Portfolio Manager Chuck Royce discusses 3Q17’s shift to value with Co-CIO Francis Gannon and what he expects next for small-caps.
Francis Gannon: Chuck, it was an up-and-down third quarter. Rates bottomed somewhere around September 7th timeframe, and right around that timeframe we began to see that shift back to the value again. What are your thoughts on that and where do you think we are in that normalization process?
Chuck Royce: I do think rates are the single most important indicator of style at the moment. And, for me, this normalization process is a very critical process that influences value, therefore, influences active managers. I think it’s very significant. And I think it puts us back in the place that we started with in early '16, where we had a beginning of a longer run for value. And I believe that is being reestablished as we speak.
FG: What do you think is driving that rotation in the market?
CR: I think the economy has continued to march along. The cyclical forces are very real. I think they have considerably more to go. It’s been an area we have a preference for, or certainly, we use.
To me it's a combination of investor preferences preferring, willing to look at these lower multiple value stocks. But I actually think the underlying economics are continuing to make progress. The other story going on is the rest of the world is improving. There's no question that Europe is continuing to advance. That's extraordinary development, very positive to global growth.
FG: People continue to be worried about a correction in the market, though, just given valuations. Do you think we are setting ourselves up for what could be a corrective phase in the market?
CR: Corrections will be part of the normal way markets function. We happen not to have had one this year. So, we certainly can have one. But the better way that we tend to look at it is measuring markets from major peaks to major peaks. And we had a major correction a couple of years ago, through February of '16. We've had a reasonable advance, but nowhere as near the kind of advance that we've had historically. So, I take comfort in sort of where we are in that cycle.
FG: There’s been a lot of noise, if you will, coming out of Washington, D.C., about perspective, or the possibility that we could get changes from a tax perspective, or infrastructure spending. How are you thinking about those things in your attempt to identify great businesses today?
CR: We're not overly trying to get all involved in whether tax reform will happen one way or another. It's very difficult to implement. It takes a variety of forms. So, honestly, this isn't a major macro issue for us.
What we are doing is trying to identify exceptional businesses that are always adapting to the circumstances, taking advantage of particulars that are going on in their industry, and have great long runways. We're not actually interested in being, you know, a profit around tax reform.
FG: One of the more interesting things, I think, being an active manager in the small-cap space, is many of the headwinds we have faced, are now becoming tailwinds. And you can see it in the performance of a variety of our portfolios. But we are benefitting now from the weaker dollar, which hurt us for a couple of years. You're seeing deregulation. You're seeing continued economic growth domestically, as well as a synchronized global economic recovery. How are you thinking about all those different factors in, in your stock selection today?
"There's no doubt that we're coming back to an era where active management is doing much, much better."
CR: There's no doubt that we're coming back to an era where active management is doing much, much better. The principal factors for me, probably is the 10-year bond, again, that is returning to normal. This has encouraged more value type of investing styles. Most active managers have a value tilt, one way or the other. So, I think all of these things are coming together exactly the way you've said.
The dollar has been weaker. That is helping our sort of quality value axis. There's no doubt that we're entering into a global recovery. That's helping our more cyclical companies. So, this is coming into a better era for what we historically do.
FG: Given that, where are you finding opportunities in the market today?
CR: We still look sort of off the grid to things that are underperforming or have had a recent decline in enterprise value. We're looking currently, and have positions in agriculture. We're looking in shipping. Those are two, I think, exciting areas to look. Banks are another area. We've historically been under invested. As we build confidence in higher rates, I believe banks can do a lot better.
FG: So, for a period of time, we've been calling for value to reassume leadership in the overall market. And for the majority of 2017, we've been wrong. That changed during the month of September when we saw a decisive shift in the market back to value. What are your thoughts on value versus growth in today's world?
CR: What happened this year was sort of not what we were expecting or hoping for. We were expecting the value reset, pivot to value, to continue in a more orderly basis. But at some level we know that these things are not straight line. They're not linear, that things are always sort of bouncing around as they tend towards a new direction. So I am very convinced that the long-term arithmetic for value is very strong. And I’m very convinced that value is about to regain its leadership.
Article by Chuck Royce, The Royce Funds
