The equity markets currently appear to be caught in a daily tug-of-war between increasingly mixed macroeconomic data and strong microeconomic reports from corporations across several different industries.

If we use history as a guide, the period of transition from economic recovery to expansion is nearly always a rocky road. It becomes even more challenging when combined with a eurozone sovereign debt crisis, a slowdown in China, a major oil spill and continued global tensions.

At a recent dinner in New York, Jim Grant of Grant's Interest Rate Observer gave a speech entitled, "Bonfire of the Currencies." In it, he extolled the virtues of gold (a point with which we wholeheartedly agree) and, more importantly, espoused equity alternatives to the supposed safety of U.S. Treasuries as a way for investors to ride out these uncertain times. Mr. Grant spoke of undervalued companies that have the "proven adaptability" to operate through many different business cycles while continuing to grow and generate above-average returns on equity.

Although we spend very little time attempting to marry the daily macro musings with our analyses of companies, we do consistently search for the company qualities mentioned in the speech—in our case, undervalued smaller businesses that have a record of success and a history of above-average returns—what Mr. Grant describes as "proven adaptability."

To be sure, these are uncertain times. Listening to and reading the sage advice of macro strategists and economists is always an interesting exercise. Yet, perhaps the world is too macro with us of late. Here at Royce, we try instead to take advantage of the opportunities that the market is providing on any given day as we build our portfolios from the bottom up.

The recent macro-micro tug-of-war has created potentially profitable opportunities for long-term investors like us in the Natural Resources and Technology sectors. During the last quarter, for example, we found tech companies that demonstrated proven adaptability by moving from the rollout of desktop computers to the world of cloud computing. Others were survivors of the dot.com bust that are now benefiting from the pent-up demand from corporations, many of which slashed IT budgets during the recent recession. We also found technology companies that are gaining from the adaptation of new applications of existing technologies, such as LED lighting and semiconductor-driven variable speed motors that are being used to improve the energy efficiency of a variety of products.

At the same time, we increased weightings in the energy services industry, which had been punished in the wake of the BP oil disaster. Many of these businesses have developed key drilling technologies over the years, allowing them to adapt to and create the extraction of unconventional onshore natural gas and oil resources as their customers pursue exploration and production in several North American shale plays.

"Proven adaptability" is a concept that transcends our investment process. We have not changed our investment process to adapt to the whims of the current cycle or any cycle for that matter, but over time we have adapted in order to remain focused on the business of finding high-quality small-cap businesses, wherever they might be.

Stay tuned...
FDG

PS My favorite quotation from the second quarter is taken from a recent research report by James Furey of Furey Research Partners:

In the past 6 months, more than five times more money has moved into bond funds than equity funds. This differs from 2003, when money was moving into equities (and out of bonds) even one year after the recovery began and the market rebounded more than +60%. Assets in equity funds as a percent of assets in bond funds remains near a 15-year low. In the past, when this ratio was near its low, equities have significantly outperformed bonds.

James Furey
Furey Research Partners
Small-Cap Macro Mosaic
June 22, 2010