Kaplan: Finding Upside in a Challenging Environment

Jason Stipp: I'm Jason Stipp for Morningstar.

We're checking in today with Jay Kaplan, of small-cap specialist Royce to get some insights on the small-cap investing space and also some updates on the funds' strategies today.

Thanks for joining me, Jay.

Jay Kaplan: You're welcome.

Stipp: You're a manager on the Royce Value portfolio. I took a look at that portfolio recently. You have pretty big stakes in energy and materials companies, higher than the category norm, as of the last reported portfolio.

These sectors have lagged some other sectors in recent times. Can you talk about some of the opportunities you've find there, and if your thinking has changed about that sector recently?

Kaplan: Well our thinking hasn't changed, and materials encompasses a really broad spectrum of companies. So energy is kind of part of that, metals and mining are part of that, steel is part of that, chemical is part of that, fertilizer is part of that. So grouping it together can be a little bit tricky, but there a lot of different opportunities across a lot of different areas.

We haven't really changed our thoughts on some of these. They are growing, they are inexpensive, they are attractive in the long term--a little out of sync right now, perhaps, but we think that will be cured over time.

So everything we do is with a three- to five-year time horizon. So we're trying to look out a bit, and we think everything's going to work out over time.

Stipp: Have you been adding to any these positions? There has definitely been some weakness in those sectors broadly. Have you been adding to any of them?

Kaplan: I've been adding a little bit to energy in here outright, and the other thing that's going on is, fund flows haven't been great in small-cap equity funds. So if we don't sell some of the material stocks when funds flow out, that kind of brings the weightings up. So even though maybe we're not exactly buying, we may be bringing some of those weightings up as we sell some things that aren't quite so attractive.

Stipp: You folks are generally long-term investors. You'll hold positions for a long time. You're buying sometimes smaller cap stocks and you'll let them grow into the mid-cap space. So you sort of let them run. As you're looking at your portfolio today, are there any firms that you've had for a while that you still a lot of runway left that maybe you've grown up with a little bit? Any stocks you feel like, these are going to be great for the long-term and even beyond?

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Kaplan: Let me give you a great example--a company called Lincoln Electric. As a firm, we have probably owned it for 20 years. That's a long time. We still own it, and we still like it. It's in the welding business, globally, welding consumables. We love consumables businesses, but that's a solid, high return, well-managed company. Up and down, it's economically cyclical, because you don't weld so much when there is not a lot of construction, but for the very long-term, that's a great place to be.

Helmerich & Payne is another stock we've probably owned for 10 years. Oil and gas, land drilling. They have a better mousetrap, they drill faster, better, cheaper than their competitors, and they have a lot of runway, too.

So these are companies that we've grown with and hopefully we'll continue to grow with.

Stipp: When you're thinking about when you would sell a company, is there a size that it would reach where you'd start to take a look at getting that out of the portfolio, and also from a valuation perspective, does something ever just get too overheated, and you have to take some of that money off the table?

Kaplan: Oh, overheated, absolutely, that happens all the time. Part of risk control is looking at valuation, and we set buy and sell targets for our stocks, and when they get very expensive and they move past our sell targets, we're happy to sell them.

Selling something because it gets big, we don't do that very much. That's a high-class problem to have. You don't necessarily want to sell something just because it got big, if it's still attractive. So we'll stay with those.

But the reality is, there aren't a lot of small cap companies that actually grow up to be large-cap companies. It doesn't really happen that way; it doesn't really work that way. A lot of the companies, they stumble, they get big, they stumble, the stocks come down again, the market cap comes down again, and we recycle the merchandise. We use the same names over and over again, or sometimes they get taken over. So it's pretty unusual for a small-cap company to grow up into a large-cap company. You would think that would happen, but not really.

Stipp: You alluded to this earlier when you mentioned inflows and outflows of investor money. We've certainly seen a trend where investors are continuing to put money to work in fixed income to the detriment, at times, or a lot of times, of U.S. equity strategies. There are a lot of different explanations for this. Some say demographics, some say risk aversion, some say yield seeking from money markets, a lot of different reasons--it's probably a combination of them. But in general, do you feel like this trend, this headwind, is going to be something that equity managers are going to have to live with for a while?

Kaplan: I suspect we're going to be living with this for a little while, until people start to lose money in fixed income. If you buy a long-term Treasury and you get 1.5%, 1.6%, 1.7%, that's a bad bet. There's not a lot of upside. If we get any kind of inflation, erosion of purchasing power, that's a terrible bet, and when interest rates go up for folks who know about bonds, prices of bonds go down--that's bond 101. So, rates will be low maybe for the next couple of years. But at some point, when the economy gets better, rates will go higher, people will start to lose money in bonds, and they'll figure out that the bet for safety really wasn't there, and maybe they should take a little risk in equities to really try and get the bigger rewards.

Stipp: Another fund that you're a manager on is the Royce Dividend Value Fund, and aside from fixed income, we are also seeing investors have generally an income focus, and they are looking for dividends. We've had some folks concerned that dividend-payers are getting a little bit overheated, because of all the interest in dividends. When you're looking at that fund and your opportunity set, have you found that it's narrowed a bit as the attention on dividend-payers has grown?

Kaplan: Not really, and here is why: We look at our dividend-paying funds, like we look at our other funds… Let me tell you what we don't do. We don't chase the highest coupons we can find, and we don't invest in companies with a lot of leverage. So we're not invested in a lot of REITs, and that's probably in the category of things that have gone way up, and MLPs--master limited partnerships--in the category of things that have gone up, and utilities in the category of things have gone up some.

So all those things with leverage and high coupons, that's not where we're investing. We're investing in solid companies with strong balance sheets that happen to pay a dividend, happen to generate free cash flow, have the opportunity to grow that dividend over time, and have the opportunity to grow the value of the business you're investing in over time.

So we take kind of a different approach than the people who are purely out for yield. So, are some things overheated? Yeah. Are large-cap dividend-payers getting a lot of focus? Yes, but that's not really where we are. We think we can deliver a total return strategy that has some income component, not a gigantic coupon, but really gives you total return over the long term.

Stipp: We've had some managers mention to us that current income is getting a little bit overheated, as you mentioned, but the opportunities for dividend growth in some names, still you can find attractive valuations. Would you agree with that notion?

Kaplan: I think so. If you find companies with great free cash flow and management teams that use that free cash flow in a shareholder-friendly way, like paying and increasing dividends or even buying back stock or reinvesting in the business when that makes sense, over time as those businesses grow, and the cash flows grow, dividends should grow, too.

Stipp: Last question for you: We're seeing especially in the last couple of years that macro headlines seem to be dominating the conversation. There's no shortage of sources for these macro headlines.

But I'm interested from your take as a fundamental investor, you're looking bottom-up, you're examining stocks and stocks' prospects, how do you account or how should you account, if at all, for these macro headlines that we're seeing? How does that trickle down to a fundamental analysis and the prospect for a company?

Kaplan: It does trickle down. It's very hard. There's a lot of noise. There's a lot of media. News is 24/7 now. So we hear about these things all the time. They exist, they are real, there are challenges in the U.S. economy, there are challenges in the world economy, there are challenges in governments. We're all in very slow growth mode at best around the world. So all that stuff is there.

We try and take a longer-term three- to five-year approach, try and drown out the noise if we can a little bit, and we look at companies, we look at their prospects, we look at how they've grown through the difficult period that we've had already. We try to make a judgment about how they might grow through what we think could be a difficult period again, or maybe it won't be, but if the market consensus believes that growth in companies will be muted, and we can value those companies based on that muted growth and pay a low value relative to that very muted outlook, we have a lot of ways to be surprised on the upside: If things are better than we think, well earnings will be better and that will help. If companies grow faster than we think, multiples will go up, and that will help. But we can protect the downside by viewing our investments in the context of, things aren't going to be so good for a while.

Stipp: Jay Kaplan of Royce Funds, thanks for joining us today and for your insights on the small-cap space.

Kaplan: My pleasure. Good to be with you.

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