Commentary

David Nadel

Both international Funds seek long-term growth of capital by investing primarily in equity securities issued by non-U.S. ("international") companies—i.e., companies domiciled outside of the U.S.—that we believe are trading significantly below our estimate of their current worth.

The key difference? Royce International-Smaller Companies Fund has a small- and micro-cap European bias (its average market cap was $695 million as of 9/30/07), while Royce International Value Fund favors small- and mid-cap companies from around the globe (its average market cap was $1.3 billion as of 9/30/07). Click here to read more from the Funds' prospectus.

Please note that the Funds' names are changing as of February 15, 2008:
Royce International Smaller-Companies Fund is changing to Royce European Smaller-Companies Fund (read more). Royce International Value Fund is changing its name to Royce Global Value Fund (read more).

What effects, if any, have you been seeing in foreign stock markets as the U.S. equity indices continue to be so volatile?

DN: It used to be the case that when the U.S. sneezed, foreign markets got a wicked cold. That was the old paradigm. Today, foreign markets are increasingly decoupled from the U.S. Our economic hegemony is fading, and investors are accepting the notion that new leadership is emerging from abroad.

The key Asian markets, excluding Japan, continue to power forward and detach themselves from U.S. domestic volatility. We're not just talking about China, which gets all the attention. Markets in South Korea, India, Indonesia have advanced 30-60% this year alone, and we think there are still attractive values to be found within those markets.

Sure, there are some days when all geographies and asset classes seem to crumble together—maybe it's another hedge fund blowing up and being forced to liquidate. But frankly those days are useful to us because we can selectively bolster our investment commitments to the areas we believe should survive a downdraft. But by and large, what we see, and continue to expect going forward, is that the economic reality of decoupling, and an unprecedented global wealth transformation, will be reflected in the stock markets such that disciplined global investors should benefit.

Are you concerned about the potential ripple effect on global markets if the U.S. slides into a recession, or a more decidedly bearish stock market?

DN: Not really, and in fact, a bearish stock market in the U.S., or even a U.S. recession, could actually be beneficial for global investors because the global wealth effect inevitably has to find a home.

The issues in the U.S.—be it the credit crunch, the housing bubble, or even the challenge of eking out incremental productivity gains—are fortunately not mirrored in many of the foreign countries in which we invest. So, as I was alluding to earlier, the notion of a ripple effect from the U.S. is a bit outdated.

Why is it outdated?

DN: Foreign economies are less dependent on the U.S. than at any time in the post-World War II period, and they are also structurally stronger: many so-called emerging markets are sitting on fat reserves. It's not an accident that the IMF [International Monetary Fund] is struggling for relevance these days.

Many emerging economies no longer need the U.S. and other parts of the developed world to prop them up. They have their own strengths. For example, a recent trip I made to see companies in Brazil showed that its housing market—yes, housing—is booming, and actually the country's demographics and interest-rate structure support continued expansion.

And natural-resource based economies with strong currencies, like Canada or Norway, are just motoring along. Frankly, as a global investor, the prospect of a recession in the U.S. doesn't worry me all that much—and it could ultimately help reveal to us here in the U.S., what we need to do in order to stay competitive. 

Are you still seeing what you think are better values in foreign stocks than here in the U.S.? Do you think that is likely to change if American stock prices continue to decline?

DN: Yes, on average those of us at Royce who are involved in international investing still see better values abroad, and expect this trend will continue. We've seen that across the various countries we've visited this year to meet with local companies, from Finland to South Africa to France.

Foreign small-cap markets are 20 years behind the U.S. in many ways: broker research is sparse, so the smaller companies attract less investment, and foreign money managers in any case tend to invest in a limited universe of well-loved large growth companies—like many American money managers did with the Nifty-Fifty in the 1970s. This inefficiency creates tremendous opportunities for us and our investors.

Where are you finding good values right now?

DN: Some of the emerging markets such as South Africa and Indonesia have some very good values as you might expect, but less obvious is the fact that good values can be found in Japan and even Western Europe. Mark Rayner, Royce's London-based senior analyst, is finding some interesting cases right in Western Europe. Italian small-caps, for example, have become oversold lately, partly due to the perception—which isn't always correct—that they are all exporters vulnerable to a strong Euro.

Russia's another interesting market for our style. We are scheduling a trip for early next year to see companies there—should be nice and cold for us! For better or worse, I think the trend of better values abroad may stay with us. Of course, there are still good smaller U.S. companies for us to buy. They just happen to be those companies that derive much, if not most, of their revenue from abroad—so in a sense, they are really global businesses.

As a manager with a more global outlook, are you anxious at all about the ongoing weakness in the U.S. dollar?

DN: I wouldn't say anxious. The important thing is to accept the reality, and try to keep emotions in check. Sure it's undeniable that there are serious issues surrounding the U.S. dollar, such as its declining purchasing power.

The question is: How to profit from a weakened dollar? I think the answer is to invest globally with an approach like Royce's. In other words, invest over the long term in great foreign companies, giving extra consideration to industries, such as energy and mining, that offer the intrinsic worth of hard assets.Which is not to say all foreign currencies give us equal confidence. For example, I'm fairly cautious on the British pound, and we have tweaked our UK exposure particularly in Royce International Smaller Companies Fund.

Overall, we feel the U.S. dollar could continue to weaken further over time against the world's key currencies, particularly if foreign governments start unloading their dollar-denominated reserves. The dollar makes up about two-thirds of the world's currency reserves, and China alone is sitting on a quarter of them. Who will be the buyer for all that paper when China wants to sell?

Finally, there's also the prospect of the key oil-producing countries in the Middle East de-pegging their currencies from the dollar. The point is these aren't just distant events we're immune to. It's dangerous for Americans to think that just because we live here and pay in dollars, a falling dollar isn't going to hurt us. It will. That's why we are building our commitments abroad.

Thank you, David.

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