Getting in Position

Chip Skinner

Royce Value Plus Fund delivered 19.7% total return for calendar 2010, solid on an absolute basis, though the Fund's performance lagged the Russell 2000, the Fund's benchmark. Can you walk us through some of the headwinds that the fund faced?

Click here for the Fund's 1-year, 3-year, 5-year, and since inception performance for the periods ended December 31, 2010.

Last year was a bit of a roller coaster market, despite it being a very strong year for small-cap stocks. The first half was somewhat stalled, with mostly negative returns. By spring, there was a lot of concern about growth in China, European sovereign debt and a double-dip recession here in the U.S., all of which helped lead to a more than 20% correction for the Russell 2000 between late April and early July. Royce Value Plus Fund outpaced the Index during the spring-summer correction, losing 16.7% versus 20.3% for the Russell 2000 from 4/23/10 through 7/6/10. The Fund underperformed mostly in the bullish second half.

We would have liked the Fund to have participated more fully in the 'go-go' environment that marked the second half of 2010. Low-priced stocks fared better than high quality, which put us at somewhat of a disadvantage, as the portfolio was more largely invested in what we deemed to be quality stocks. Coming out of a recovery, higher-quality, faster-growing companies can be expected to do better, and we are positioning the portfolio for that outcome. I feel more confident today that we are firmly in an economic recovery, albeit a slower one than others that we have experienced in the past.

What specific areas drove the Fund's underperformance relative to the benchmark last year?

RVP's performance in 2010 saw strong positive contributions from investments in the Natural Resources, Technology, Industrial Products and Industrial Services sectors. However, we had a bit too much exposure to several turnaround situations that hurt relative performance.

What were some of the areas that you thought you were buying a little early?

Semiconductors, banking and natural gas industries were three industries that we liked, but didn't climb as high as the rest of the market. We're pretty comfortable with this because we buy with a long-term investment horizon.

About a year ago, there was a period of inventory replenishment in the semiconductor industry, which gave these companies a real boost. We started buying them in spring 2010. Unfortunately, share prices started to fall due to slowing demand and worries about a double-dip recession. Concerns over a second recession have since disappeared. There also seems to be more sustainable end-market demand, so we're still optimistic for the industry.

We were also early to banks, which were battered more than any other industry in the financial crisis. While our holdings in this industry did not detract much from the Fund's performance in 2010, they did offset results in very bullish periods, notably in the third quarter. One of the Fund's largest bank holdings was Marshall & Ilsley, which was acquired, but at a lower-than-expected premium. We sold the position between October and December.

I think that we are still in the early phases of a recovery for U.S. banks, as they focus now on setting aside reserves and reducing their exposure to commercial real estate. It seems likely that the M&A (merger and acquisition) trend will continue. For a variety of reasons, the healing process is taking longer than the S&L bank crisis cycle in the late '80s and early '90s, but we believe that this thesis is viable, and that more consolidation is in the offing.

As for natural gas, the portfolio's energy exposure has been more oriented toward it during a period when oil has been stronger. A number of natural gas companies struggled in 2010, primarily because gas prices were driven down by a glut in supply. Technological advances such as horizontal drilling have enabled the gas drillers to access a lot more gas each time they drill. Supply was further augmented by significant shale basin discoveries.

Talk to us about the turnarounds, and the mix of growth and value stocks.

We define turnarounds as companies recovering from depressed operating margins due to company, industry or sector specific factors. We held a number of turnaround candidates that didn't work out the way we had hoped—some took too long to fix their problems, while others had problems that were more extensive to fix than initially expected.

Are there any themes you will be looking at going forward?

We've been looking at opportunities in Technology, particularly in semiconductors and semiconductor capital equipment, which seem to have a longer up cycle underway than some investors had thought. Some of the drivers include innovations in bandwidth, such as Smartphone conversion—there's so much more data that you can get on your phone now.

Related to this is a paradigm shift from desktop computing to mobile device computing like the iPad, which is a trend that's here to stay. Streaming video over the internet is also a lasting trend—YouTube is now the second-biggest search engine site after Google. Video conferencing and cloud computing, which improves IT efficiency, are two other dynamic areas that we are interested in, that require a great deal more bandwidth investment by the service providers.

Some additional themes would include metals, infrastructure plays, and housing, which has been in a five-year decline. At some point soon, we expect to see the pendulum swing back.

What else are you doing to re-position the portfolio?

We are working now to increase our exposure to companies that we think have very strong growth prospects, while also deemphasizing turnaround situations. The Fund has increased its Technology weighting and is now overweight relative to the Russell 2000; conversely, it is underweight in financials and banks. We will be closely monitoring the energy sector, especially the price of natural gas versus oil. Finally, we'll be looking more closely at micro-cap companies and international stocks.

RVP has had some out of sync moments, but it's not unusual for a portfolio to go through a period like this. We have a good handle on what helped and hurt recent performance. Sometimes when your time horizon is longer, as ours is, you can be out of sync in the short term. RVP experienced that last year but we believe we are positioned well for the long run.