Chuck Royce

Do you think that the rally that began off the low on March 9 is likely to continue?

I think the first phase of the bull market is probably complete. By that I mean the kind of market that we've seen since the March lows, which has been characterized by dynamic, double-digit returns, and stocks of all sizes in nearly all sectors and industries benefiting greatly.

Around the middle of June, the market fell into a corrective period, almost as if it were catching its breath after this wild run-up of stock prices. This period could last for another few months or could be over by the time this interview is being read, though I would not be surprised to see overall modest declines in the range of 10%-15% regardless of the time frame.

I expect the next phase in the current cycle to be bullish, but the returns will not be as lofty. My expectation is that we'll see more historically typical performance patterns, with more sector and industry rotation and greater discrimination on the part of investors for quality companies. I also feel confident that higher quality stocks—those with solid earnings, high returns on invested capital and/or that pay dividends—should take the lead in the next bull phase.

Are you surprised that the rally has so far shown more favor to  'lower quality' stocks?

Not entirely. The rally was good for all kinds of stocks, even as it gave many low-priced stocks an extraordinary boost because companies whose share prices had hit single digits looked particularly attractive.

Of course, we do a lot of work in that area, but our search is for quality small-cap companies that have fallen on hard times, while many other investors seemed to be more recently focused only on the notion that it takes very little for low-priced stocks to score large percentage-point gains.

It was an understandable temptation, especially considering just how bad a beating so many lower-quality stocks had taken over the last nine months or so. They seemed to suffer more than their peers in the collapse, so it wasn't surprising to see them rebound so strongly when the market rallied.

Why do you think that quality stocks can lead the market when share prices begin to rise again?

I do think that the next phase will be a quality phase. My reasoning is that enough investors will begin to focus on company quality now that the period of momentum-driven results appears to be behind us. It seems to me that quality stocks should do well across all asset classes and in all industries where they can be found.

So we may see, for example, small-cap leadership for a short time, then a period of large-cap outperformance, etc. However, quality is likely to be a lingering presence in a solid bull market that should otherwise see a lot of rotation in leadership.

When do you think an economic recovery is likely to begin?

The economy is the elephant in the room. The recent rally was fueled in large part by investors' expectations of an economic recovery that, perhaps needless to say, has thus far not materialized.

I think that some investors confused economic stabilization with economic recovery, which I'm sure helped the prices of certain stocks to run ahead of what their fundamentals might suggest, which in part explains why the rally lost steam in June. From an equity investor's standpoint, recovery is necessary for the market's bullish moves to be sustained.

There's going to continue to be a lot of rancorous debate about where the economy is and where it's going. There'll be plenty of disappointment and cynicism, as well as an ample supply of naysayers along the road to economic recovery, which I think will proceed slowly, by fits and starts, to the point that within a year a recovery should be well underway.

I don't think it will be as driven by consumer spending, but instead will be led by revived industrial activity, natural resources and perhaps even financial services. Consumer activity will still play an important role, but I expect consumer spending to account for far less of GDP than it did prior to the recession, which will be a positive development.