Whitney George on 2011: High Volatility and Attractive Valuations

Whitney George

How are small-cap valuations as we head into 2012?

We think that valuations for our portfolio companies are as compelling as we've seen since the last market bottom early in 2009. When we look at the combination of earnings progress and the pull-back in prices since the late April 2011 high, the overall picture looks very similar to what we saw nearly three years ago.

We've used the volatility to construct refreshed portfolios so that in aggregate, the risk-reward picture looks as promising as we can recall. Of course, the small-cap universe is both large and deep, with a very wide range of valuations. People have been pointing recently to small-caps as being statistically more expensive than large-cap stocks, which strikes us as a very broad generalization.

We've been focusing more on those areas that are economically sensitive, that have been punished by fears of another recession to the degree that these prices look very attractive, particularly when measured with average P/E multiples, price-to-book multiples, balance sheet quality, and business fundamentals.

What do you make of the severe volatility of gold and silver prices in 2011?

Gold was very volatile in 2011, silver even more so. Much of the world sees gold as a kind of currency, which is especially true in the developing world, and currencies in the developed world were also highly volatile in 2011, which made gold's movements unsurprising.

For many, investments in precious metals represent a form of insurance against economic disruption, whether inflationary or deflationary. From time to time people who buy insurance need to make a claim. In this case, they sold gold because it's a liquid asset that can be sold easily when other sources of funding became scarce.

We saw something similar happen in the fall of 2008 during the financial crisis when gold corrected very sharply. Not long after, it resumed its near-decade long upward move.

The prices of silver and gold mining companies were even more volatile and disappointing in 2011 given that gold prices were still up for the year. We continue to see great opportunities with these companies mostly because the conditions for gold and silver prices to climb remain in place.

Considering that interest rates are below long-term inflation rates, we are still in an environment of negative real interest rates. Traditionally, this has provided a tailwind for gold, and therefore our enthusiasm for mining companies was undiminished by last year's volatility.

What is the case for investing overseas right now?

One of the things I think we need to come to terms with here in the U.S. is being part of a global community, which means that we must pay attention to politics and headlines coming out of Europe and other parts of the world.

What happens in Europe now matters here in the U.S., and one of the challenges is that they do business differently and have done so for a long time. There are 17 countries that are linked by a common currency, the euro. This means that there are 17 prime ministers, 17 central bankers, 17 finance ministers, etc., each of whom can say something that may disturb the markets, rather than just our own Ben Bernanke, Tim Geithner and President Obama.

So I think with time, we, like the Europeans, will become accustomed to this process. As messy as it seems here, it's been a lot messier in Europe, at least from a headline standpoint. I see this ultimately as a positive because we are seeing price points overseas that are very attractive, in many cases as compelling as they were early in 2009.

Major overseas stock market averages were down in 2011; for example, the FTSE was down 2.7%, the Hang Seng lost 17.3% and the DAX fell 16.6%, all in U.S. dollar terms. We do not hedge currencies at Royce, so the recent strength in the U.S. dollar has made some of these international opportunities even more attractive.

What sectors and industries have you been focusing on most recently?

We've been investing in those economically sensitive, cyclical businesses, while most other investors who have chosen to remain in equities have been gravitating to more defensive areas.

Our emphasis has been on sectors such as Materials, Industrials and Technology, which have been key areas for us during the last few years. These sectors corrected sharply in 2011, which was very disappointing in the short term, though it did allow us to build positions in those names in which we have the highest confidence.

We continue to believe that the U.S. is on a slow but very real path to recovery and that U.S. companies are well-positioned to grow globally. We like businesses that are based here in the U.S., where they have access to ample and inexpensive energy and raw materials to make products that can then be sold in fast-growing international markets.