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Whitney George on Q4 2012: Company Quality Making a Comeback

01/07/2013

Do you think we will soon see an end to the range-bound, tightly correlated market of the last couple of years?
I don’t really know, to be honest. While there have been some encouraging signs, the market still seems stuck in the same risk-on/risk-off mode that it’s been in for the last few years. Investors vacillate between worrying about the ramifications of political headlines and optimism because there’s so much liquidity here in the U.S. and in the rest of the developed world thanks to multiple rounds of quantitative easing. So we still need to deal with fears like fiscal cliffs and debt limits offset somewhat by the lack of competitive returns outside of equities.

As government’s role has expanded, it has politicized the markets—more government intervention via monetary policy, corporate bailouts, more regulation, etc. A dramatic amount of financial risk has shifted from the private sector to the public sector. During the negotiations about how to avoid the fiscal cliff, Congress and the President were debating how to raise $1.2 trillion in new revenue and save $1.2 trillion over the next 10 years. In spite of the tax deal struck in early January, these spending and budget issues still need to be more fully worked out. Until these issues are more effectively resolved, we look likely to run annual deficits of close to a trillion. So it doesn’t appear that this dynamic is going to change anytime soon. Investors have to learn to live with that. We’ve tried to take advantage of the pessimism by investing when opportunities arise, and sell or trim when investors are more sanguine. We are, however, encouraged by the recent recovery in Asian markets, which have been early directional indicators over the last five years.

What is your take on the proliferation of ETFs over the last few years?
I think that passive investment strategies become more popular when returns overall are low, as they have been for the most recent five-year period. A low-fee investment product has appeal when strong results are hard to come by. ETFs are easier to understand for less sophisticated investors offering a one-stop shop for investments in broad indexes and sectors, different themes, or even individual commodities. They make it easier for investors who don’t have the time or inclination to do traditional company analysis. As a consequence, they’ve moved investors away from the idea of having an ownership share in a business. I believe this has a lot to do with the market’s high level of correlation over the last 10 years. But ultimately it is the underlying companies in ETFs that create wealth. I have yet to see an ETF create a billionaire.

When do you expect investors to begin paying more attention to company quality?
I think it’s started already. Our portfolios, which generally focus on quality, have been doing a lot better since September, though the valuations in many cases remain compelling. Over the last three months we’re also seeing quality companies doing investor-friendly things, such as paying out special dividends at rates I haven’t seen before. The willingness of these businesses to do so alerts investors to the benefits of owning high-quality companies. So while I’m still not sure the pattern of correlation has been broken, what we’ve seen in the last four months of the year gives me some confidence going into the new year.

What sectors and industries have you been focusing on most recently?
At the risk of sounding like a broken record, when people are worried about a recession—and anxiety over the fiscal cliff reignited recessionary concerns in the fourth quarter—economically sensitive sectors suffer, with valuations becoming compressed and expectations reduced. So we continue to find what we think are great bargains in Technology, Energy, and Industrials while we continue to find very little that meets our quality and valuation standards in more defensive sectors. Throughout our history, and certainly recently, we have never held substantial investments in Utilities or banks. The latter in particular have benefited this year from zero-interest-rate policies. Until fairly recently, lower-quality companies have also been beneficiaries of record-low interest rates, which have given many a new lease on life. We have been focusing, as always, on companies with strong balance sheets and high returns on capital, or companies with the potential to produce high returns. This is the third year in a row that these kinds of businesses have suffered because of recessionary concerns.

 

Important Disclosure Information
Whitney George is Co-Chief Investment Officer and a Portfolio Manager of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. George’s thoughts in this interview concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

For more than 35 years, Royce & Associates has been managing smaller company portfolios using a disciplined value approach. We are dedicated to providing the best in small-cap value funds, both domestic and international. Small-cap value investing is our core business.

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