Portfolio Manager and Principal Chris Clark offers insights into our disciplined, long-term investment process by emphasizing the role that contrarian thinking plays in our portfolios. Chris has 24 years of investment industry experience and joined Royce's investment staff in 2007.One of the more tried-and-true axioms of equity investing is the idea that increased diversification is key to reducing downside risk in a portfolio. The thinking goes that a greater number of smaller positions reduces the impact that any one stock can have on the portfolio as a whole.
Attempting to reduce the impact of "left field" events, especially in small-cap portfolios, where there is a greater degree of intrinsic company risk than one finds in larger, more diversified businesses, is often considered of paramount importance.
We largely agree with this notion. In Buzz Zaino's Royce Opportunity Fund, it's a fundamental tool for risk reduction. However, we would also argue that the time for diversifying a portfolio and the time for concentrating it often run counter to the intuitions of most investors. (Many Royce portfolios, including Pennsylvania Mutual, Total Return, and Opportunity Funds, remain broadly diversified regardless of the market climate.)
We have long espoused the view that the world, and its financial markets, are cyclical in nature. Economies advance and contract, and do so for any number of reasons including innovation, access to natural resources, demographics, education levels, war, and the vagaries of human behavior, to name just a few.
Businesses in general correlate to these trends in terms of profit cycles, growth potential, stakeholder returns, and valuation. Investor sentiment plays a prominent role in the last of these, generally rewarding companies with premium valuations in moments of success and according them lower ones in times of contraction or uncertainty about their future prospects.
So which environment is the most risky for investors?
From our perspective, it is those moments of economic success when valuations are high during which investors should tread most lightly. Diversification in these moments is especially important; investors assume the combination of ever-present business risk, cyclical economic risk (that is, the eventual downturn), and valuation risk. Companies priced for perfection have much farther to fall, so we think it's better to diversify that price risk across a larger number of businesses.
In contrast, during periods of contraction and uncertainty, we would argue that increased concentration in high conviction ideas may be advisable. We think that limiting holdings to those in which we have greatest confidence can make sense when valuation risk is being largely mitigated and economic risks are gradually inverting, becoming positive potential catalysts. The asymmetry of risk and reward is likely to grow more favorably skewed as a result of the reduced price risk.
The current investment climate is clearly tilted toward uncertainty, and for very good reasons. The range of potential outcomes from the current global economic, fiscal, and monetary malaise is quite wide, with some of the more fatalistic forecasts predicting a challenging future indeed. As a result, economic risks have been weighing heavily on sentiment, financial markets have been highly volatile, and investors have been exiting equities in droves, which has led to a severe drop in valuations.
An additional byproduct of this pervasive disillusionment is that individual stock correlation has been rising, resulting in very little differentiation in investors' minds between high- and low-quality companies. The decisions are focused not on which equities to own, but whether to own equities at all.
As long-term investors, we recognize that stock market corrections are as inevitable as they are unpleasant. Yet they are a very important element in our investment process, periodically giving us the opportunity to parse the small-cap universe in order to improve the overall quality of our portfolios.
Downturns also compel us to look at our existing portfolio holdings to see how the merits of existing positions compare to the new opportunities that surface in a broad decline. Marginal positions are often exposed and easier to exit as conviction builds around the most compelling ideas, so one consequence of these periodic declines is for certain portfolios to be pruned and become more concentrated.
Over time, the shift from diversifying portfolios when markets are strong and making moves toward concentration when they are weak can be challenging—it goes against natural human inclinations. However, it is our belief that investing this way can provide an edge for a portfolio.
Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements.
Read the original here.
Attempting to reduce the impact of "left field" events, especially in small-cap portfolios, where there is a greater degree of intrinsic company risk than one finds in larger, more diversified businesses, is often considered of paramount importance.
We largely agree with this notion. In Buzz Zaino's Royce Opportunity Fund, it's a fundamental tool for risk reduction. However, we would also argue that the time for diversifying a portfolio and the time for concentrating it often run counter to the intuitions of most investors. (Many Royce portfolios, including Pennsylvania Mutual, Total Return, and Opportunity Funds, remain broadly diversified regardless of the market climate.)
We have long espoused the view that the world, and its financial markets, are cyclical in nature. Economies advance and contract, and do so for any number of reasons including innovation, access to natural resources, demographics, education levels, war, and the vagaries of human behavior, to name just a few.
Businesses in general correlate to these trends in terms of profit cycles, growth potential, stakeholder returns, and valuation. Investor sentiment plays a prominent role in the last of these, generally rewarding companies with premium valuations in moments of success and according them lower ones in times of contraction or uncertainty about their future prospects.
So which environment is the most risky for investors?
From our perspective, it is those moments of economic success when valuations are high during which investors should tread most lightly. Diversification in these moments is especially important; investors assume the combination of ever-present business risk, cyclical economic risk (that is, the eventual downturn), and valuation risk. Companies priced for perfection have much farther to fall, so we think it's better to diversify that price risk across a larger number of businesses.
In contrast, during periods of contraction and uncertainty, we would argue that increased concentration in high conviction ideas may be advisable. We think that limiting holdings to those in which we have greatest confidence can make sense when valuation risk is being largely mitigated and economic risks are gradually inverting, becoming positive potential catalysts. The asymmetry of risk and reward is likely to grow more favorably skewed as a result of the reduced price risk.
The current investment climate is clearly tilted toward uncertainty, and for very good reasons. The range of potential outcomes from the current global economic, fiscal, and monetary malaise is quite wide, with some of the more fatalistic forecasts predicting a challenging future indeed. As a result, economic risks have been weighing heavily on sentiment, financial markets have been highly volatile, and investors have been exiting equities in droves, which has led to a severe drop in valuations.
An additional byproduct of this pervasive disillusionment is that individual stock correlation has been rising, resulting in very little differentiation in investors' minds between high- and low-quality companies. The decisions are focused not on which equities to own, but whether to own equities at all.
As long-term investors, we recognize that stock market corrections are as inevitable as they are unpleasant. Yet they are a very important element in our investment process, periodically giving us the opportunity to parse the small-cap universe in order to improve the overall quality of our portfolios.
Downturns also compel us to look at our existing portfolio holdings to see how the merits of existing positions compare to the new opportunities that surface in a broad decline. Marginal positions are often exposed and easier to exit as conviction builds around the most compelling ideas, so one consequence of these periodic declines is for certain portfolios to be pruned and become more concentrated.
Over time, the shift from diversifying portfolios when markets are strong and making moves toward concentration when they are weak can be challenging—it goes against natural human inclinations. However, it is our belief that investing this way can provide an edge for a portfolio.
Important Disclosure Information
Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements.
Read the original here.
