US Videos

Royce: Better Times Ahead for Quality Stocks

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. We are checking in today with president and co-CIO of Royce Funds Chuck Royce to get his take on small cap investing in today's environment. Thanks for joining me, Chuck.

Chuck Royce: Great.

Stipp: Recently you had an update to shareholders that said, "unfortunately the recent pattern of risk-on, risk-off behavior has not allowed the market to establish a consistent direction."

Given that macro headlines seem to be dominating the market on a day-to-day basis. As a fundamental investor, has it been a frustrating environment for you to work in?

Royce: I think that's absolutely correct. This whole idea of risk-on, risk-off is probably a way too complicated way of saying that things have become more correlated on the way up and on the way down.

We are in the active management category. We want to win over time. We want to beat our appropriate benchmarks. It has been tougher in this kind of directional market--straight up, straight down. I'm looking forward to return to more normal period, which I think is coming and has sort of started in the last couple of months.

Stipp: Sometimes when the market is up or down on a big macro news [headline], you can go in and find opportunities, things get mispriced.

But might we expect to see some of that mispricing continue until some of this uncertainty clears up? The European situation that seems to be dominating headlines, now this fiscal cliff that everyone is just intently focused on. Will it be a while, do you think, until we start to see convergence?

Royce: We're never going to clean up all the macro headlines. What we do is try to work underground. We're always working underground. There is always macro headlines. You cannot go back to a single year where there wasn't kind of a worry or a big deal.

So, when I say we want to go back to normal, normal still is macro headlines, but normal is less correlation, less of a directional move in the market, and more of a routine market, if there is such a thing, with returns in the positive cycle, but not so high that we can't do better.

Read Full Transcript

Stipp: Speaking of the economic situation and the macro headlines: Arguably you can say a lot of the economies of the world have slowed down, remain sluggish, or are potentially in for a period of recession.

But when you're looking at corporate fundamentals, what do you see when you look at corporate strength in the balance sheets? Are corporations in a better state than a lot of the sovereign countries that we're seeing?

Royce: Absolutely. The corporate balance sheets per se are in great shape. Our small-cap companies, which tend to have a global orientation, are doing very well in their balance sheets. They are saving money for last year's fiscal crisis. They are looking forward to, they would say, a greater level playing field from a tax standpoint or a regulatory standpoint. I think they're right in some way, but their balance sheets are better than the headlines suggest.

Stipp: When you're looking at companies from a fundamental basis that may be operating in parts of the world that could be slowing down, how do you think about their prospects in an environment where you could see less spending or there could be pressure on business spending and business investment?

How can you look at your companies and see, can they at least hold up better than others, or maybe even this could be a period where they could expand or perform better?

Royce: Our quality theme has very high quality companies, great balance sheets, of course they have very strong returns on capital goals, so they are very judicious as to how they spend their money, maybe even more conservative than we would like in some cases.

There is a slowdown in the world in various ways. I don't think we're going into a recession in this country, but obviously we're in a slowdown phase, but we always look ahead. We're looking out three to five years at all times and developing a scenario and a valuation that's appropriate for a long-term view.

Stipp: You mentioned quality there, and this is one of the things that you look for across your portfolio--quality companies. Can you talk a bit more about what is it mean to be a quality company, and specifically are there differences in what you need to see for a smaller company to be considered a quality company than you might need to see for a bigger company to be considered a quality company?

Royce: That's a great question. Let me answer that first. There probably isn't, but inherently in a small company there is more fragility. They're smaller. There is probably less management depth. It could be the first or second generation management since the founding. So, there is that fragility that's very real. So, we have to be doubly sure that the company has a margin of safety in its balance sheet, primarily. The first stop for us is the balance sheet. So, we have a very strong leverage benchmark that we seldom violate.

Now, the second area for quality for us is returns on capital. We look for that to be real, sustainable, understandable where it's coming from, and we need to have conviction that it can be sustained over long periods of time.

Stipp: What about margin of safety on the stock price? How much do you demand? What kind of a discount do you want to see based on what you think the stock is worth?

Royce: Ideally a 50% discount, buy a dollar bill it for $0.50, ideally. Now, you don't always get that opportunity, and at all times the portfolio may not represent exactly that because once you buy it, it goes in the portfolios, prices change. But on a ideal basis, it's definitely to double our money in three to five years.

Stipp: So, let's talk about opportunities broadly. When you look across the portfolios at Royce, maybe look at the cash stakes, the money that you've been putting to work. Would you say that your opportunity set--those good companies with those balance sheet characteristics that you look for, the valuations that you look for--is it good hunting time for you right now … or are you sitting tight?

Royce: We are close to fully invested. We absolutely believe that we're entering into a much better market period in the next three to five years than in the last three to five years. I believe that we are going to solve this fiscal crisis. One way or the other, we're going to fight about it. We're going to have horrible headlines. We're going to have all sorts of hiccups, but I absolutely believe it is critical and is solvable. So, I believe the environment is going to be very positive for equities. I believe our quality theme is going to work very well. It has not worked as well in the last three years, because monetary stimulus tends to favor actually less-quality companies.

Stipp: Last question for you. Aside from a trend that we've seen of investors putting a lot of assets into fixed income, which is its own issue that we could discuss. We're also seeing more money flowing to passive investments. Can you make the case for me of why active management can add value in small caps?

Royce: Active management, the historic evidence is very strong that we can add … value in the small cap world. Our record is excellent in that. We are very proud of that. It's primarily because there is so much you can do in the small-cap world. Small cap is deep and broad. Small cap is a couple trillion dollars. Small cap is 5,000 to 8,000 companies--just domestically. So, logically there is more to do that allows you to beat the benchmark.

Stipp: On the case of fixed income, do you think this is a trend that we're going to continue to see for a while? Maybe there is demographics behind it, maybe folks in money markets are looking for yield, but the flows into fixed income at the expense of U.S. domestic equity have been pretty eye-popping over the last year or even longer. How much of a headwind? How long might this persist?

Royce: This is a bubble going on right now, as we speak, it is equivalent to the growth stock bubble in the late '90s in terms of impact, and how much damage it will do to the people participating in it in the next five years.

Stipp: What do you think is potentially going to pop that bubble? Negative returns for fixed income?

Royce: I think negative returns for a quarter or two, losing 5% of principal. People just don't understand that you can lose money in bonds.

Stipp: Chuck Royce, it's always great to check in with you and get your take on the markets in the small cap space, specifically. Thanks for joining me today.

Royce: Great. Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.