Chuck Royce on 4Q 2011: Quality Small-Caps Look Poised to Rebound
When investors were subjected to months and months of inaction, dithering and partisan bickering, they began to lose confidence in both political leadership and the market. In fact, we've seen capitulation on several fronts, especially since so many of us view stocks as an economic bellwether.
What's gotten lost in all of the fiscal worry and political melodrama was the fact that many companies across the globe, and certainly here in the U.S., have been managing their way through the recession and the current slow-growth economy very, very well. For example, the general state of corporate balance sheets and cash flows—two key metrics in our security analysis process—is excellent.
So we expect that as the economy continues to grow and political leaders finally begin to pass workable policies, more investors will begin to notice how strong fundamentals are throughout the equity world, which should help to usher in a solid decade for stocks, one that we suspect will feature frequent leadership rotation between asset classes and between higher quality and more speculative stocks.
Our belief in reversion to the mean and the related idea that markets remain cyclical bolsters our confidence going forward. More specifically, some recent research has shown that high-quality small-caps, as measured by returns on invested capital (ROIC), are not only cheap on an absolute basis, but relative to their large-cap counterparts as well.
So while there's been a lot of analysis devoted to showing that large-caps are statistically less expensive than small-caps, many of the companies that have been drawing our interest within small-cap are not. It's no surprise, then, that we think this is a very opportune time for active small-cap management. Historically, when returns are both highly correlated and underwhelming, inefficiencies develop that we seek to use to our long-term advantage.
We are confident that active small-cap managers can generate satisfactory absolute results as returns begin to differentiate again. As we detailed in a research paper on the importance of active small-cap management, consistency, discipline and a long-term investment horizon are critical to realizing the goal of strong absolute long-term results that, as a byproduct of that effort, have also beaten small-cap benchmarks.
Essentially, we think that small-cap indexes may well lose ground to their large-cap peers in the years ahead, but as equity returns become less correlated, active small-cap management should do just fine.
Highly volatile markets tend to create even greater opportunities because they drive share prices lower and lower. This created a host of short-term disappointments in 2011, while it also presented us with a number of what we believe are very promising long-term opportunities.
It's also important to point out that, while daily volatility was very high, monthly returns in 2011 weren't as wildly out of sync with other years as the day-to-day drama might lead one to believe.
I think that we are in a new era of high daily volatility that investors will better adjust to in 2012 and beyond.
How would you make the case for small-cap investing going forward?
I think that there is a strong case to be made for investing in stocks. We saw a great deal of capitulation throughout 2011, inspired in part by market volatility, but more by the lack of confidence, especially in Europe and the U.S., that our political leaders would enact effective policies to curb deficits, deal with debt and/or stimulate the global economy.When investors were subjected to months and months of inaction, dithering and partisan bickering, they began to lose confidence in both political leadership and the market. In fact, we've seen capitulation on several fronts, especially since so many of us view stocks as an economic bellwether.
What's gotten lost in all of the fiscal worry and political melodrama was the fact that many companies across the globe, and certainly here in the U.S., have been managing their way through the recession and the current slow-growth economy very, very well. For example, the general state of corporate balance sheets and cash flows—two key metrics in our security analysis process—is excellent.
So we expect that as the economy continues to grow and political leaders finally begin to pass workable policies, more investors will begin to notice how strong fundamentals are throughout the equity world, which should help to usher in a solid decade for stocks, one that we suspect will feature frequent leadership rotation between asset classes and between higher quality and more speculative stocks.
We are confident that active small-cap managers can generate satisfactory absolute results as returns begin to differentiate again.
What is the case for small-caps?
Coming off a difficult year, in which high volatility definitely hurt performance, small-caps look very well-positioned to bounce back strong, at least in our estimation.Our belief in reversion to the mean and the related idea that markets remain cyclical bolsters our confidence going forward. More specifically, some recent research has shown that high-quality small-caps, as measured by returns on invested capital (ROIC), are not only cheap on an absolute basis, but relative to their large-cap counterparts as well.
So while there's been a lot of analysis devoted to showing that large-caps are statistically less expensive than small-caps, many of the companies that have been drawing our interest within small-cap are not. It's no surprise, then, that we think this is a very opportune time for active small-cap management. Historically, when returns are both highly correlated and underwhelming, inefficiencies develop that we seek to use to our long-term advantage.
We are confident that active small-cap managers can generate satisfactory absolute results as returns begin to differentiate again. As we detailed in a research paper on the importance of active small-cap management, consistency, discipline and a long-term investment horizon are critical to realizing the goal of strong absolute long-term results that, as a byproduct of that effort, have also beaten small-cap benchmarks.
Essentially, we think that small-cap indexes may well lose ground to their large-cap peers in the years ahead, but as equity returns become less correlated, active small-cap management should do just fine.
Do you think that the U.S. small-cap market hit a bottom in October 2011?
I think that it did. I think that the combination in 2012 of better economic news and more action on debt and deficits will encourage investors both to pay less attention to headlines and to look more closely at the actual condition of companies. My guess is that high volatility, at least on an intraday basis, will remain a fact of life in 2012, but that the overall movement of the market will be positive.Did the high volatility in 2011 make any impact on Royce's investment process?
It did not. We invested in 2011 in much the same way we have since 1972—with a disciplined, long-term approach that kept a close eye on what we deemed attractive prices for great companies. Historically, we have seen volatility as a key part of our arsenal of tactics.Highly volatile markets tend to create even greater opportunities because they drive share prices lower and lower. This created a host of short-term disappointments in 2011, while it also presented us with a number of what we believe are very promising long-term opportunities.
It's also important to point out that, while daily volatility was very high, monthly returns in 2011 weren't as wildly out of sync with other years as the day-to-day drama might lead one to believe.
I think that we are in a new era of high daily volatility that investors will better adjust to in 2012 and beyond.
