While global equity markets were bringing sizable returns to many investors prior to the recent Asian-driven correction, Royce & Associates Co-Chief Investment Officer (Co CIO)Francis D. Gannon believes the situation represents something akin to a suspension of laws of finance. He believes the booming small-cap market in the U.S. is irrational and unlikely to be sustained – nor should it. “Now this is starting to crack,” Mr. Gannon recently told The New York Times. “I think we are on a road to normalisation.”
Though at times by fits and starts, markets continued to move forward in the first half of 2015.
“The Russell 2000 Index made a new all-time high, as did the Nasdaq Composite,” Mr. Gannon observed. “Both were driven in large part by ongoing extraordinary results for biotech and, to a lesser extent, pharmaceuticals. There was a lot of volatility in biotech and plenty of commentary suggesting these stocks were in a bubble. These concerns proved to be no more than speed bumps as biotech companies remained market leaders through the end of the second quarter, while previous investor favourites such as utilities and REITs cooled off considerably.”
“The concern going forward is the very narrow breadth of returns, evident to a large degree in the Russell 2000 Growth Index. It gained 8.7 percent year-to-date through June, versus an increase of 0.8 percent for the Russell 2000 Value Index. The Russell 2000 gained 4.8 percent.”
A specialist in small-cap equities, Mr. Gannon and his team have argued for some time that the U.S. small-cap market is disjointed. This has led them to pass on some recently outperforming stocks.
“We are an active manager who embraces being an active manager,” Mr. Gannon explained. “Our process has certain biases we have to embrace, so we’re not going to be involved in certain aspects of the market. It’s been challenging, waiting for many of our highest-confidence holdings to turn around. The shift we anticipated has taken longer than any of us initially thought.”
“Change can take time. Often we’re only aware that a dramatic move has occurred in retrospect. We’re content to keep investing the same we always have – with a keen focus on managing risk, and by looking for the intersection of attractive valuation and organic growth potential.”
The Royce Funds team believes U.S. Federal Reserve policies designed to keep the economy and capital markets above water, including multiple rounds of quantitative easing and keeping interest rates at or near zero, had unintended consequences – with outsized effects on small caps.
“It became easy and affordable to add debt, eroding risk differentials between lower- and higher-quality businesses,” Mr. Gannon said. “Lower-quality and more highly levered companies began a historically atypical period of outperformance in which our funds mostly did not participate.”
“The Fed’s zero-interest-rate policy (ZIRP) stoked an intense hunger for yield, which drove up values for bond-proxy equities such as REITs and utilities, regardless of their underlying quality or profitability. This has only recently begun to correct.”
These actions boosted stock correlations and reduced volatility. They also led to significant runs for high-growth, non-earning, and more speculative businesses, many with negative EBIT (earnings before interest and tax). All told, these historically aberrational moves have made it harder to find the kind of mispriced opportunities that have always been the stock in trade of active managers like Royce Funds.
“The recent contraction of small-cap leadership in the U.S. represents more of a bet on long-duration assets than current profitability,” Mr. Gannon observed. “In each case, our more qualitative, risk-conscious approaches have in general kept us away from these areas. While we are confident this trend will fade and speculative bubbles will burst, we understand the frustrations of investors over the last few years as active managers such as ourselves continued to lag our benchmarks.”
“Economic growth has been a bit irregular, but we’re seeing gathering strength in many previously depressed or sluggish economies. Revenue growth for many U.S. small-cap companies is in the 6-7 percent range, with earnings growth approaching 10 percent. Pretty strong and very encouraging.”
Rising interest rates also should create more opportunities for active managers like Royce Funds.
“A higher-risk environment tends to benefit quality companies: conservatively capitalized, profitable businesses with high returns on invested capital and effective, shareholder-friendly management,” Mr. Gannon explained. “High rates are synonymous with higher risk, and nearly always correlated with a greater number of mispriced companies.”
“We are not worried about rates rising or greater market volatility. In fact, we welcome both.”
Mr. Gannon and his team have been engaged in spirited debates about what will be “normal” going forward. Yet all agree that the most recent declines should ultimately be good news for profitable companies with low leverage, which have historically held better during declines and periods of increased risk.
“You have an economic period now of pretty moderate growth, a low inflationary environment, solid earnings growth for small-cap companies and revenue growth anywhere between 6 and 7 percent,” he said. “It’s an interesting time to be looking at the small-cap space, particularly our part of the overall market, because there are some valuation discrepancies.”
With small-cap returns being driven by lower-quality areas, Mr. Gannon believes “a wonderful period from a value proposition” is being set up.
“We saw a number of small-cap companies in the retail space – many of them old Royce favourites – that looked attractively undervalued or otherwise primed for growth. A flourishing economy with better employment numbers and lower energy prices has not spurred consumer spending to the degree many were anticipating. However, we usually have good-sized exposure to discretionary businesses in several of our funds, and we expect consumer activity to continue intensifying.”
“The fact is we have great portfolios of higher-quality businesses that we think are trading at a substantial discount to the overall market, in a world where people are forgetting about risk.”