Jim Harvey on Why It’s a Stock-Picker’s Market: Royce Funds Commentary
Are you concerned about the effect that the looming fiscal cliff could have on the stock market?
I'm not as concerned with the fiscal cliff itself as with the need for a more workable plan to deal with the deficit and bring a greater level of certainty to the economy and markets.
The changes coming in January include billions in tax increases and deep spending cuts—a combination that would immediately help tame the deficit, but that would also create a 0.5% hit to GDP next year, with the first half of the year bearing the brunt of the contraction. In addition, this could potentially push unemployment back up to 9.1%, according to the CBO (Congressional Budget Office). No one is in favor of that kind of scenario.
I am optimistic that our political leaders will take advantage of the opportunity to strengthen the economy and reduce the deficit. We may even see some action on reform of the overall tax code. Any changes to the corporate tax structure could be particularly bullish for equities. Regardless of the specifics, I'm hopeful that intelligent and effective decisions will be made that reduce uncertainty, put people back to work, and give some much-needed traction to the equity markets.
My thought is that we're likely to see stop-gap measures in the current lame-duck session of Congress with the real heavy lifting being done early in 2013. Investors need to understand what the playing field looks like. Once we all have a better idea of what kinds of policies are being put in place, business leaders can again focus on growth, and the economy will receive a boost. Many companies are flush with cash, but we've been hearing from a lot of the management teams we talk to that they're waiting until things feel surer on an economic basis before they begin to put that cash to work.
With the recent run-up for small-caps, what sectors and industries in the U.S. look attractively undervalued?
As is always the case at Royce, the bulk of the research we've been doing is focused on finding companies that meet our exacting value criteria. As a group, we're more interested in what we think are well-run, conservatively capitalized businesses than sector or industry plays.
Although the market here in the U.S., including small-caps, has done pretty well year to date, I'm still finding companies that look attractively undervalued—they have strong balance sheets, established earnings histories, and high cash-flow yields. Many of these stocks are involved in Technology and Telecommunications Services, although I've also seen what look like terrific, high-quality companies in the Industrials, Materials, and Energy sectors as well.
The perception that equities are too risky has definitely hurt a lot of stocks, in spite of the rebound we saw in the third quarter. The upshot of that unfortunate attitude is that I'm still seeing companies that meet my quality and valuation standards.
Are you still investing in China?
I am- it's a challenging market, but it's one that we've spent the last decade getting to know well, and it continues to present some really compelling opportunities. And for all of the anxiety about the Chinese economy suffering a hard landing and related concerns about political transitions and corporate governance standards, Hong Kong's Hang Seng Total Return Index rose 21.6% through October 31.
In fact, most of the markets we are invested in throughout Asia have seen positive returns year to date, with the Russell Asia ex Japan Index up 15.3% through the end of October. To me, it looks as though earnings troubles have bottomed out, while the new political leadership in China seems committed to keeping their economy on track, targeting a more reasonable 7-7.5% growth rate, down from around 8-10% over the past few years. The bottom line is that Western perceptions of the Chinese economy are more negative than the reality of what is happening on the ground.
When it comes to investing in China, our guiding principles from the beginning have been caution and patience. I look for companies that meet the same exacting standards I have for domestic businesses; I also want to see an even longer-term track record of profitability, one that goes back at least five to ten years, and a history of treating shareholders fairly.
This does not leave an enormous number of candidates, but it does provide a solid group of companies that makes me very comfortable with the firm's current exposure to China, especially since we recently parted ways with some stocks in which we had lost confidence or that had been languishing a little too long. Most of these Hong Kong listed companies we own today are positioned to benefit from the ongoing internal consumption story within China or from the export of products into the higher growth regions within Asia.
Where have you been seeing value elsewhere in Asia and in Europe?
I see the current global situation very much as a stock-picker's market, so for Europe and the rest of Asia, it's much the same as it is for U.S. and Chinese stocks—I've been seeking out opportunities based on the screens we run that are designed to reveal quality.
I'm looking for that same long-term earnings history, talented management, high or growing dividend payout ratios and shareholder-friendly corporate actions. I'm particularly interested in companies that can demonstrate operating leverage where EBIT (earnings before interest and taxes) grows faster than sales.
We also have an international team that meets regularly to vet ideas, compare notes, and review the macro picture, which has been very helpful in sharpening our international stock-selection efforts. Over the last 10 years, we have compiled a substantial informational and intellectual database of non-U.S. stocks.
In one sense, the non-U.S. markets resemble ours; you can always find a lot of cheap stocks. However, our job is to uncover quality companies that are trading below our estimate of their worth as a business. Those companies are difficult to find no matter where you're looking for them. It should be noted here as well that, as bad as things may feel given the onslaught of negative headlines, the Russell Global Small Cap Index was up 12.5% through the end of October.
Considering all of the volatility and correlation of the last three years, what has been your biggest challenge?
The dominance of macro forces on investors' behavior has been the biggest challenge. It's been difficult for people to concentrate on company fundamentals—as we do here at Royce—when the rest of the world is focused on our deficit, European solvency, China, the elections, etc.
Stock prices have been very susceptible to large-scale macro events and news, regardless of whether these matters affected the company directly or not, with the result that stocks are currently seen as too risky. Yet there are companies paying dividends and managing their businesses very effectively that are being ignored by investors.
I'm very comfortable owning a portfolio of companies that can deliver stable and relatively high earnings yields. I am optimistic that investors will begin to recognize these types of attractive attributes within equities in 2013 once the macro picture here in the U.S. becomes clearer.
Important Disclosure Information Mr. Harvey's thoughts in this piece concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. The Hang Seng Total Return Index is a free float-adjusted market cap-weighted stock market index in Hong Kong that records and monitors daily changes of the largest companies of the Hong Kong stock market. The Russell Asia ex Japan and Russell Global Small Cap Indexes are unmanaged indexes of Asian (excluding Japan) and global small-cap stocks, respectively.