article 07-01-2015

More Volatility: A Positive Environment for Active Managers

Dating from the year-to-date low for the 10-Year Treasury on January 30 through the end of the first half, we have observed promising signs that the market may be taking greater strides toward normalization. CEO Chuck Royce and Co-CIO Francis Gannon discuss how higher rates might benefit bottom-up stock pickers, the potential for quality companies to regain leadership as volatility increases, the possible consequences of global economic recovery for both domestic and non-U.S. small-cap stocks, and the favorable landscape for consumers and its effect on our portfolio positioning.

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What was your take on second-quarter and first-half results for stocks?

Francis Gannon: The market continued to move forward in the first half, though at times it moved by fits and starts. The Russell 2000 Index made a new all-time high in the second quarter, as did the Nasdaq Composite. Both were driven in large part by the ongoing extraordinary results for biotech and to a lesser extent pharmaceuticals companies. There was a lot of volatility in biotech during the first half and plenty of commentary suggesting these stocks were in a bubble. But these concerns proved to be no more than speed bumps as biotech companies remained market leaders through the end of the second quarter while previous investor favorites such as Utilities and REITs cooled off considerably.

The concern going forward is the very narrow breadth of returns, which you can see to a large degree in the first-half results for the Russell 2000 Growth Index, which gained 8.7% year-to-date through the end of June versus an increase of 0.8% for the Russell 2000 Value Index. The Russell 2000 gained 4.8% in the first half of 2015.

Chuck Royce: Even amidst this far-from-ideal, narrow band of high returns, we saw other, very promising signs that the market's behavior is slowly moving back to what we would call its historical norm.

There was a positive directional trend that we observed, dating from the year-to-date low for the 10-Year Treasury on January 30 through the end of the first half.

During this period, which included the bearish April, we were pleased with the way many portfolios either outperformed their indexes or began to narrow the gap. This was very clear during the growth scare when the negative first-quarter GDP numbers came out, and companies began revising their earnings expectations.

Once it became clear that much of what put a drag on those first-quarter numbers was temporary—awful winter weather, the West Coast port strike, the plunge in oil prices—recent data suggests that economic activity, as well as growth-stock returns, began to pick up again fairly quickly.

Why do you think higher interest rates would benefit many Royce portfolios?

Chuck: During the first "taper tantrum" back in 2013, several portfolios began to perform better. We saw much the same this year from that January 30 10-Year Treasury low.

The reasons why seem pretty clear to me and in my view relate at least as much to risk than to higher rates in and of themselves. That is, higher rates create more uncertainty, be it about inflation, the cost of capital, or a number of other issues.

This in turn typically leads to more mispricing in the short run, which creates opportunities for us as bargain hunters.

Francis: A higher-risk environment also tends to benefit quality companies, by which we mean conservatively capitalized, profitable businesses with high returns on invested capital and effective, shareholder-friendly management.

High rates are synonymous with higher risk. They are nearly always correlated with a greater number of mispriced companies. So we're not worried about rates rising or greater volatility in the markets. In fact, we welcome both.

High rates are synonymous with higher risk. They are nearly always correlated with a greater number of mispriced companies. So we’re not worried about rates rising or greater volatility in the markets. In fact, we welcome both.

So you see quality companies gaining an advantage as volatility increases?

Chuck: Absolutely. We see quality differentiating itself when risk premiums are rising because quality businesses are better businesses—as profitable, financially sound enterprises, they're built to survive periods of higher risk and/or greater uncertainty.

So the market of the last several years has seen many of these companies disadvantaged owing to the easy-money, ZIRP ("zero interest-rate policy") environment.

The Fed's policies made it easier for low quality to do well because there were few if any penalties to taking on more debt or not being profitable. In contrast, there were few of the traditional advantages that usually accrue to high quality.

We feel confident that this era is over. We expect lower returns for stocks as a whole, but relatively better returns for both high-quality companies and more cyclical, less defensive sectors.

I suspect that in a few years we'll look back at 2015, maybe even the longer period from 2013-2015, as a hinge period in which the gradual sun-setting of interventionist Fed policies, coupled with the steady growth of the economy, restored the capital markets to something closer to their historical patterns of performance and volatility.

Why do you think that the success of passive strategies may have peaked and that active management is poised for a relative rebound?

Chuck: I think it relates to the piling on effect we often see when a certain style or sector leads the market—sooner or later all that momentum must slow. Increased volatility plays a large role, too.

When we've seen volatility pick up in the past, it's generally become harder for indexes to stay in front. Markets remain cyclical, and in most periods all companies are not going to perform equally well.

As more and more volatility creeps in to the capital markets, those portfolios with an active decision-maker at the helm are likely to do better.

The economic recovery has been expanding more globally so far in 2015. What do you see as some of the possible consequences of this expansion for both domestic and non-U.S. small-cap stocks?

Francis: The increasingly global reach of the recovery is already benefiting several of our portfolios in the global and international space. Along with Royce Smaller-Companies Growth and Micro-Cap Opportunity Funds, our best performers in the first half were Royce Global Value, International Premier, and European Small-Cap Funds.

Like that in the U.S., the pace of non-U.S. economic growth been a bit irregular, but we're seeing gathering strength in many previously depressed or sluggish economies. In addition, revenue growth for many U.S. companies has been in the 6-7% range with earnings growth approaching 10%. That is pretty strong and very encouraging.

Chuck: There are two interesting and related points about the recovery outside the U.S. The first is that quality has been a participant in the recovery for many non-U.S. stock markets so far in 2015. This of course is in stark contrast to what we have seen here in the U.S., where quality small-caps, as measured by ROIC, continue to lag.

Yet we see plenty of room to run because the rallies for many overseas economies and equity markets are just getting under way. So we're very encouraged by what we're seeing outside the U.S. as well.

We expect lower returns for stocks as a whole, but relatively better returns for both high-quality companies and more cyclical, less defensive sectors.

Many commentators have been predicting increased consumer spending against a backdrop of low debt loads, lower energy prices, and rising income and employment. How is this affecting activity in your portfolios?

Francis: Certain portfolios have increased their exposure to Consumer Discretionary companies, beginning late last year in most cases.

We saw a number of companies in the retail space—many of them old Royce favorites—that looked attractively undervalued or otherwise primed for growth in the context of a flourishing economy with better employment numbers and lower energy prices.

These factors have not spurred consumer spending to the degree that many were anticipating, in particular after the collapse of oil prices. However, we've usually had a good-sized exposure to discretionary businesses in several of our funds, and we expect consumer activity to continue intensifying as the economic recovery expands.

What other sectors have you been active in recently?

Chuck: We hold a similar view on many of our holdings in the Industrials and Materials sectors—two other economically sensitive, cyclical areas that have not yet ignited in spite of solid overall economic growth.

Much of the lag can be attributed, I think, to reduced CAPEX spending, which has not yet fully come back. We continue to hold these companies because they have many attractive characteristics that the market has not yet recognized. Needless to say, we expect that to change as the economy heats up.

In our view, their profitability, growth prospects, and reasonable to attractive valuations make them coiled springs—we see a lot of untapped potential in these sectors, in which we are mostly overweighted firm wide.

Francis: It's been challenging for us waiting for many of our highest-confidence holdings to turn around. Transitions are never easy, and to be sure the shift we've been anticipating has taken longer than any of us initially thought it would.

But change can take time, and often we're only aware that a dramatic move has occurred in retrospect. So we're content to keep investing the same we always have—with a keen focus on managing risk and by looking for the intersection of attractive valuation and organic growth potential.

With oil prices stabilizing at somewhat low historical levels, how are you seeing your investments in energy companies?

Chuck: We're still holding a number of energy stocks, with most of our exposure in services companies, as it has been historically. Many portfolios remained overweight in energy at the end of June.

Late last year and into 2015 we sought to use the catastrophic plunge in the oil price to our advantage by high-grading our energy holdings as we waited for a rebound. A dramatic disruption such as we had last year can't help but create the kind of mispricing that we try to benefit from over the long run.

Amidst all the talk about an eventual increase in interest rates—which could be very beneficial to banks—are you reconsidering your historical low level of bank ownership?

Chuck: We see financial services as an area that's as interesting as energy—it's an area that we've focused on for many years, mostly in the asset management, insurance, stock exchange, and consumer finance areas.

I've typically not had a lot of exposure to banks in my portfolios. Other managers here at Royce—Buzz Zaino and Bill Hench, Jay Kaplan, and Chip Skinner—have had more exposure than I've had.

With the prospect of increased rates, however, I've been looking around for interesting opportunities in bank stocks. I've also continued to focus on asset managers. The prospect of inflation should help these businesses, and their global reach is a feature that I think many other investors have not quite appreciated.

Average Annual Total Returns as of Quarter-End 6/30/15 (%)

  QTR* YTD* 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE
Smaller-Companies Growth 4.05 9.05 8.92 17.84 14.20 8.85 12.57 06/14/01
Micro-Cap Opportunity -0.75 4.30 -4.04 18.39 N/A N/A 16.43 08/31/10
Global Value 5.20 7.71 -8.38 6.58 6.74 N/A 4.77 12/29/06
International Premier 7.95 13.78 1.35 12.12 N/A N/A 5.54 12/31/10
European Small-Cap 6.55 11.64 -9.03 10.57 9.58 N/A 3.29 12/29/06
Russell 2000 Index 0.42 4.75 6.49 17.81 17.08 8.40 N/A N/A
Russell Global Small Cap Index 2.39 6.37 0.34 13.69 11.77 7.36 N/A N/A
Russell Global ex-U.S. Small Cap Index 3.93 7.74 -3.46 11.35 8.99 7.07 N/A N/A
Russell Europe Small Cap Index 6.19 10.01 -4.56 17.85 13.09 7.33 N/A N/A
Smaller-Companies Growth Annual Operating Expenses: Gross 1.34% Net 1.25
Micro-Cap Opportunity Annual Operating Expenses: Gross 1.56% Net 1.28
Global Value Annual Operating Expenses: Gross 1.35% Net 1.29
International Premier Annual Operating Expenses: Gross 3.02% Net 1.29
European Small-Cap Annual Operating Expenses: Gross 2.98% Net 1.29

* Not Annualized

Important Performance and Expense Information

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee payable to the Fund (2% for Royce Global Value, International Premier, and European Small-Cap Funds). Redemption fees are not reflected in the performance shown above; if such fees were reflected, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. All performance and expense information reflect results of the Fund's oldest share class (Investment or Service Class, as the case may be). Gross operating expenses reflect each Fund's gross total annual operating expenses, including management fees, any 12b-1 distribution and service fees, other expenses, and any applicable acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of each Fund's most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses through April 30, 2016 to the extent necessary to maintain net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) to no more than 1.24% for the Investment Class of Royce Smaller-Companies Growth and Royce Micro-Cap Opportunity Funds and to no more than 1.44% for the Investment Class of Royce Global Value, International Premier, and European Small-Cap Funds. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses through April 30, 2025 to the extent necessary to maintain net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) to no more than 1.74% for the Investment Class of Royce International Premier and Royce European Small-Cap Funds. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by any applicable Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of a Fund's Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Fund's Investment Class. The Royce Funds invest primarily in securities of micro-cap, small-cap, and/or mid-cap companies, which may involve considerably more risk than investments in securities of larger-cap companies (see "Primary Risks for Fund Investors" in the respective prospectus). Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. Please read the prospectus carefully before investing or sending money.

Important Disclosure Information

Mr. Royce's and Mr. Gannon's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

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. The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Nasdaq Composite is an index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The Russell Global Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks. The Russell Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. The Russell Europe Small Cap Index is an unmanaged, capitalization-weighted index of European small-cap stocks. Index returns for the Russell Global Small Cap, Russell Global ex-U.S. Small Cap, and Russell Europe Small Cap Indexes include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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