Portfolio Managers Boniface "Buzz" Zaino and Bill Hench talk about their diversified portfolio approach, why their opportunistic style worked well in 2012, their stock-picking criteria, how they are currently positioning their portfolio, and the relationship between employment and interest rates as it relates to a continuing recovery.
We typically expect our investments to pay off 18 to 24 months after we begin to purchase shares. We tend to get in and out of positions slowly. There are always cheap stocks in the market, even during bullish times. But for a stock to get into the Funds it has to be cheap for what we think will be a temporary reason and be statistically valid for a value portfolio.
Bill: The critical metrics for us are the price to sales and price to book ratios. These signal to us that a company has what it takes to rebound from whatever difficulties they're facing. Once we've identified companies that fit that criteria, we want to buy at entry prices that look very good. We're looking for situations that can turn around and blossom in that 18- to 24-month period.
Bill: By keeping the portfolio highly diversified, we try to manage volatility. One example would be the case of housing stocks. We were confident that after the housing bubble of 2007-2008, prices would eventually rebound as plans to restructure debt and stabilize the banks took effect. As the economy began to gradually climb out of recession, we began to find buying opportunities in a number of industries related to housing—household durables, building products, software, and chemicals—and waited for what we judged to be the right time to begin adding positions to the portfolio.
By early 2011, however, credit levels began to open and money was beginning to flow. We saw a surge in investors buying up foreclosed properties for rental income, which was taking inventory off the market. At that point we were seeing what looked like the beginning of a historically normal recovery from a recession. We took this as a sign that demand for residential building would increase and that housing would begin to rebound shortly. We didn't know exactly when this would happen, of course, but a lot of stocks looked attractively inexpensive to us, and we began to buy.
Bill: We intentionally took a broad-based approach by investing in a full spectrum of housing-related businesses. If our thesis was right, the housing recovery would benefit several different kinds of companies. So we looked to companies in those sectors and industries that seemed most likely to benefit. We invested, for example, in homebuilders, building product suppliers, window components, and lumber companies. We bought companies that make everything from decking to mortgage software, from water valves and fixtures to financial companies that provide mortgage and title insurance. So we were really pleased to see many of these companies do well in 2012.
However, we are seeing some attractive opportunities in certain areas. Many tech-related stocks have not made a substantial market impact in almost 10 years, so there are still a lot of opportunities in the Information Technology sector, especially in capital goods and semiconductors. The consumer demand for technology is still there, principally in mobile applications, and the infrastructure that needs to be built around them still needs to be completed around the world—not just here in the U.S. or Asia—but everywhere. Africa is emerging as a significant tech spot now, too. However, we're not necessarily just looking at companies with a global presence.
Bill: When it comes to a lot of technology companies, especially for people making components, it's hard to figure out where the end-market is because there are many pieces of the puzzle to consider—distribution, assembly, and engineering can all be sourced from different parts of the world for products which can be sold right here in the U.S. The reach and scope of tech products make the Information Technology sector equally attractive to us at the moment.
We're also adding a lot to small banks. Though we've been looking at small- to mid-sized banks since around the time we were getting into housing, now we have a slightly different bent. We're looking for the likely acquirers—banks that are looking to expand by buying other institutions and profiting on the increased deposit base. When bigger banks are able to pick up small branches, especially those that are geographically close to where the bigger bank's branches are also located, it's M&A 101: You can add to or expand business in those cities and towns while lowering costs. In addition, smaller banks are going to find it increasingly difficult to support that infrastructure—and specifically the regulatory infrastructure resulting from Dodd-Frank—that they need in order to be compliant in today's market.
Buzz: Banks would also benefit greatly from an increase in interest rates. If you look at the income statements of banks today, you'll see that they're doing okay in mortgage underwriting. Loan volume is not uniformly up everywhere but it's positive. The other place where you can really add a lot to the income statement is the net interest margin, which will expand when rates eventually rise.
According to Fed Chairman Bernanke, interest rates will go up when unemployment slips below 6.5%. That means some areas will benefit and some areas will not benefit when we get to that place. One area that will benefit will be banks because their spreads will increase. I think retail and other consumer goods should do well. Although there is the potential pressure of inflation in the future, the most likely reason for interest rates to rise is a strong economy with improved employment.
Buzz Zaino and Bill Hench are portfolio managers of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Zaino's and Mr. Hench's thoughts in this interview concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce Opportunity Fund invests primarily in small-cap and micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). Royce Opportunity Select Fund (ROS) invests primarily in small- and/or micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). ROS also invests primarily in a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of these stocks would cause ROS's overall value to decline to a greater degree (Please see "Primary Risks for Fund Investors" in the prospectus). ROS may sell securities short which involves selling a security it does not own in anticipation that the security's price will decline. Short sales present unlimited risk on an individual stock basis since ROS may be required to buy the security sold short at a time when the security has appreciated in value. ROS may invest up to 25% of its net assets in foreign securities, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)
Distributor: Royce Fund Services, Inc.
Why do you think your opportunistic style worked so well in 2012?
Buzz: I think our approach worked because of the efforts that we made in 2011 to try to make Royce Opportunity and Opportunity Select Funds successful over the long run. One important aspect of our approach is that we routinely look ahead trying to position the portfolios for future success. So we are always looking for companies that look attractively valued.We typically expect our investments to pay off 18 to 24 months after we begin to purchase shares. We tend to get in and out of positions slowly. There are always cheap stocks in the market, even during bullish times. But for a stock to get into the Funds it has to be cheap for what we think will be a temporary reason and be statistically valid for a value portfolio.
Bill: The critical metrics for us are the price to sales and price to book ratios. These signal to us that a company has what it takes to rebound from whatever difficulties they're facing. Once we've identified companies that fit that criteria, we want to buy at entry prices that look very good. We're looking for situations that can turn around and blossom in that 18- to 24-month period.
Can you describe your approach in more detail?
Buzz: The investment style we use—and have always used when building the portfolios that Bill and I manage—seeks to take advantage of what I like to call opportunistic situations, including turnarounds, emerging growth companies with interrupted earnings patterns, companies with unrecognized asset values, and undervalued growth companies. These are our four investment themes.Bill: By keeping the portfolio highly diversified, we try to manage volatility. One example would be the case of housing stocks. We were confident that after the housing bubble of 2007-2008, prices would eventually rebound as plans to restructure debt and stabilize the banks took effect. As the economy began to gradually climb out of recession, we began to find buying opportunities in a number of industries related to housing—household durables, building products, software, and chemicals—and waited for what we judged to be the right time to begin adding positions to the portfolio.
Can you discuss when and how you determined that stocks related to housing were closer to recovering and what criteria you used to select the companies you chose?
Buzz: The theory was thatthe normal recovery from almost all recessions has started with a decline in interest rates, where those people who can afford houses or cars begin to buy because the rates are more attractive. But in this recovery, this was delayed because while people wanted to buy houses or cars, the banks were not lending money in the early part of the recovery.By early 2011, however, credit levels began to open and money was beginning to flow. We saw a surge in investors buying up foreclosed properties for rental income, which was taking inventory off the market. At that point we were seeing what looked like the beginning of a historically normal recovery from a recession. We took this as a sign that demand for residential building would increase and that housing would begin to rebound shortly. We didn't know exactly when this would happen, of course, but a lot of stocks looked attractively inexpensive to us, and we began to buy.
Bill: We intentionally took a broad-based approach by investing in a full spectrum of housing-related businesses. If our thesis was right, the housing recovery would benefit several different kinds of companies. So we looked to companies in those sectors and industries that seemed most likely to benefit. We invested, for example, in homebuilders, building product suppliers, window components, and lumber companies. We bought companies that make everything from decking to mortgage software, from water valves and fixtures to financial companies that provide mortgage and title insurance. So we were really pleased to see many of these companies do well in 2012.
How have you been positioning the portfolios recently? What sectors and/or industries look most attractive?
Buzz: After a bullish year like 2012, things are more challenging now. There's been an influx of cash into the market that's driven up share prices almost across the board, which makes it more difficult to buy stocks cheaply, that is, at the valuations we tend to usually look for.However, we are seeing some attractive opportunities in certain areas. Many tech-related stocks have not made a substantial market impact in almost 10 years, so there are still a lot of opportunities in the Information Technology sector, especially in capital goods and semiconductors. The consumer demand for technology is still there, principally in mobile applications, and the infrastructure that needs to be built around them still needs to be completed around the world—not just here in the U.S. or Asia—but everywhere. Africa is emerging as a significant tech spot now, too. However, we're not necessarily just looking at companies with a global presence.
Bill: When it comes to a lot of technology companies, especially for people making components, it's hard to figure out where the end-market is because there are many pieces of the puzzle to consider—distribution, assembly, and engineering can all be sourced from different parts of the world for products which can be sold right here in the U.S. The reach and scope of tech products make the Information Technology sector equally attractive to us at the moment.
We're also adding a lot to small banks. Though we've been looking at small- to mid-sized banks since around the time we were getting into housing, now we have a slightly different bent. We're looking for the likely acquirers—banks that are looking to expand by buying other institutions and profiting on the increased deposit base. When bigger banks are able to pick up small branches, especially those that are geographically close to where the bigger bank's branches are also located, it's M&A 101: You can add to or expand business in those cities and towns while lowering costs. In addition, smaller banks are going to find it increasingly difficult to support that infrastructure—and specifically the regulatory infrastructure resulting from Dodd-Frank—that they need in order to be compliant in today's market.
Buzz: Banks would also benefit greatly from an increase in interest rates. If you look at the income statements of banks today, you'll see that they're doing okay in mortgage underwriting. Loan volume is not uniformly up everywhere but it's positive. The other place where you can really add a lot to the income statement is the net interest margin, which will expand when rates eventually rise.
Do you think the U.S. economy will continue to recover in 2013?
Buzz: Yes, I think the economy will continue to recover, mostly by virtue of the growth in employment. The building cycle employs a lot of construction workers, and there's a fairly major derivative effect in increased activity. The Energy sector is also providing good employment opportunities with terrific wages. If you look at places that have a lot of exposure to the energy industry—certain parts of Texas and North Dakota, for example—unemployment is low to virtually nonexistent.According to Fed Chairman Bernanke, interest rates will go up when unemployment slips below 6.5%. That means some areas will benefit and some areas will not benefit when we get to that place. One area that will benefit will be banks because their spreads will increase. I think retail and other consumer goods should do well. Although there is the potential pressure of inflation in the future, the most likely reason for interest rates to rise is a strong economy with improved employment.
Important Information
All 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 here. Operating expenses reflect ROF's total annual operating expenses for the Investment Class as of ROF's most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. Gross operating expenses reflect ROS's gross total annual operating expenses for the Investment Class and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of ROS's most current prospectus. Royce & Associates has contractually agreed, without right of termination, to waive fees and/or reimburse expenses to the extent necessary to maintain the Investment Class's net annual operating expenses, other than acquired fund fees and expenses, at or below 1.24% through April 30, 2015. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by ROF or ROS through its investments in mutual funds, hedge funds, private equity funds, and other investment companies.Buzz Zaino and Bill Hench are portfolio managers of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Zaino's and Mr. Hench's thoughts in this interview concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce Opportunity Fund invests primarily in small-cap and micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). Royce Opportunity Select Fund (ROS) invests primarily in small- and/or micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). ROS also invests primarily in a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of these stocks would cause ROS's overall value to decline to a greater degree (Please see "Primary Risks for Fund Investors" in the prospectus). ROS may sell securities short which involves selling a security it does not own in anticipation that the security's price will decline. Short sales present unlimited risk on an individual stock basis since ROS may be required to buy the security sold short at a time when the security has appreciated in value. ROS may invest up to 25% of its net assets in foreign securities, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)
Distributor: Royce Fund Services, Inc.
