Small-Cap Industrials

Small-Caps And The Importance Of Buying In Declines

Chuck Royce and Co-CIO Francis Gannon discuss the October downdraft, the ongoing prospects for cyclical businesses, and more.

Q3 hedge fund letters, conference, scoops etc


Image source: Wikimedia Commons

Francis Gannon: So, Chuck, what’s your take on the downdraft that hit the market in mid-October?

Chuck Royce: It, you know, it really wasn’t that severe. We’re talking about 11% from peak to valley, but all types of stocks were hit. I don’t think there was anything particularly impressive about it. To me, it’s sort of been the most expected decline that we’ve had.

FG: It seemed as if the environment was ripe for some type of volatility, although everybody seems to be trying to search for a reason behind the decline.

CR: Sure. And you know people made up reasons sort of after the fact, after it was going low and finally rates caught up; I mean, there doesn’t need to be a reason. It certainly was highly possible we would have a correction.

FG: So given the current economic backdrop and market backdrop, how are you positioning your portfolios?

CR: I would say the one thing that is different from a year or two ago is we were avoiding, you know, high multiple stocks.

FG: What risk do you think investors are missing in the current market?

CR: There’s plenty of risk in the equation. The risks of geopolitical, risk of, you know China tariffs. I mean we can come up with a litany. I’m not so worried about any of those. I think markets will have more normal volatility. We plan to take advantage; we think we’re entering into a somewhat lower return period over the next three to five years. So to me, that’s what we’re focused on, and the correction is a very routine part of that.

FG: In my travels of late, it seems to be people are waiting for the next recession, trying to figure out where we are in the economic cycle because this particular cycle has been so long. You and I have talked about rolling recessions throughout the economy starting. Is that something that you think we’ll see going forward?

CR: First place, I firmly believe we’re not going to have a financial crisis. That’s yesterday’s issue. Of course, we will have future financial crisis type events, but not in the magnitude we just had. So I think that’s a worry that we should not be focused on. Having routine recessions, the big recession I don’t think is in the cards at all. So I very much think that is the model for the next X years of individual areas having pauses, slowdown in rate of growth; that’s normal. We’re probably in a period overall economically of peak growth. Completely normal. So none of that gives me a major concern.

FG: Some people are blaming the current pullback in the market on the psychological level of 3% for the 10-year bond. What are your thoughts on that?

CR: I do think it is an important level, absolutely. We’ve only been above three for consistently… only recently, only the last 45 days. I do think it marks a very real shift in the economic circumstances. We’ve been rooting for normalization, which is rates, you know, moving up more gradually. I do think it’s now a very real phenomena, especially in the high momentum and high multiple stock area that will absolutely constrict those performance areas in the next few years. So we are very sensitive to that. I also think it’s very healthy, the 3% plus.

FG: Reflective of a better economy?

CR: Absolutely.

FG: Do you feel still confident in the prospects for cyclical businesses?

CR: Sure. We start with an observation that high-quality cyclicals are very good valuation. They’re very good long-term bets. We’ve used them for a long time. And yes, we are sort of sticking with them. The cyclicality, as it plays out in their economic circumstance is one thing. It plays out differently in the market. But I’m comfortable continuing to own these somewhat cyclical companies.

“We added to the stocks we like, and we like a variety of types of stocks. We are always playing in the intersection of quality and value. We always, as a firm, want to add in declines.” — Chuck Royce

FG: Why do you think they’ve underperformed in a market where you should be rewarding companies for having better earnings?

CR: All focus has been on tech and health, 100%, all the eyeballs, tech and health.

FG: We’ve been talking about being selective in the small-cap space for a long period of time now. Were there particular areas of the market that you found more opportunities in this decline?

CR: As we know, value hasn’t done that well this year. In fact, there’s a large spread between value and growth. Now you did do better in the decline, but not by much. We added to the stocks we like, and we like a variety of types of stocks. But basically we are always playing in the intersection of quality and value. We always, as a firm, want to add in declines. That is just classic, that’s a standard principle for us, and we certainly did that.

Article by The Royce Funds

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