Whitney George of Royce Funds on 2Q 2012: The Value of Patience and Fundamentals
If anyone had told me two years ago that we would be worried about a double dip recession for the third year in a row at the identical time of year, I would have not believed them. There is a lot going on politically that's contributing to the uncertainty with close to a record number of elections scheduled to take place later this year in the western world. So there is plenty for people to be uncertain about, and Europe and the U.S. are still some distance from figuring out the solution to their debt and deficit issues. So unfortunately we could be in this sort of choppy, risk-on, risk-off environment for a little longer than we would all like. Our hope is that we have entered the late innings of this corrective phase of choppy markets with high correlation, which has made what we do a bit more difficult.
What has been most frustrating about the recent volatility?
I think the range-bound, repetitious aspect. Without being able to establish any clear direction, the stock market has really been struggling. Our goal of building strong, long-term absolute returns for our investors is very difficult to achieve in this kind of short-term focused, very choppy market, especially one in which politics is starting to affect the way businesspeople run their businesses. It's hard to grow a business when you don't know what the tax rate is going to be six months from now, or when you don't know what fiscal policies are going to be in effect. It causes managements to be extra cautious in terms of their planning, which means that the business may not grow as vigorously as it might otherwise. You would expect with interest rates so low that there would be plenty of opportunities to take risk, build companies, and create new products, but at the same time all of these uncertainties are offsetting those developments.
Is patience critical in the current environment?
In a time like this, I think it is particularly important to be patient. Low portfolio turnover is also very important because we are in an environment that is dominated by investors with very short time horizons. It's a little bit like being stuck in quicksand, where I think the best thing to do is to not wiggle around and instead hold our positions, keep paying very close attention to fundamentals, and maybe make some improvements if we can around the edges. Our discipline has worked well through many market cycles, although it hasn't worked all the time. During the late ‘90s dot-com bubble era, where investing in regular companies became very unpopular, our approach was out of favor and people questioned whether or not it was still viable. It was greed that drove people to internet companies at the expense of cash-flow producing businesses. Today, we have a different one-way trade in Treasuries, which is being driven by fear and has been crowding out investment in equities in general, and recently in small-caps. After the dot-com bubble burst, and many more traditional equities performed well for the next several years. We believe that investors currently gripped by fear will once again look more favorably on small-cap equities, though this current range-bound market has admittedly lasted longer than we thought it would.
Why are company fundamentals even more important right now?
Our insistence on balance sheet strength is very important because we don't know how long things will be challenging. We want companies that look capable of finishing the race because you can't win unless you finish, so we look for companies with the kind of fundamentals that should help them to survive. Those that generate free cash via high returns can give investors a return in the form of dividends, take advantage of their low valuation by buying back stock, or make acquisitions to grow their business when organic growth is harder to come by. Strong fundamentals mean these companies still have the tool set they need to get through difficult periods and come out on the other end in good shape, so that's where we focus our attention.
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The thoughts expressed in this piece are solely those of the person speaking 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.
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