Commentary

Chuck Royce

Do you remain concerned about the state of large financial institutions in light of the recent bailout of Bear Stearns?

CMR: Yes, I am, absolutely. It's something that I think all investors will be paying close attention to in the coming months. Prior to the Bear Stearns buyout by JP Morgan Chase, my view was that the ground had been cleared for a slow recovery for stocks, but only if there were no significant negative developments among our large financial institutions. Obviously, the Bear Stearns situation qualified as a major negative event. More specifically, it represented the consequences of the active de-leveraging that's been going on since last summer as firms write down billions in bad debts. For now, we watch and wait for the market to begin acting with more confidence.

Are you confident in the long-term prospects for equities?

CMR: I am. My confidence is based on there being no more large-scale problems like we saw in mid-March. We're still as guardedly optimistic about the next three to five years for smaller companies as we were in January, though events in the first quarter at times made me more guarded and less optimistic. However, the forced buyout of Bear Stearns and the Fed's extension of credit to investment banks went a long way toward alleviating concerns about a liquidity crisis. Without that worry, the market is now free to work through a host of other difficulties—recession, a declining dollar, the credit crisis and the further unwinding of the housing bubble—in the context of a functional financial system. So while each presents formidable challenges of its own, they are also problems that I believe have solutions. One or two of those issues may take some time to work out, but that's something that I think the market can account for while still beginning to move in a positive direction. It therefore seems possible to me that the Bear Stearns buyout marked the bottom, and I still think that three to five years from now smaller stocks should be fine. However, the road from here to there could have a few more potholes that we didn't see as clearly at the beginning of 2008.

Do you think that the Federal Reserve Board has taken appropriate action in exchanging Treasuries for less liquid securities?

CMR: Yes, I think the Fed has been very creative in doing this. It's something that many European central banks have been doing for years, but that was new to the U.S.'s central bank. It's been a great way to promote liquidity, which is the life-blood of the financial markets in many ways. That the Fed recognized this so clearly, then acted so quickly in doing it is a major positive step toward securing stability and promoting confidence in the markets. It's important to remember, especially during times like the present, that so much of what goes on in the markets is perception driven, so it's critical that the Fed has taken definitive action to preserve liquidity and spread the perception that the system is sound, which I believe it is. I see the Fed's actions as part of  a larger pattern in which the bigger financial firms have been working to resolve their problems. The better-run businesses have been tightening credit standards, raising capital, writing down bad loans and reducing overhead, basically getting their houses in order.

Do you anticipate more severe declines for large-cap stocks, or do you expect that they will continue to better weather the downturn than smaller companies?

CMR: Even with the turmoil in larger financial stocks, the S&P 500 continued to lead the small-cap Russell 2000 on most of the down days of the first quarter. However, as small-cap showed a strength that I found pleasantly surprising during the mini-rallies so far in 2008, I've shifted my perspective somewhat. At the end of 2007, I was convinced that large-cap would be out in front during any near-term rebound for equity prices, but now I think that smaller stocks could have a slight lead when stock prices begin to show some sustained recovery.

Why might the current smaller-company bear market be a terrific time for contrarian investors?

CMR: I continue to see what I think is substantial value in smaller stocks. As of March 31, the Russell 2000 lost 18.9% from its previous peak in July 2007, and that figure was larger at several instances in the first quarter. Declines that significant create what we view as terrific long-term  opportunities. They feed my optimism about the next few years. What's interesting is that the bargains go beyond what our managers and I are seeing in obvious places such as the consumer and financial areas to industries that have not seen as much attention but where the values look quite compelling to us.