We look at the practice of paying dividends as an excellent measure of a company's underlying quality. Kaplan also sees it as a sign of prudent capital allocation and intelligent corporate governance.
While talk of dividends has been all the rage lately as investors seek both yield and stability, performance from dividend-paying securities has been uneven throughout the course of 2012. Royce's dividend-paying funds have not been immune to this performance pattern in 2012. Kaplan sat down to share his insights regarding valuations, opportunities and performance.
What do you make of year-to-date equity performance and what have been the drivers of that performance?The opening performance period in 2012 has once again been volatile and unnerving for many investors with a virtual repeat of what we saw in the first half of 2011 and 2010. In each of the past three years, markets have experienced a strong opening period mostly driven by healthy corporate earnings reports only to be followed by a sharp correction as macro-economic fears resurface to unsettle the landscape.
Investors have become very defensive in their behavior and how could you blame them given the market volatility over the last few years. The interest in return of capital is trumping the interest in return on capital and thus the strong migration to fixed income securities and high yielding equities.
Two equity sectors that fit this description are REITs (real estate investment trusts) and utilities – both of which have been performance leaders in 2012. In fact they have led the equity market both on the downside, as you would expect, and surprisingly on the upside as well. While we have seen solid performance from a variety of our sector holdings, our relative lack of exposure to both REITs and utilities has hurt our year-to-date performance.
Our approach has always been one that focuses on companies with low leverage and high returns on invested capital and neither REITs nor utilities meet that criterion. Our basic tenet of managing risk revolves around the idea of identifying companies with strong balance sheets, i.e., companies with at least 50% of their balance sheet funded by equity. While REITs have done well this year, it is important not to lose sight of the fact that in order to get an adequate return on real estate, you have to use leverage. Investors may have lost sight of this and other underlying risks, such as business and valuation risk, in their singular focus on the high relative yields currently afforded by REITS.
Where are you seeing compelling valuations today?Our research process is leading us to more cyclically–oriented companies, many of which have significant amounts of exposure to markets outside the U.S. Areas such as industrials, technology and energy look increasingly interesting. Lately, the investment community has shunned these more economically sensitive sectors along with those with significant international exposure given uncertainties created by the sovereign debt crisis in Europe and the economic slowdown in some of the world's important emerging economies such as China and Brazil. While out of consensus in the short term, we believe the pro-cyclical areas are where the best long-term opportunities reside.
As we've waded through this most recent downturn, industrial and manufacturing businesses in general have done a pretty good job of restructuring themselves. Their margins remain solid even in the face of a slowing economy both here and abroad, so while you may not see significant revenue growth, their improved profitability enables them to remain very competitive. So if valuations are low and profitability is somewhat stable, the return on capital can still be quite decent for investors.
In addition, many companies, both large and small, are flush with cash. Given the current state of valuations, acquisitions are a great way for companies to obtain top-line growth that they are struggling to generate organically.
Have you been surprised by the low rate of M&A activity that has taken place this year?Yes, and I'm not completely sure why that is. Companies are cash rich and financing is readily available, so it does surprise me that more of our companies haven't been acquired. It could be that the world is just not yet willing to look out beyond the next quarter or two and price in any sort of meaningful recovery.
Why should equity investors be encouraged?If not encouraged, they should at least be cautiously optimistic. In my opinion, there is a big disconnect between valuations and the health of the underlying businesses. What we hear from our portfolio companies is in sharp contrast to what we read in the financial press, namely, that while it's not easy, business is available to be had. Successful business results through the recent economic and market downturns are a real testament to the underlying strength that many of our portfolio companies possess.
In our opinion, investors have also lost sight of the importance of preserving and growing the purchasing power of their investments. Bonds can't do that given the current rate structure. Equities and small-cap companies in particular may provide the opportunity for investors to potentially earn meaningful long-term rates of return above that of inflation.
Kaplan discussing small caps on Bloomberg:
Important Performance and Expense InformationAll performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.roycefunds.com. Gross operating expenses for Royce Dividend Value Fund reflect the Fund’s gross total annual operating expenses for the Service Class, and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Net operating expenses for Royce Dividend Value Fund reflect contractual fee waivers and/or expense reimbursements. Operating expenses for Royce Total Return Fund reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management fees, other expenses, and acquired fund fees and expense. All expense information is reported as of the Fund’s most current prospectus. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds and other investment companies.
Important Disclosure InformationThis material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Jay Kaplan is Portfolio Manager and Principal of Royce & Associates, LLC, investment adviser to The Royce Funds. Mr. Kaplan’s thoughts in this piece are solely his own and, of course, there can be no assurance with regard to future market movements.
The Royce Funds invest primarily in micro-cap, small-cap and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). The Funds may invest a portion of their respective net assets in foreign securities, which may involve political, economic, currency and other risks not encountered in U.S. investments (see "Investing in International Securities" in the prospectus). The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors. The Russell 2000 is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. Distributor: Royce Fund Services, Inc.