Recent Volatility Signals a Market in Transition
article 10-01-2015

Recent Volatility Signals a Market in Transition

CEO Chuck Royce and Co-CIO Francis Gannon talk about why they believe the decline for equities in 3Q15 is part of the market transitioning back to more historically typical performance patterns, why a rate hike could be positive for small-caps and stocks as a whole, how history reveals the importance of discipline, the necessity of diversification within the small-cap asset class, and more.


Were you surprised that the Fed opted to keep interest rates unchanged in September?

Chuck Royce: Yes, we were both surprised and disappointed because the U.S. economy continues to expand.

This solid pace of GDP growth, which was revised significantly upward from 2.3% to 3.9% for the second quarter, is as clear a sign as we could all receive that the Fed could safely put an end to the last of its two major and unconventional interventionist policies.

We were also disappointed by Fed Chair Janet Yellen's reasons, particularly those that dwelled on the slowdown in China as part of the rationale for not raising rates.

As much as we'd agree wholeheartedly that the entire world is increasingly connected economically, it seems a bizarre stretch to us that the Fed—as the central bank of the U.S.—would therefore feel they were under an obligation to adopt a global mandate. That strikes us as a pretty obvious misunderstanding of their purpose.

Do you think a rate hike would be a positive for stocks?

Francis Gannon: Absolutely. We think a rate hike would be a positive development for the economy and the capital markets—it could actually spur lending.

In fact, the likely increase in rates at the end of the year, which would mark the end of the significant interventionist policies of the Fed, places us all at an important crossroads in terms of what will drive equity returns going forward.

We think the markets are well prepared for an increase and the more historically typical economic and investment climate that looks likely to go along with it.

In one sense, then, we're seeing the "real" business cycle just now getting under way in that current signs are pointing toward a market in which earnings matter, leverage is a factor, and fundamentals appear to be steering performance against a backdrop of solid economic growth.

With correlations continuing to decline, and narrow market leadership likely to broaden, we feel very confident about the prospects for our value and core approaches and very comfortable with our growth portfolio.

Do you think we're in the early stages of a bear market or a less serious, shorter-term correction?

Chuck: I would definitely describe it as a correction—one that's entirely unsurprising in the context of how consistently high equity returns have been over the last several years, a heady period that has also had relatively low volatility. I can't say for sure what the amount of the decline will ultimately be, of course, but I'm fairly confident that it won't exceed 15%.

What's more important, I think, is the large number of U.S. companies that remain in excellent financial and operational condition. In other words this correction is not being driven by weakness in the economy or a contraction in earnings.

Both, in fact, are growing. So the downturn seems more motivated by perception—by fear of a global slowdown that we think is overblown, especially as it concerns U.S. companies.

The downturn seems more motivated by perception—by fear of a global slowdown that we think is overblown, especially as it concerns U.S. companies.

Do you still see structural headwinds in the market and economy that are affecting the performance of certain areas of the small-cap market?

Chuck: Yes—but we think their intensity and influence are on the wane. In the economy, as we mentioned, the Fed's policies are sunsetting—that's probably the most significant factor.

We also saw a pretty sharp correction for biotech stocks during the third quarter while small-caps with steady profitability generally held up better. These two developments suggest, to us at least, that investors are becoming less enamored with more speculative, long-duration assets and should continue to look to businesses that earn money as a source of their own returns.

Francis: It wasn't always easy to tell given the large amount of volatility, as well as fear and desperation, running through the equity markets in the third quarter, but we're also seeing the credit markets repricing risk.

High yield spreads have widened by about 200 basis points in the last two years as the 10-year Treasury rate has been almost unchanged. This shows that the private sector is more than ready to resume its job of rationing capital, distinguishing between better companies and worse ones.

Much of what we've seen from the market over the last five years has been anomalous. Do you recall anything similar in your experience?

Chuck: We've certainly endured asset bubbles many times over the last several decades, and we've tried to assiduously avoid them since the fall of the "Nifty Fifty" back in 1974.

We've lived through atypical markets in which stocks struggled to the point where many investors were questioning the viability of equity investing as a whole—which was the case in 1979 with the infamous "Death of Equities" cover story in Business Week.

The Internet Bubble was a more recent period when our disciplined, risk-averse, and earnings-centric approach was being questioned or simply dismissed as irrelevant. And I suppose I should also mention that when we first began to invest in small-cap stocks with a risk-aware, fundamentally based approach, many people said that it would never work.

So while the recent period has certainly been frustrating in terms of relative performance, we've been out of favor before and have come back strong.

Why do you think the equity returns over the next three to five years will look so different from those over the last three to five years?

Francis: There are three unusual aspects of the current market that we expect will reverse and make the next three to five years different.

The first is that equity returns have been significantly above their historic averages for most of the last five years, so basic reversion to the mean would strongly suggest that overall returns for stocks will be lower going forward.

The second is that companies with negative EBIT (earnings before interest & taxes) have had mostly positive returns for the last three years, which is atypical and unsustainable. Throughout the history of the stock market, profitable companies have had an edge, and we don't see this fundamental rule of capitalism being repealed.

Based on EV/EBIT, high ROIC companies are selling at a discount to low profitability companies or those with no earnings at all.

The end of this run should coincide with a return to a more historically normal environment in which profitable companies outperform unprofitable ones. Premium-quality companies, as measured primarily by ROIC (returns on invested capital), are in many cases cheaper than they've been in several years. Based on EV/EBIT (enterpise value over earnings before interest & taxes), high ROIC companies are selling at a discount to low profitability companies or those with no earnings at all.

So the third reversal we expect is for share prices of these higher-quality businesses to rise, better reflecting their intrinsic value. Earnings growth should be sufficient to drive investment returns in many of our portfolios—multiple expansion is not required as it usually is in the growth segment.

We think all of these reversals will help active management generally and many Royce Funds specifically.

Do you expect more volatility in the markets over the next several months?

Chuck: We do. As much as we think better times are ahead on a relative basis for many of our portfolios, we also know that these kinds of transitions often involve a fair amount of market tumult before settling into a new phase.

Think for a moment about biotech, which was still leading the small-cap market through the end of September and has been the dominant industry in the market for nearly three years. Within the Russell 2000, 88% of the 154 biotech stocks are unprofitable—less than 20 companies were making money at the end of September.

Francis: We see more of this growth-driven trend when examining the Russell 2000 Growth and Value Indexes.

Outperformance for the small-cap growth index has been extreme—a two standard deviation event, in fact. From our perspective, this kind of dominance is very unlikely to continue.

Why do you think small-cap investors should be diversified in terms of investment approach?

Chuck: First, I think diversification in investing is always a good idea. Part of this relates to timing—no one has consistently been able to call tops and bottoms for any asset class or investment vehicle, so diversification is a critical tool in managing risk.

And while we're calling for better times for steady earners, we can't say when exactly this is going to happen—and there's always the chance that we're wrong or too early in our call.

Even if we're absolutely correct, we'd never recommend that people put all or most of their money in those kinds of stocks. Diversification is an important aspect of an all-weather approach, especially within small-cap.

Francis: Our funds have different return profiles and can be expected to perform differently based on the environment.

If you believe the correction is going to last, then we have three strategies—Royce Total Return, Special Equity, and Dividend Value Funds—that we believe have done well historically during downturns.

If you expect a continuation of the current environment of slow economic growth, low interest rates, and low inflation, then growth funds should continue to do well, and our Smaller-Companies Growth Fund has also done well in this period.

Finally, if you think the U.S. economy is likely to shake off this latest growth scare, resulting in both stronger growth and slightly higher interest rates, then both our more economically sensitive value funds—Royce Opportunity and Small-Cap Value Funds—our value-oriented core portfolios—Royce Pennsylvania Mutual and Premier Funds—look well positioned.

Why do you think the firm's ability to consistently execute its disciplined approaches will ultimately be successful?

Chuck: There are a number of reasons. Some of it relates to reversion to the mean, which has always been a very formidable force in the market.

Here are some of the larger factors that have characterized the last three to five years: low volatility, above-average returns, and zero-level interest rates—which have prolonged the lives of marginal businesses and created record-low numbers of bankruptcies.

We also moved, somewhat suddenly, from a period of high correlation to very narrow small-cap market leadership; approximately 60% of the Russell 2000's trailing five-year return came from just three sectors—Health Care, Information Technology, and Financials.

All of this helped to create one of the worst periods we can remember for active small-cap management. Yet now we find ourselves at a moment in which the valuations of high-quality companies, as measured by ROIC and EV/EBITDA, are attractive on both an absolute and relative basis.

Combined with a growing economy and enough volatility to encourage investors to look more closely at fundamentals such as balance sheet strength and profitability, this looks like a very good time for bottom-up, disciplined approaches.

Average Annual Total Returns as of Quarter-End 9/30/15 (%)

Dividend Value -10.29 -7.85 -5.65 7.66 8.58 7.50 N/A N/A 7.95 05/03/04
Opportunity -15.50 -14.93 -9.70 8.72 9.10 6.13 8.64 N/A 11.49 11/19/96
Pennsylvania Mutual -12.99 -12.92 -8.30 6.97 8.10 5.63 8.74 9.61 13.79 01/01/00
Premier -12.42 -10.95 -10.06 5.87 7.57 6.96 9.38 10.41 11.10 12/31/91
Small-Cap Value -10.88 -9.82 -7.60 6.12 6.70 6.25 N/A N/A 9.61 06/14/01
Smaller-Cos Growth -11.05 -2.99 3.60 10.49 9.87 6.31 N/A N/A 11.42 06/14/01
Special Equity -11.35 -11.81 -4.23 5.91 8.72 7.37 10.78 N/A 8.55 05/01/98
Total Return -9.56 -8.89 -3.90 8.30 9.07 5.90 8.47 9.86 10.33 12/15/93
Russell 2000 -11.92 -7.73 1.25 11.02 11.73 6.55 6.51 7.95 N/A N/A
Dividend Value Annual Operating Expenses: 1.29%
Opportunity Annual Operating Expenses: 1.15%
Pennsylvania Mutual Annual Operating Expenses: 0.92%
Premier Annual Operating Expenses: 1.10%
Small-Cap Value Annual Operating Expenses: 1.18%
Smaller-Cos Growth Annual Operating Expenses: Gross 1.34% Net 1.25
Special Equity Annual Operating Expenses: 1.12%
Total Return Annual Operating Expenses: 1.19%

* 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. Investment and Service Class shares redeemed within 30 days of purchase may be subject to a 1% redemption fee payable to the Fund. 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 Funds’ Investment Class. All performance and risk information presented in this material prior to the date of commencement of Investment Class shares for Royce Small-Cap Value Fund and Royce Smaller-Companies Growth Fund on 3/15/07 and Royce Dividend Value Fund on 9/14/07 reflects Service Class results. Shares of those Funds’ Service Class bear an annual distribution expense that is not borne by the Investment Class. Operating expenses reflect each Fund’s gross total annual operating expenses, and included management fees, any 12b-1 distribution and service fees, other expenses, and any applicable acquired fund fees and expenses. Royce and Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain Royce Smaller-Companies Growth Fund's 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) at or below 1.24% through April 30, 2016. 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.

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. Investments in securities of small-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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