Staying the Course: Uncertainty Abounds, But Our Approach Remains Consistent

"Of course, you cannot predict anything with precision. Forecasting volatility is like forecasting the weather. You can measure the intensity and path of a hurricane, and you can calculate the odds of its landing; but, as anyone who lives on the U.S. Eastern Seaboard knows, you cannot predict with confidence exactly where it will land and how much damage it will do."
-- Benoit Mandelbrot, The (Mis)behavior of Markets

Staying the Course: Uncertainty Abounds, But Our Approach Remains Consistent

August was a month of high anxiety, increased volatility, and more uncertainty. The widening stresses in Europe seemed to spread to the banking system, while U. S. economic data was producing mixed signals, raising business caution and encouraging potential contractions.

The odds of a recession have moved up, with even the Federal Reserve at its August meeting substantially lowering its forecast for economic growth in the latter part of the year, while at the same time announcing it will keep short-term rates near zero at least until mid-2013.

Gold rallied to touch $1,900 per ounce, S&P downgraded the debt of the United States, the CBOE Volatility Index (VIX) spiked to 48 (after sitting at 15 at the end of April) and the yield on the 10-year U.S. Treasury momentarily fell below 2%.

The east coast of the United States was even rocked by an earthquake just days before a hurricane barreled up the coast. For its part, the small-cap Russell 2000 Index fell 8.7% for the month and was down 15.6% from its 2011 high on April 29.

Investors are understandably nervous, and for the moment we seem to be caught in a seemingly endless negative feedback loop. So how are we at Royce dealing with all the volatility?

From our perspective, the answer is simple—we are coping with increased volatility just as we always do—by focusing on risk, absolute returns and a long-term investment horizon, using declines as an opportunity to refresh our portfolios.

The indiscriminate selling over the past month has allowed us to re-enter some of our highest-quality names at what we believe are highly attractive absolute valuations. Ideally, these purchases will help to lay the groundwork for performance over the next two or three years.

As we have always done during very difficult periods, we are adding risk as the market is removing it by reducing valuations. To be sure, attempting to properly value a business has always been an integral part of our investment process and our portfolios' total return experience.

In today's uncertain economic environment in which short-term interest rates are effectively zero, uncovering quality companies at appropriate valuations is of paramount importance. To that end, those companies that possess a strong balance sheet, a history of earnings, high returns on invested capital and the ability to generate free cash flow are critical.

Ironically, today's slow-growth economy is a favorable backdrop for our disciplined style because of the importance of company quality, in particular free cash flow. We have always thought that a company's ability to generate excess cash flow is often linked to its capacity to sustain positive earnings and to generate a high internal rate of return.

Having the financial flexibility of excess cash flow allows companies to focus on growth, pay down debt, or even pay a dividend. All of which, in our opinion, are markers of quality. This is why our valuation methodology has always focused on free cash flow yield as an important metric in determining a company's absolute valuation.

August has historically been a difficult month for the markets, and the most recent one did not disappoint. Uncertainty abounds, but our approach remains consistent.

As we have mentioned before, while volatility will most likely increase or stay elevated over the next several months as macroeconomic uncertainty persists, we remain steadfast in our approach and our focus on quality. The importance of free cash flow should also increase for this reason. Perhaps not for a long time has the continuing generation of excess cash been more valuable.

The fortunes of quality companies in all asset classes will resemble the growth in the economy—slow and steady, not very dramatic, but in retrospect highly satisfying.

We continue to believe that inexpensive high-quality companies are under owned, especially within the small-cap space.

Stay tuned…and stay the course!
FDG

P.S. We found an interesting quotation from Michael Churchill of Churchill Research for those focused on the precious metals and mining industry, as we are: "The economic situation is not as bad as in 2008, but markets are more fearful than in 2008. A statistical recession in the U.S. is certainly possible but a freeze-up of the financial system (à la 2008) is highly unlikely. For investors in precious metals stocks, all that really matters is that the economy avoids a severe contraction and that financial markets continue to function properly. Both seem likely."