article , video 06-24-2015

Small-Cap Value Fund: Trying to Profit from Low Expectations

Portfolio Manager Jay Kaplan talks about how he manages risk, the advantages of knowing a company's history well, where he is currently finding value in the small-cap market, portfolio positioning, and more.

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Francis Gannon: How do you think about managing risk in Royce Small-Cap Value Fund?

Jay Kaplan: Well, the Fund is one of our more concentrated portfolios, and it's going to have bigger positions than a lot of our other funds. And as each individual stock exhibits its own volatility, there will be times where it's a little more volatile than some of our other products. I think I'm willing to tolerate that on a day-to-day basis.

You really have to think about it as owning a portfolio of businesses, and you're going to have behavior that's going to be different than that of the market index on any particular day, as there's news that impacts those companies. We try and offset that with risk control.

We use the sort of traditional things that people think about at Royce. We try not to buy companies with a lot of leverage. We try to invest in businesses that earn high returns on capital. Better businesses. And we try to buy them cheaply, and all of that is part of the risk control of the firm.

Specifically, when you get to the style of Jay Kaplan and what I do, I try to invest in businesses where Wall Street has very low expectations—where I think the expectations are unreasonably low and can be beaten—and where those businesses sell at unrealistically low prices.

If I'm right, I have two ways to win. If the expectations for the business are exceeded, the stock's going to go up just because the business has done better, and that's really good, and that's kind of the first level of performance. When that happens, there's a follow through. Second level, you get a revaluation of the multiple. So people will be willing to pay a higher P/E for those stocks. So the stock has gone up because the business is better, and then it goes up more because somebody else is willing to pay me more than they were before.

Francis: Can you give us an example of a stock where you have had a long experience with the company and have been able to take advantage of kind of the historical knowledge base that you have?

Jay: There are a few. Stein Mart, which is an off-price retailer, has its roots in Florida and the southeast. I've been an investor in Stein Mart more than once, and I've seen the strategy change over time. I've seen many of the next level-C executives change from time to time with those strategic changes.

Reinsurance Group of America—that's another company. The CFO was here a few days ago meeting with me, and we were talking about how we met on the IPO 20-some years ago. That's a great example. You get to know the people, you get to know the business, you get to understand the challenges and the cycles, you get to understand the market perception, you get to understand the market's valuation, and you can use all those things as part of your mosaic, hopefully, to move in and out as it makes sense over time.

Francis: In looking at the sector weightings in the portfolio, you would've seen a larger weighting in Consumer Discretionary over time and, more recently, technology moving up in the portfolio. Can you discuss that?

Jay: It's interesting. Part of the issue when we say technology is it means a lot of things. If you look at actually what's in the technology sector, it's everything from high-tech semiconductors to people answering phones when you call your cell phone company for customer service. So we have a lot of different businesses that do a lot of different things. A lot of it is low-tech tech, some of it is industrial manufacturing of technology products. But we think that's where the value is today.

Part of the strategy, if you really cut through it, is to buy what's on sale, is to buy the opportunities that the market presents to you at any given time. And, lately, technology stocks have been that opportunity.

Francis: You've been the lead manager for a little over two years now. What changes have you made to the portfolio?

Jay: When I took over, fully, the management of the portfolio in the spring of 2013, we had a very big precious metals bet—not a sector I like very much. That's now gone. I don't want to say it's been replaced, but now—two years later—the portfolio looks a little more concentrated with better valuations, higher returns on capital, and what would appear today to be two pretty big sector bets: one in consumer, one in technology.

I hate to use the words "sector bet." A lot of people, when they look at the portfolio, talk about it that way. I don't. I tend to think about it as a collection of businesses that are out of favor, where the expectations are very low. And what happens in the market is sectors tend to get out of favor, and you wind up finding collections of really good businesses that are out of favor within those out-of-favor sectors. I try to find what's on sale and buy those high-quality companies at great valuations, and often times it leads to what looks like a sector bet.

Francis: So what should investors expect going forward?

Jay: I think investors should expect that they're going to own a concentrated portfolio of really good businesses. They should expect that, from time to time, it will look like there are sector bets. We would hope that, when the market goes down, we'll go down a little bit less and we'll do just fine in the up markets, and over time we think we can have pretty good risk-adjusted results.

Important Disclosure Information

Jay Kaplan is a Portfolio Manager and Principal of Royce & Associates, LLC, investment adviser to The Royce Funds. He serves as portfolio manager for Royce Small-Cap Value Fund (RVV, formerly Royce Value Fund), Royce Total Return Fund (RTR), Royce Dividend Value Fund (RDV), and Royce Capital Fund – Small-Cap Portfolio (RCS). He also serves as assistant portfolio manager for Royce Pennsylvania Mutual Fund (PMF). The thoughts and opinions expressed in the video are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce Small-Cap Value Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. In addition, as of 3/31/15 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)

Percentage of Fund Holdings as of 3/31/15 (%)

  RVV RTR RDV RCS PMF
Stein Mart 0.51 0.22 0.25 1.07 0.19
Reinsurance Group of America 3.00 0.63 1.24 2.25 0.45

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.

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