article 03-31-2015

How should we think about risk today in an investment world that has largely rewarded it?

The removal of "patience" from the Federal Reserve's vernacular might be as close as investors get to a more concrete timeframe for an increase in interest rates, at least for now.

After its March 18 meeting, we know that the Fed "judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting," and that there is still reason to doubt that rates will increase in June. We also know that the Fed's economic outlook has wavered a bit, and that a rise in rates is still very much tied to the health of the labor market and inflation. The question, to us, is how much longer will risk be rewarded in the equity markets?

Two corollaries to investors' recent penchant for high yield and fast growth have been a neglect of business fundamentals and a hunger for risk, related no doubt to the rewards for taking on so much of the latter.

One may ask, then, why risk management remains at the forefront of our evaluation of small-cap companies. The Fed's monetary stimulus programs and zero interest-rate policies have had the unintended consequence of stoking appetites for high yield and distorting asset prices—creating very little (if any) consequences for companies carrying a lot of debt.

It is no surprise, then, that more defensive and fast-growing sectors and industries drove the Russell 2000's performance in 2013 and 2014. Yet during the long bull market that has followed in the wake of the 2008 financial crisis, we have mostly avoided these areas.

The companies that populate Utilities and REITs typically do not meet our conservative capitalization and/or quality standards while fast-growing biotech and social media stocks usually lack a history of long-term profitability.

Our task is to find what we think are undervalued companies that show signs of long-term financial sustainability, excellent prospects for growth, or both.

Most commonly, we look for signals of overall financial health by carefully scrutinizing the balance sheet. We prefer companies with low leverage, which we typically measure by looking at the ratio of assets to stockholders' equity.

Part of our rationale lies with the fact that unexpected events shape the market's behavior every day. A company with a strong balance sheet (or other asset strengths) is more likely to weather out-of-left-field occurrences than a more highly levered business.

Highly levered companies have, however, benefited a great deal from the ready availability of inexpensive capital over the last five years—a highly anomalous phenomenon. The incongruity is not that these companies performed well in the initial recovery phase after the crisis, but that they have continued to mostly lead the small-cap market ever since.

Historically low interest rates have allowed more highly levered companies to refinance their debt, or even take on more debt, with few if any negative repercussions.

But we believe this is changing. Interest rates will rise. Credit spreads, which are driven by higher interest rates, have already begun to widen—raising the cost of capital and thus creating a potential advantage for more conservatively capitalized businesses. To us, these elements set the stage for a more normalized investment environment.

Every portfolio manager at Royce seeks to effectively manage risk. And in our 40+ years of investing, we have learned a few things: most trends eventually reverse, patience—particularly during periods of unpredictability—often proves rewarding, and risk remains a very real element in equity investing.

Important Disclosure Information

Francis Gannon is Co-Chief Investment Officer and Managing Director of Royce & Associates, LLC, investment adviser to The Royce Funds. Mr. Gannon's thoughts and opinions expressed in this piece are solely his own 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.

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 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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