Commentary

Lauren Romeo and Jay Kaplan with Chuck Royce

Where are you seeing opportunities in this market?

Lauren: Our goal on a day to day basis is to look at the opportunities that the market is giving us, to find high-quality companies selling at a discount to what we believe they are truly worth. I try to take advantage of sectors that are out of favor, almost forgotten. Technology, energy services and some financial service companies have been looking more and more interesting lately.

Jay: Given the recent rally in the small-cap market over the summer, bargains have been harder to come by, although prospects have increased with the most recent September pullback. I’ve been seeing some opportunities in the technology and healthcare sectors while more recently, the insurance industry has also been looking very interesting. Finally, I would say that micro-caps have been attracting my attention, too.

Jim: Consumer discretionary stocks still look historically cheap and continue to be a major focus for me. I find myself very interested in what look to me like quality Asian equities that trade on the New York and Hong Kong Stock Exchanges.

What do you make of the severe sector rotation we have seen, especially in the third quarter? Are we making selective bottoms on some sectors?

Jay: Looking at what’s happened most recently, financial stocks rallied sharply in July and August, as did some other areas that had been down a lot. At the same time, energy and material stocks declined mostly because of a perception that the rest of the world was slowing down and that we were all connected. We don’t know why that in turn would have you turn around and buy financial stocks, because it’s not good news for business or for any part of the market.

Wearing our three to five year hat, it is hard at times to look beyond the daily noise. However, if one were to look at the energy industry, we don’t think energy stocks ever got anywhere near to a valuation that reflected oil prices of between $100 to $140 per barrel. We think they got stuck more in the $60 to $80 per barrel oil price range, and in the $7 to $8 mcf (1,000 cubic feet) natural gas price range. So the stock market was skeptical of the run up in commodity prices to begin with. To have prices then correct to where oil dropped to nearly $100 a barrel seemed to us like it created some even greater values. These are all limited resources; these are industries that have been under-invested in for the last 20 years.

If you believe that the global economy is going to muddle through and eventually be O.K., maybe not growing rapidly, demand for those limited resources will continue and the supply is still shrinking. So fundamentally we believe that these companies still look attractive. It seems likely that when people are feeling a little more bullish about the market or the global economy, they will scamper back to the energy names fairly quickly. Overall, we remain very optimistic about natural resources and would note that very compelling valuations remain: prices at seven, eight, nine times earnings for companies that are growing on an absolute basis with a scarce resource looks compelling to us.

Jim: Recent sector rotation has been a big help as we search for new ideas and has created some very interesting opportunities both domestically and internationally. This volatility enables us to take our time in building our positions and pay the prices we want to pay, all of which could potentially benefit the portfolio over the next several years.

How do you view your role as an Assistant Portfolio Manager in Royce Pennsylvania Mutual Fund?

Francis: At the end of the day, Chuck is the portfolio manager. My goal is to contribute new ideas within the areas of the Fund that he would like me to concentrate on. Lately, my focus has been on making sure we are focusing on those high quality companies that should benefit in these uncertain times and have underperformed significantly going into this tightening credit environment. The next year or so will be a time to prepare and position the portfolio for a market and economic rebound that remains at least a year or two away.

Jim: I think it is important to understand that everybody zigs and zags differently. We all notice different things, be it at a meeting with a company’s management team or reading a research report. Our structure gives us the ability to exploit our strengths and introduce ideas from our perspective that might not otherwise be brought to light. Chuck recognizes those nuances and capitalizes on them.