article , video 08-31-2015

Near-Term Headwinds Offer Attractive Buying Opportunities

With many companies in more economically sensitive sectors of the small-cap market poised for incremental margin expansion and accelerated earnings growth as the U.S. economy continues down the path of normalization, Portfolio Managers Steven McBoyle and Lauren Romeo are trying to take advantage of current headwinds that should ultimately reverse with more robust economic growth.

TELL US
WHAT YOU
THINK

What's Our Outlook for Small-Caps?

Steven McBoyle: U.S. companies are generally seeing good growth—we seem to be operating in an environment that one can almost characterize as “Goldilocks” in nature. Corporate profitability is obviously very high. Companies are exceptionally lean at this point in time. Incremental margins have been exceptionally strong, particularly in certain industries, and I think if we see any acceleration in terms of unit volume growth, profitability is likely to surprise on the upside.

Skilled labor is in shortage, certainly within select industries. We're beginning to see that in terms of wage rate inflation. We're paying close attention to that as that applies to inflation, though we do anticipate at this point in time that will remain tepid at best.

M&A activity has returned to peak levels, and seems to be accelerating. That should be very favorable for our portfolio of companies. More than anything, I think CEOs and companies are looking for certainty around the rate regime. We are of the belief that one or two increases in rates, perhaps over the next 18 months, will not only be favorable for the economy, but, more specifically, will be helpful in terms of future capital investment, as the market likes certainty.

What's Our View on Industrials Stocks?

Lauren Romeo: From an industry perspective, in the Industrials and Materials sectors we've seen a bit of a slowdown because of the cutback in energy capital spending in light of the 50% decline in oil prices in the back half of last year. The stronger dollar has also arisen as a bit of a headwind.

That being said, I agree 100% with Steve when he talked about the high incremental margins that these companies are poised to demonstrate, as they've all done a great job of reducing their cost structures so when sales growth does reaccelerate, we expect that earnings growth will be even faster and as a result of this inherent operating leverage. 

What Changes Are Creating Opportunities?

Lauren: In the Energy sector, we've seen a pretty dramatic supply-side response where you've seen rig counts cut in half and E&P capital spending down 20-30%. You're seeing layoffs at a lot of the services companies and idling of equipment. So we think while they're near-term painful, they're certainly positive steps towards getting the industry back towards a rebalancing of supply and demand.

The social media companies and cloud computing get all the headlines and attention, but there are other places within technology that are very vibrant. Industrial automation is a secular theme that a lot of companies are benefitting from. In the semiconductor area, the semiconductor capital equipment companies are really benefitting from what's being called an inflection point in how chips are made, and as a result you're seeing demand and replacement of equipment with new equipment and more equipment to be able to make the chips and new architecture. That too seems to be a secular tailwind for that industry.

How Financially Healthy Are Consumers?

Steven: Certainly the consumer is healthy once again—obviously a very powerful statement as it applies to the U.S. economy being 70% consumption driven. We're seeing credit card delinquency rates at 10-year all-time lows. Net worth is effectively back to prior peak levels. Effectively, credit and liquidity has returned to the marketplace. So consumers seem to be reacting favorably, and we've been seeing that of late in consumer confidence numbers.

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons 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

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