Commentary

We've just had a true correction, bordering on bear market, for the first time in five years. Does that present you with challenges or opportunities?

I think that the correction in the early part of this year has presented the best investing environment that we have seen in five years. That's encouraging for us because these good investing environments offer us opportunities to set up ultimate long-term performance. It's hard to predict whether there will be further correction—there may well be. But it's during these downturns that we tend to distinguish ourselves. We are risk managers, and risk management isn't a particularly apparent skill, until you go through periods like the current one.

Is the subprime mortgage crisis behind us?

We aren't going to bounce back from this quickly. I believe we are coming out of a credit bubble whose consequences may be every bit as severe and broad ranging, if not more so, than those of the tech bubble that we experienced in the late 1990s. It will take a long time for those sectors that were most affected to come back to a normal state of affairs. The stocks that have been most adversely affected are the ones that were the most levered—most notably banks. Banks typically use more leverage than life insurance companies, which use more leverage in their model than property and casualty insurance companies.

Do The Royce Funds have exposure to stocks in the subprime mortgage market?

Not significantly. To the extent that we have financial exposure, it has been concentrated in those sectors that are the least leveraged. The idea of low leverage runs through our entire investment philosophy. We look closely at balance sheets. We always have. That has become a particularly useful and effective discipline as we work through the ramifications, and the unwinding, of the enormous amount of leverage in the overall system, both here and internationally. Leverage is showing up in a lot of unexpected places. It's not just in the hedge fund community, it's not just in the mortgage business, but it's even in the way municipalities and states finance projects. There was a very long complacent period in which this leverage built up. Just as technology has struggled to return to its former glory in the market in the eight years since it peaked, I would suggest that financial stocks, broadly, are not going to go back to where they were for quite some time. We experienced a 26-year period of declining interest rates—rates peaked in 1981—that provided a very strong tailwind for companies that were using leverage and lower financing costs. And now financing costs are going up.

So where are the opportunities now?

Central Banks are working very hard to provide liquidity in this unwinding phase, but the money that they are producing is unlikely to go back to the sectors that caused the problem. After the tech bubble burst, money didn't return to tech stocks when it became cheap and available. It ended up going into a place in which people had enjoyed a positive experience: housing. And what started out as a very reasonable and conservative investment trend in the housing sector got out of control. The trick now is to look across the landscape to identify areas that are sensible investments now, where people are likely to gravitate. So far this year hard assets have been doing very well. Agricultural stocks (there's nothing more basic than food) and certainly precious metal stocks, for example. It's now working into people's minds that inflation is going to be higher. And it's not going to go away quickly. So it's not hard to envision people moving a small portion of their assets into hard assets—something to buffer the effect of rising inflation rates.

What's working in the Portfolios that you manage?

In the portfolios I'm involved with, we have an emphasis on Natural Resource stocks—notably precious metal mining companies, and energy companies. And that's been helping performance. In energy, people focus on oil at $100 a barrel, but they haven't looked much at natural gas, which has been our focus. Prices are low now, especially relative to oil prices, but have recently begun to perk up. We think it's an interesting natural resource play. And even more interesting are the service companies that help locate natural gas. The world is having a hard time locating sources, and the discovery and extraction of gas has become much more technical, so the service companies are more important than ever. We have also found lots of them with great balance sheets.

We own some healthcare stocks. They have been expensive for a long time, so we haven't bought many. They have been doing well—the category seems to be resilient as people worry about the economy. We have been adding to tech stocks, finding lots of bargains, strong balance sheets, decent business models, and low expectations. We will be selectively buying financial stocks, but we need to get our arms around where the balance sheets are before we can start to figure out what kind of earnings potential these companies have going forward. We need to understand where the margin of safety is. It's all still unfolding. We'll take it slow.

Thank you, Whitney.