Commentary

Chuck Royce

After five months of difficulties for stocks, do you anticipate further declines?

CMR: We could definitely see further declines. At the end of the day a drop of 20% or more from the Russell 2000's interim peak in July wouldn't surprise me at all. However, I do think that the worst is behind us.

The most depressed areas of the stock market, such as financial and consumer stocks, have already been hit very hard, and I don't think subsequent price erosion will be as acute as what many companies in those areas have already endured. Bad news travels quickly, and the effects hit stocks hard and fast, which is actually why we're optimistic about the next three to five years.

While we're always focused on downside risk, we are just as excited about promising long-term opportunities that we see in certain smaller stocks in the current market. We understand that no investor enjoys these periods in which so many companies seem to be struggling and returns are falling further into negative territory.

At the same time, declines, corrections and the occasional bear market are part of the price of doing business in the stock market, especially if one is in it for the long haul, as we have been since 1972. And these are precisely the times when we seek out risk because so many others are avoiding it.

As the saying goes, "Pain is inevitable, but misery is optional." We have always believed that uncovering opportunity in poor market conditions is one of the most effective ways to build strong absolute long-term performance.

What effects to do you think the credit crunch will have on the economy and the stock market?

CMR: As with share price declines, it seems to me that most of the damage has already been done. Which is not to say that the credit crunch will stop affecting stocks or the economy, but rather that most of the larger institutions have been working on solutions.

Many of the same institutions that were very cavalier about risk prior to last summer are now behaving much more cautiously, owing to the subprime implosion, the credit crunch and looming anxiety over the possibility of a recession here in the U.S.

Do you expect smaller stocks to fare poorly or well in the event of a recession here in the U.S.?

CMR: It's hard to say. Historically, though smaller companies have emerged from recessions in relatively better shape than large-caps, over the full course of recessions the historical record is actually more mixed. Considering their performance over the last five years, it would be easy to argue that any coming recession would hurt small-caps harder.

I think consumer spending will remain reasonable, yet we've seen several smaller consumer stocks hit so hard you'd think large numbers of people boycotted Christmas shopping this year. Sooner or later, the market should reward those companies that seem to have been punished well out of  proportion to their worth as businesses.

Ultimately, I think that the economy will soften to the point of a fairly benign recession, and that by the time that happens, the market will be looking forward to an economic recovery. On an absolute basis, I think that smaller companies will be just fine during such a scenario, which I think is the most critical issue.

How important are macro-economic issues in relation to the firm's security selection process?

CMR: We've always watched macroeconomic events and kept track of developments in both the domestic and global economies. When tough times hit an industry, we move as quickly as possible to see what attractive values can be found there.

That being said, we respond to potential opportunities to buy quality stocks at a discount, not as a reaction to economic models or predictions. We don't have any economists on staff, or use economic consultants. So while we're always aware of what's going on in the economy and what people are predicting might happen next, we think that the stock market tells us all that we need to know.

The market is in many ways very democratic in that it functions like a giant voting machine that bestows favor or disapproval on thousands of companies every day.

Can you discuss some of the reasons the firm has been broadening its international investments over the past few years?

CMR: It's important to point out that we've been involved in overseas investing to one degree or another for many years. We've also been buying American companies with substantial global business for just as long, so a more global outlook is not really new for us.

The most important lesson we learned from buying non-U.S. companies over the years is that a good business looks the same in Italy or England as it does here in the States. The business models and metrics are similar, and today nearly all companies publish their relevant information in English. As large as the domestic smaller stock market is, it's dwarfed by the size of the international small-cap marketplace. To us, this really represents the best of two worlds—a domestic universe that we still feel great about and an international arena that we think is a source of enormous potential.

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