I do. Of course, we've been calling for a more typical market environment for a while now, so our recent forecasting has been less than stellar. However, the market's second-half results were telling. In the third quarter we saw many quality stocks keep pace with the small-cap market as a whole. Many of these businesses then went on to outpace the Russell 2000 in the fourth quarter, particularly in October, when the rally began to cool. To us, this was as clear a sign as we've seen in more than two years that the market was moving away from high correlation and into a phase that looks likely to be better for active, quality-biased managers such as ourselves.
Why do you think quality stocks generally underperformed through much of 2011 and 2012?
I think it has a lot to do with both the zero-interest-rate policies that the Fed has been implementing over the last few years and its successive rounds of quantitative easing. With rates so low, companies were finding it very easy to restructure debt, or take on more debt. The price companies were paying to do so was miniscule, and investors acted accordingly, rewarding a number of fast-growing, highly leveraged companies while often ignoring those with strong balance sheets. In an environment where the cost of debt has been virtually nil, low-debt companies lost their traditional advantage. However, I think we've reached a stage where this advantage is diminishing because rates have been quite low for a few years now and monetary stimulus no longer has the same dramatic effect it had with the first two or three rounds of QE. Again, I think this is a good sign for high-quality small-cap stocks.
Has recent underperformance changed your view of the importance of balance sheets?
It has not. We remain as disciplined about quality—and as committed to it—as we have always been. The recent era of low rates and ample liquidity has not changed our view of the importance of strong balance sheets. It also hasn't altered our view of other quality attributes such as high returns on invested capital, cash flows, or dividends. Many small-cap companies that possess any number of these characteristics have underperformed the Russell 2000 since 2010 or 2011. So our disciplined approach was definitely derailed, which can be seen in many of the Funds' one- and three-year results—and in some cases in the five-year returns—through the end of 2012. However, we don't pay lip service to patience and discipline. We did not enjoy watching so many portfolio favorites languish. It was as frustrating a time as I've seen in 40 years. But not once did any of us consider doing things differently. We knew that we were in a highly anomalous market, one that we may not see again for more than a generation. So we stayed patient and consistent while we waited for the cycle to shift.
Do you think that active management can outperform in a new cycle?
I do. As correlation continues to abate, I think there will be an excellent opportunity for quality to emerge. This is ultimately why I was not surprised by the market's strength in the second half, even with all the ongoing uncertainty. It seems clear to me that the market has entered a cycle in which stock picking matters. My optimism is bolstered by the fact that in the years ahead, earnings growth can accelerate for small caps and should be robust as the economy continues to improve.
What impact is an effective budget deal from Washington likely to have on the economy and equity markets?
First, I strongly believe that a budget deal is inevitable. I also think the market has believed that for at least a couple of months, which is why in the second half of 2012, it seemed better able to keep moving upward in the face of macro events such as natural disasters, elections, ongoing concerns in Europe, and the hand-wringing over the fiscal cliff. Companies are definitely hesitant about capital expenditures, but those issues have more to do with timing. That is, businesses aren't willing to start spending until the President and Congress strike a deal. But I don't think there's any question about their willingness to invest. I also think that a budget deal is likely to spark a very important conversation about tax and entitlement reform, which is key to dealing with long-term structural deficits. To me, that will be among the most compelling political stories in the next couple of years.