Keeping It Simple: An Interview with Whitney George

Whitney George

Can you talk about how managing portfolios in the current bear market compares to previous difficult times such as 2002 and late 1998?

Each bear market is different, but our disciplined approach doesn't change. So while each down period has its own characteristics that need to be taken into account, our work remains grounded in the same principles — strong balance sheets, high returns on capital and the ability to generate free cash flow. What differs from bear market to bear market is both where you find those companies and how they perform when share prices are falling. In 2002, we were generally more successful at holding value than we have been in the current period. However, in any period we're looking forward three to five years from now, to get a sense of what areas are likely to recover strongly and which will not. In some ways, I think we're now paying the price for the fallout in 1998 and in 2002 not having been as severe as perhaps it should have been. In both cases, the government chose to lower interest rates and generally encourage greater liquidity, which had the effect of creating very mild recessions that in turn may have encouraged the reckless approach to risk that helped bring on our current situation.

What are some of the specific challenges in managing a more diversified portfolio, such as Royce Micro-Cap Fund, as compared to a more limited portfolio with larger small-caps such as Royce Premier and Value Funds?

In each portfolio, we use a very simple model where we start with the balance sheet. We look very closely and broadly, generally settling on those companies that we feel have fortress-like protection in terms of their assets. A really strong balance sheet provides the best protection that we know of. It can help a business to survive through short-term economic disruptions and in the more general turmoil that we have currently. That's our starting point. After that, we look for good businesses, which for us means high returns on capital. That's as a good a measure as there is to gauge the historical quality of a business. We want to understand how the business got there and why it's sustainable. Ultimately, we're contrarians, and we like a good price when we're buying. Our practice is to dollar cost average — we tend not to plunge in and out of stocks, but rather we wade in and out, closely watching the stock price as we make our moves.

Has the bear market changed any of these practices?

No, but it's certainly made the selection process more interesting, especially in the micro-cap sector. As of the end of February, more than 75% of the stocks in the Russell 2000 were micro-cap stocks and about 22% of the S&P 500 were small-cap stocks. [Data from FactSet] Each universe is just exploding with opportunities right now. With the number of micro-cap and small-cap companies growing higher with every down day, our challenge is to not over-commit. Of course, given both their vulnerability and volatility, we're generally pretty diversified with micro-cap stocks in any market climate, and our selection standards throughout our universe have remained as exacting as they've ever been, if not more so. We are happy to see many micro-cap and small-cap companies that have been breaking even while operating at roughly 45% of capacity, which to us is a very promising sign of both resilience and comeback potential.

How are you approaching Royce Low-Priced Stock Fund now that the share prices of so many companies throughout the market are falling to less than $10 per share?

In much the same way. It's certainly been interesting to see so many blue chips enter the low-priced area, even the very low-priced zone of less than $10 per share. The rest of the world has had to get used to investing in low-priced stocks, whereas we've been there for 15 years. In fact, even a modest recovery would mean a great boost for many low-priced stocks. So from our standpoint, all of the reasons that would lead you to run a low-priced stock portfolio have only grown stronger.

What is attractive to you about stocks in energy, hard assets and fertilizer?

It comes from us thinking about what the world will look like in the next three to five years, when we think the equity markets and economy will be growing again. We don't think we'll be in an economy in which consumer spending represents 70% of GDP, but people need to eat — every day there are about 270,000 new mouths to feed in a world with finite resources and only so much arable land. Our interest in fertilizer companies comes from that and the fact that we've seen some great values in that area over the last several months. Energy and hard assets are likely to benefit not only from our own efforts to rebuild infrastructure, but those in China and eventually Europe as well. It's easy to forget that prior to the credit crisis, there was a very encouraging revival in industrial activity here in the U.S., and I think there's a good chance that it will resume as the economy begins to rebound. In addition, I wouldn't be surprised to see ample foreign interest in domestic industrial and mining companies as governments and other foreign investors look for a more potentially profitable way to invest in the U.S. than owning Treasuries or other agency debt.

Do you think we've seen the worst of the bear market?

While last week's rally was certainly welcome, I really don't think there's any way to predict that. Another encouraging sign is that so far in 2009, there have been a growing number of days when selling was fundamentally driven rather than liquidity driven, or at least it's looked that way to us. We've still seen plenty of the latter kind of selling, but it is slowly beginning to change. Having said that, I still think we could approach new lows in the coming months because so many investors are still anxious, uncertain and afraid.

Tell us about the newest portfolio that you manage—Royce Focus Value Fund.

I think it's a good time to introduce a portfolio that emphasizes the traditional Royce fundamentals of strong balance sheets, attractively low valuations and high returns on invested capital. I wanted the freedom to roam more freely in areas that have become depressed. In some cases, larger companies have seen their values deteriorate significantly, but look otherwise well-positioned to rebound when the economy recovers. So the portfolio invests in micro-, small- and mid-cap stocks, but may also invest in large companies as well.