Portfolio Manager Chuck Royce discusses the first half of 2017 with Co-CIO Francis Gannon, and what he expects to happen next.
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Francis Gannon: Interesting start to the year for small-caps. What are your thoughts on the first half of 2017?
Chuck Royce: It was more or less flat. But I view it as just a pause in a very strong market for small cap and ultimately, a strong market for small-cap value.
FG: Do you think we have a chance of breaking out of this consolidation that we've seen in the market in the first half of the year?
CR: Yes. I actually think if I had to bet on this, obviously, we make investments based on much more longer-term thoughts. But, to me, the market smells like it wants to go higher.
FG: The first half of this year is eerily reminiscent of 2015, where growth did quite well. If you recall, back in 2015 the market rallied up until June of that year in a spike forward, the growth area of the market. How do you feel about that?
CR: Well, growth did very well in this first six months also. But it really wasn't the same conditions. We have begun to normalize interest rates. The dollar has begun to weaken. I think the climate is very healthy. Growth did better, tech did better, health care did better. I don’t see it as a similar environment. Value did, you know, poorly. I just think that these are pauses in the long-term journey here.
FG: Where are you finding opportunities in the pause, if you will?
CR: Well, we have been adding to several sectors. We believe we're entering now into an exceptionally favorable period for banks with better loan growth and better spreads. Really an ideal environment there.
We'll continue to see M&A activity also. So, we are adding to our positions there. We're adding, selectively, to health. I think we've traditionally done a good job in health care, but probably not as much as we could have, should have done.
FG: Many people have been looking for a correction in the market, almost waiting for a correction to get into the small-cap space. Do you think we're on the cusp of a correction in the market?
CR: I would say it's an extraordinary amount of people kind of looking for that correction now. Of course, corrections are going to happen. Of course, they're going to, we're going to get frequent corrections, certainly ten percent-plus corrections are very normal, happens once a year, on average. It'll probably come out of the blue.
We know corrections will happen. We know that our job is to take advantage of those things. We like volatility. So, we fully plan on sort of knowing that there will be a correction, and that we'll take advantage of it.
FG: How do you feel about valuations in general?
CR: Look, valuations are high historically, but they're reasonable when you compare it to alternatives, and that is the conundrum that we live with. We are long-term investors. We understand that valuations can sort of shift. But we're making long-term bets.
FG: Rising rate environment would actually be good for some of our businesses and, in fact, in many of the businesses that you own in your portfolios. Why?
CR: Well, I think rising rates is very indicative of the road to normalization. So I view it as highly consistent. I don't see it as an impediment at all to stock market positive returns.
Another aspect that, that this will favor, I believe, is quality. Quality is an important, enduring theme for us as a firm. In a very real way, having higher rates certainly will be more difficult for the non-earners, for the inferior company.
It allows the better companies, the ones we favor, to take advantage of the opportunities that come along in a way that they really were prevented from when rates were zero. We're always trying to intersect value with quality.
FG: We have been talking for some time now about this return to normalization. Where do you think we are in that return to normalization?
CR: I think we're just getting started. We're in the first couple of innings. Rates, if we all recall, were–the ten-year rate was one and something only a year ago. And when they rallied they took a pause, came back to, to 2.12 a few weeks ago, and rallied again.
10-Year Treasury Yield
From 12/30/16 to 12/30/17
I am very, very confident that rates are creeping up. They're creeping up around the world. Canada just raised their short term rates today–first time in seven years. So, we are leading, as we led coming down, we're leading on the way up.
I truly believe a normal environment gives value an edge, gives active managers an edge and gives the quality, value intersection an edge also.
FG: As we debate a more normal environment, what is a normal environment?
CR: I don't think we quite know, let's say, what will the environment be in three years? I don't think we quite know. I mean I could guess that the ten-year is three and a half, four. I think that's a good proxy for normal. I do not see it as having a detriment to housing.
I do think what it does is make it very clear that if you're a great, high-quality company, you can make decisions better. You can operate better, you can exercise your M&A, and it's a win, win, win.
Article By Chuck Royce and Francis Gannon - The Royce Fund
