article 08-28-2015

Downturns create buying opportunities.

Even with the stock market's rebound over the last several days, the recent declines for equities were alarming for most investors. The question of just how bad things might get remains unanswered (largely because it's unanswerable).

Bear markets and sharp declines, however, are part of life. And from our perspective this most recent sell-off shed light on the importance of being selective.

Downturns, especially dramatic ones, have historically had a clarifying effect, typically highlighting the difference between the kind of high-quality companies we look for in several Royce portfolios and those fundamentally weaker, usually unprofitable companies that are more dependent on cheap financing and have benefited from the zero interest-rate environment.

In fact, we welcome higher volatility in all of our portfolios because declines offer price-sensitive, risk-conscious active managers important opportunities to add value for the long term. This is especially important now because the small-cap market has been in a historically anomalous state for some time.

When the Fed pushed rates down and began quantitative easing, we saw the highest-levered small-cap companies do very well on both an absolute and relative basis. Many of these companies had no earnings, yet they outperformed their small-cap peers dramatically.

Today, about a third of the Russell 2000 is comprised of non-earning companies, the highest level it's reached since the 2008 financial crisis.

The kind of higher volatility that the recent growth scare created should help return stocks to a more historically normal environment. To be sure, the Russell 2000's 17%-plus average annualized returns for the three- and five-year periods ended June 30, 2015 are simply not sustainable.

Along with increased volatility, we see more muted returns for small-caps (and equities overall), which we think will be a positive development for active managers like ourselves who prefer strong fundamentals and steady profitability.

So while the signals from China, whose woes triggered this most recent correction, are not encouraging, they seem somewhat overblown to us, at least insofar as their effect on the U.S. economy and equity markets is concerned.

We don't know where or when the bottom of this correction is going to be. Every day, however, we seek to take advantage of dislocations in the small-cap market to build strong absolute long-term returns.

In an environment characterized by higher volatility and lower returns, discipline and selectivity will be essential. We also believe that high-quality, low-leverage companies are both best positioned to participate in an accelerating U.S. economy and to deliver attractive returns.

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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