How A Deep Value Approach Is Outperforming In A Growth-Led Market

Portfolio Manager Buzz Zaino explains what’s working in 2017 for his deep value approach, and where he is finding new opportunities in a high-priced market.

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Steve Lipper: The Opportunity Fund is doing really well this year, particularly in a year that value has struggled. Tell us what’s worked so well.

Buzz Zaino: We're an 18-month to two-year participant. In other words, what we bought 18 months ago should be working out today; what we bought today should be working out in 18 months. So, if you look back 18 months to two years ago, what was not doing well was the technology sector.

It was in a cyclical downturn. And especially things like the semiconductor capital equipment companies, business was poor.

Impressive Rebound for Semiconductors

Russell 2000 Semiconductor & Semiconductor Equipment Cumulative Performance as of 6/30/17

It was in its own cycle. And so the valuations fit our criteria. Now just because it's technology doesn't mean it's ruled out. It's just a company and it's got revenues and earnings and will have some valuation going forward.

So, we establish positions then and now the cycle is turning in their favor. Everything we see today is based on some kind of electronics and chips and smaller chips. And they need equipment and so there's a whole cycle of buying and business is very good for these companies and the valuations have improved.

Then there's always a series of companies, especially in technology that go through their own little cycles. And it's always an interesting circumstance because the IPO happens when a company has just gone through a good period, three or four good years of rising sales and earnings. And they have very high multiples because, you know, the implication, if not the investment banker, will say, "This growth is going to continue."

But you have to realize, with smaller companies, they lack the depth, and especially the depth of management that the larger companies have. And, therefore, something happens along the way, usually right after the IPO that interrupts their earnings.

You know, if they don't lose money, then the earning is missed by a nickel or a dime and the growth stock investors are aggressive in this. It no longer fits my discipline, so I want to sell it. Okay, sell. To whom? You know, the growth stock buyers aren't going to buy something that's not growing anymore and the value guys tend not to buy tech. So, you get very large declines and the prices of the stocks, and suddenly the meet the valuation criteria.

You know, my partner Bill and I always laugh and we say, "We'll start buying it at below two times cash." And that typically is the case, because the IPO happens, they have nice balance sheets, they pay off their debt, and now they're in pretty good financial shape, but they're just companies that are vulnerable to their own little cycles, their own little development cycles.

Doesn't mean they're bad companies. It's simply they have their own little cycles, and now the valuations are proper for us. So, that's how we get there.

SL: Some people are surprised that you can find real value opportunities in the technology sector.

BZ: Yeah. Well, you know technology companies have to develop the next cycle, the next product line. And typically, what happens, is that early on, they will develop something that sells very well, and they have a group of happy customers and they're going to have products that are being developed that are going to supersede what they have.

And they have a ready market for them, because they have existing happy clients. So that's very viable. The thing is it tends to be that the older product stops growing faster than the new product tends to take its place. And that usually creates the interruption in the earnings and the problems.

SL: You get technology companies where you'll get new management that can really make a difference.

BZ: That's often the case. Sometimes, as I was saying, you lack depth of management and the entrepreneur that founds the company tends to be a good engineer, a good salesman, but doesn't really know how to manage a business and is really not happy managing a business.

So, at one point in time the board says, you know, "We need somebody who is a manager." And so, there's a change in management and that person looks over what's going on and knows what to develop and what not to develop and, you know, makes some hard decisions, and usually takes a little while for all that to happen, but it does happen.

SL: Even though technology has outperformed the rest of the portfolio during the first half, you actually trimmed significantly what the overall weighting was.

BZ: We love to take a profit and therefore, we want to keep each position to a specific percentage of the portfolio and the rationale is, you know, after a stock has performed, what's the probability that it's going to continue to perform going forward?

Well, you know, the opportunity for appreciation is less. So, you take your profits in that and you find other places to put money where the appreciation has not yet begun. It's about 18-month to two-year cycle, is implemented, so go to the next one. We'd love to have, you know, a constant role, but you know, the world isn't perfect and we acknowledge that. So, at any rate, so you bring down your exposure to an area that has done well.

SL: You talk about sort of repopulating the portfolio, taking the gain, to going someplace else. Where are you finding opportunities now?

BZ: Well generally speaking, rather than the group, there are a lot of companies especially in the small stock sector that are beginning to do well because the economy is strong. And there are a lot of management changes. So we look for companies where, you know, you have a good asset base, a good base of business, and a new management. Now on that, who will rationalize it and increase their profitability.

In sectors we have some exposure to the housing market both the builders and the suppliers to the builders. Their stocks are beginning to do better. It's been a slow recovery from the recession. Mortgage money is becoming available and housing sales look much better than they have been. You can see that it's being extended for several years. So, that's a good place to look.

In a lot of these cases, not only do you look for the, the primary, the builder, but you look for the secondary and the tertiary markets, people who supply the suppliers. And they tend to benefit and they come in under the radar, so the valuations tend to be a little better.

We're expecting an infrastructure cycle where the money, the government certainly should start putting money in and probably next year being an election year, there's going to be emphasis of spending money in that area.

So, the infrastructure companies are pretty obvious, but who supplies the infrastructure companies? Well, if you get on the road and start building things, you're going to need trucks and vehicles of one kind or another. Well, who supplies the vehicles? You can buy the parts manufacturers at very, very low multiples to their earnings. And the companies are actually doing quite well in not good environments. So that when times do get better they'll have a lot of earnings in, so we think there'll be good appreciation in a number of these companies.

There is a consistency, and that is I've been doing this for 40 years.

Royce Opportunity Fund Outperformed the Russell 2000

$10,000 Invested on 11/19/96 as of 6/30/17

Deep Value Approach

Important Disclosure Information

Average Annual Total Returns as of 6/30/17 (%)

  QTR YTD 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Opportunity 2.81 8.17 36.10 5.46 13.83 6.59 11.95 12.39 11/19/96
Russell 2000 2.46 4.99 24.60 7.36 13.70 6.92 7.98 8.49 N/A
Annual Operating Expenses: 1.19%

Important Performance and Expense Information

Article by Buzz Zaino, Royce Funds