.
However, when the problems are not structural, but instead look both temporary and fixable, it gives us great buying opportunities in potentially high-growth businesses. The key for us is to be patient and to understand the nature of the problem.
A lot of companies get into trouble—the trick is to find the good ones that are capable of managing their way out of it.
Which of your four deep value themes have these investments most frequently fit into?
Buzz: Nearly all of our holdings can be considered turnarounds of one kind or another, and we often see several themes in a single company during our analysis, with one theme usually predominating. For example, we’ve just seen a few banks appreciate in the portfolios that were initially undervalued asset plays because of the real estate that they owned.
We’ve also seen some interrupted earnings, or broken IPO, stories this year, particularly in tech. During 2016, however, I’d say turnarounds have been the most common theme that we’ve explored.
Can you give a few examples of current holdings in these two sectors that exemplify your deep value approach?
Buzz: Amber Road would be a good choice. It’s a software company that develops single platforms to automate and streamline global trades, offering import and export, global logistics, and trade agreement management solutions.
Its IPO in March of 2014 arrived with a lot of fanfare, and its prospects looked bright. But when they lost a large, high-profile customer, its shares fell, and we began to build a bigger stake.
We knew that its turnaround would take time—its sales cycle is long, and only certain kinds of global businesses need its product. But we believed in the long-term viability of its business, which the company fought hard to validate after it lost that large client.
It has very few competitors, and the technology that small number has isn’t as advanced as what Amber Road is offering. The company has also said that they’re close to signing a few large contracts, which has helped its shares to rise.
Bill: Atlas Air Worldwide is an air freight and logistics company in Industrials that we were buying in the summer. Its shares have been pretty volatile lately, but we like its position as a small air freight business. In fact, we’ve owned it off and on over the last 12 years.
Its valuation would often become very attractive—more so even than its peers—during tough times for air freighters, and we generally thought both its record as a business and its assets weren’t fully appreciated.
Overall, we think the company has done a really good job managing its way through some very challenging periods for its industry.
It recently became the preferred air freight shipper for Amazon, which has begun to draw investors’ interest this year, though we think the effects of the arrangement may not be fully felt for another few quarters.
What about a company outside Industrials and Information Technology?
Buzz: I think Spartan Motors is a great example. The company makes chassis for commercial vehicles. We always thought of it as a terrific manufacturer in a very solid niche.
The company had high revenues—but tended to generate low profits. When the current CEO joined the firm in 2014, he began to revamp the management team, bringing people in who were committed to improving the company’s operational efficiency.
We liked his plan and built a large position in the stock. Earlier this year, the new team’s efforts came to fruition as earnings and margins began to improve, and its shares started to climb. We’ve been reducing our stake as a result.
Do you think macro or micro factors are likely to have a greater impact on the market in the coming months?
Bill: With GDP growth still sluggish, we believe investors will remain willing to reward companies that are executing well. The short term looks likely to be more influenced by macro factors, but over the long run we expect that micro factors will matter most.
The upcoming election, a likely rate hike in December, and global growth rates will keep many investors preoccupied. We also see the likelihood that of increased domestic spending, most probably on infrastructure and defense, regardless of who’s occupying the White House in January.
However, we think the prospects for individual companies are likely to matter more to investors once the noise of these issues abates, particularly for businesses in the process of turning operations around and beginning to execute more effectively.
Buzz: We also expect to see increased spending on infrastructure and defense. No one is surprised by the less-than-adequate state of our country’s roads, bridges, parks, airports, etc.
So we think that these problems will be addressed head on following the election after being mostly ignored for more than a decade. Our portfolios hold a number of companies that should directly benefit from increased spending on infrastructure.
We also think construction spending in the residential and non-residential segments should continue to do well. The data on residential housing continues to suggest a longer-than-normal cycle to catch up with meaningful underbuilding trends resulting from the 2008 collapse.
The non-residential side should show strong results from both public and private spending. We’re already seeing some of the anticipated rebound for several holdings.
Finally, a pickup in defense spending should emphasize technology and aviation. We expect that new systems and a more realistic evaluation of threats should drive software and cybersecurity spending over the next several years.