Jay Kaplan talks about the efforts he and Whitney George have been making to get Royce Value Fund back on track. He also discusses why the market looks likely to keep climbing and why dividend-paying stocks look popular so far in 2013.
Can you tell us about the recent changes made to Royce Value Fund?
The first and most important point is that Whitney, Chuck, and I all recognized that the portfolio has not been performing the way we would all like. While its performance in down markets was not bad, it was not protecting on the down side to the degree that we all would have liked and was also not as strong during bull phases either. So it was clear to us that we needed to get the portfolio back on track—to do a better job achieving strong absolute returns over long-term time periods.
The last two years saw a concerted effort on the part of Whitney and me to simply pick better stocks and, equally important, carefully scrutinize then-current holdings to see if they continued to fit our high-quality standards of strong balance sheets, high returns on invested capital, and the ability to generate free cash flow.
Last year's second half was an important step in the right direction. The Fund beat the Russell 2000 Index, its small-cap benchmark, from June 30, 2012 through December 31, 2012 with a gain of 11.4% versus 7.2%. However, this year's first quarter was disappointing on a relative basis. Although the Fund did all right on an absolute basis—it gained 3.1%—it trailed the Russell 2000, which was up 12.4% in the first quarter. (So far in April it's held its value better in a thus-far tougher month.)
You became sole portfolio manager in March, with Whitney moving to assistant portfolio manager. What have you been doing in the portfolio since that time?
The most significant shift was in increasing the portfolio's exposure to U.S. stocks, which went from 81.1% of net assets as of December 31, 2012 to 87.2% of net assets at the end of March 2013. Non-U.S. investments accounted for 6.8% of net assets as of March 31, 2013 versus 17.7% at the end of last year. This is consistent with my own daily focus on the domestic small- and mid-cap markets. Many of these non-U.S. companies were in the metals and mining group and capital markets industries.
The first of these groups has been struggling for a while, but my decision to sell was based more on the fact that I'm not as comfortable with most commodity-based businesses—energy, steel, and chemicals being notable exceptions. Their general dependence on capital markets as well as the cash flow characteristics of many of the businesses in the industry concern me.
With the Energy sector, where most of the Fund's exposure is in services companies, the timeline between drilling and extracting is typically far shorter than it is for precious metals, so the time and capital commitments are less risky and more short-term in nature, which allows energy companies to self-correct more quickly. I also like that energy is a consumable commodity that is in high demand, one we can't live without.
This leaves the Fund's current exposure to the Materials sector in the chemicals industry, which was a source of strength in both 2012 and this year's first quarter, and steel companies.
The market has enjoyed a great run lately, particularly since the small-cap low on June 4, 2012. With so many stocks going up, there aren't nearly as many compelling values as we saw nine months to a year ago. The result is that the portfolio is a little more concentrated than it has been historically, with 59 holdings at the end of March.
The complete re-positioning is likely to take at least a few quarters rather than a few months. We take opportunities as the market gives them to us, and it doesn't make sense to over-pay for companies just to add a bit more diversity to the portfolio.
The weighting in Consumer Discretionary is pretty high, especially when you look at it versus the benchmark. This has been the result of scouring the market for high-quality companies trading at attractive valuations, which has led us to a lot of consumer names over the last few years.
There have been more companies "on sale" in that sector than in any other. Most of the remaining recent activity has entailed adjusting sector weightings around the margins, again based on company fundamentals and not on sector or industry bets. Comparing the portfolio's sector weights from the end of 2012 with the end of 2013's first quarter, we're higher in Consumer Discretionary, Information Technology, Health Care, and Consumer Staples and lower in Materials, Financials, Energy, and Industrials.
What I like right now is that the portfolio's holdings in general have what I think is an attractive combination of high returns on invested capital and low valuations.
Do you think the market is likely to keep climbing?
I do. I've been repeating my very simple outlook like a mantra lately—as long as interest rates are low and the economy keeps growing, even very slowly, the market will have a propensity to move higher.
The recent string of down days in April was a minor setback—and last week the market started to gain some of those losses back. In order to see an increased number of new and compelling opportunities, stocks would need to correct at least 10%. In a more normal environment, we'd be seeing a fair number of badly mispriced stocks as well as value traps in the small- and mid-cap space, and our job would be to try to buy the former while avoiding the latter.
As stock prices have moved further and further up, a lot of what would usually be mispriced stocks look more reasonably priced, which leaves very few bargains for us to investigate.
You also manage two of Royce's dividend-paying portfolios—Royce Total Return and Dividend Value Funds—with Chuck Royce. What is the current state of dividend-paying small-caps?
First, each Fund did very well on an absolute basis in the first quarter (+10.6% and +9.5%, respectively), though each underperformed the Russell 2000. Of course, at Royce we've always liked dividends—we see them as a marker of company quality as well as a way to receive income and potentially mitigate volatility.
Investors remain hungry for yield, and with the 10-year Treasury still below 2%, a portfolio that includes companies paying competitive yields that also offers the potential to compound value looks a lot more attractive, at least to us, than Treasuries or other products offering yields higher than Treasuries. Of course, there are no guarantees with dividends—companies that are paying them now may stop at some point. Still, we like the potential of dividend-paying smaller companies.
REITs, MLPs, and Utilities have been very popular over the last few years because of their higher-than-average yields, but those investments can't pass our balance sheet strength test, so we typically avoid them.
Many investors seem to be flocking to these vehicles as bond proxies, which works great as long as stocks are going up, but in a down market investors are likely to be disappointed if these investments start costing them principal.
We prefer businesses that are self-financing and can grow on their own rather than paying out their cash and depending on capital markets activity for their growth.
Royce Value (RYVFX, Financial), Royce Total Return (RYTRX, Financial), and Royce Dividend Value Fund (RYDVX, Financial)
Average Annual Total Returns as of Quarter-End 3/31/13
Royce Value Fund Annual Operating Expenses: 1.45%
Royce Total Return Fund Annual Operating Expenses: 1.15%
Royce Dividend Value Fund Annual Operating Expenses: 1.50%
* Not Annualized
Important Performance and Expense 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 Funds, 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. Operating expenses reflect Royce Value and Dividend Value Funds' total annual operating expenses for the respective Service Classes as of the Fund's prospectus dated 5/1/12 and include management fees, 2b-1 distribution and service fees, and other expenses for Royce Value Fund and management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses for Royce Dividend Value Fund. Operating expense reflect Royce Total Return Fund's total annual operating expenses for the Investment Class as of the Fund's prospectus dated 5/1/12 and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by Royce Dividend Value Fund and Royce Total Return Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies.
Important Disclosure Information
Jay Kaplan is a portfolio manager of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Kaplan's thoughts in this interview concerning the stock market are solely his 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 Value Fund invests primarily in small- cap and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. In addition, as of 3/31/13 the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund 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.) Royce Total Return 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.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund 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 Foreign Securities" in the prospectus.) Royce Dividend Value Fund invests 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 Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund 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.) Dividends are not guaranteed, and a company that pays or has paid dividends may not pay them in the future. In addition, while Royce Total Return and Dividend Value Funds seek current income as an investment goal, there is no assurance that there will be net investment income to distribute and/or that the Funds will achieve this investment goal.
Can you tell us about the recent changes made to Royce Value Fund?
The first and most important point is that Whitney, Chuck, and I all recognized that the portfolio has not been performing the way we would all like. While its performance in down markets was not bad, it was not protecting on the down side to the degree that we all would have liked and was also not as strong during bull phases either. So it was clear to us that we needed to get the portfolio back on track—to do a better job achieving strong absolute returns over long-term time periods.
The last two years saw a concerted effort on the part of Whitney and me to simply pick better stocks and, equally important, carefully scrutinize then-current holdings to see if they continued to fit our high-quality standards of strong balance sheets, high returns on invested capital, and the ability to generate free cash flow.
Last year's second half was an important step in the right direction. The Fund beat the Russell 2000 Index, its small-cap benchmark, from June 30, 2012 through December 31, 2012 with a gain of 11.4% versus 7.2%. However, this year's first quarter was disappointing on a relative basis. Although the Fund did all right on an absolute basis—it gained 3.1%—it trailed the Russell 2000, which was up 12.4% in the first quarter. (So far in April it's held its value better in a thus-far tougher month.)
You became sole portfolio manager in March, with Whitney moving to assistant portfolio manager. What have you been doing in the portfolio since that time?
The most significant shift was in increasing the portfolio's exposure to U.S. stocks, which went from 81.1% of net assets as of December 31, 2012 to 87.2% of net assets at the end of March 2013. Non-U.S. investments accounted for 6.8% of net assets as of March 31, 2013 versus 17.7% at the end of last year. This is consistent with my own daily focus on the domestic small- and mid-cap markets. Many of these non-U.S. companies were in the metals and mining group and capital markets industries.
The first of these groups has been struggling for a while, but my decision to sell was based more on the fact that I'm not as comfortable with most commodity-based businesses—energy, steel, and chemicals being notable exceptions. Their general dependence on capital markets as well as the cash flow characteristics of many of the businesses in the industry concern me.
With the Energy sector, where most of the Fund's exposure is in services companies, the timeline between drilling and extracting is typically far shorter than it is for precious metals, so the time and capital commitments are less risky and more short-term in nature, which allows energy companies to self-correct more quickly. I also like that energy is a consumable commodity that is in high demand, one we can't live without.
This leaves the Fund's current exposure to the Materials sector in the chemicals industry, which was a source of strength in both 2012 and this year's first quarter, and steel companies.
:How has the market's mostly bullish run affected portfolio positioning so far in 2013?
What I like right now is that the portfolio's holdings in general have what I think is an attractive combination of high returns on invested capital and low valuations.
The market has enjoyed a great run lately, particularly since the small-cap low on June 4, 2012. With so many stocks going up, there aren't nearly as many compelling values as we saw nine months to a year ago. The result is that the portfolio is a little more concentrated than it has been historically, with 59 holdings at the end of March.
The complete re-positioning is likely to take at least a few quarters rather than a few months. We take opportunities as the market gives them to us, and it doesn't make sense to over-pay for companies just to add a bit more diversity to the portfolio.
The weighting in Consumer Discretionary is pretty high, especially when you look at it versus the benchmark. This has been the result of scouring the market for high-quality companies trading at attractive valuations, which has led us to a lot of consumer names over the last few years.
There have been more companies "on sale" in that sector than in any other. Most of the remaining recent activity has entailed adjusting sector weightings around the margins, again based on company fundamentals and not on sector or industry bets. Comparing the portfolio's sector weights from the end of 2012 with the end of 2013's first quarter, we're higher in Consumer Discretionary, Information Technology, Health Care, and Consumer Staples and lower in Materials, Financials, Energy, and Industrials.
What I like right now is that the portfolio's holdings in general have what I think is an attractive combination of high returns on invested capital and low valuations.
Do you think the market is likely to keep climbing?
I do. I've been repeating my very simple outlook like a mantra lately—as long as interest rates are low and the economy keeps growing, even very slowly, the market will have a propensity to move higher.
The recent string of down days in April was a minor setback—and last week the market started to gain some of those losses back. In order to see an increased number of new and compelling opportunities, stocks would need to correct at least 10%. In a more normal environment, we'd be seeing a fair number of badly mispriced stocks as well as value traps in the small- and mid-cap space, and our job would be to try to buy the former while avoiding the latter.
As stock prices have moved further and further up, a lot of what would usually be mispriced stocks look more reasonably priced, which leaves very few bargains for us to investigate.
You also manage two of Royce's dividend-paying portfolios—Royce Total Return and Dividend Value Funds—with Chuck Royce. What is the current state of dividend-paying small-caps?
First, each Fund did very well on an absolute basis in the first quarter (+10.6% and +9.5%, respectively), though each underperformed the Russell 2000. Of course, at Royce we've always liked dividends—we see them as a marker of company quality as well as a way to receive income and potentially mitigate volatility.
Investors remain hungry for yield, and with the 10-year Treasury still below 2%, a portfolio that includes companies paying competitive yields that also offers the potential to compound value looks a lot more attractive, at least to us, than Treasuries or other products offering yields higher than Treasuries. Of course, there are no guarantees with dividends—companies that are paying them now may stop at some point. Still, we like the potential of dividend-paying smaller companies.
REITs, MLPs, and Utilities have been very popular over the last few years because of their higher-than-average yields, but those investments can't pass our balance sheet strength test, so we typically avoid them.
Many investors seem to be flocking to these vehicles as bond proxies, which works great as long as stocks are going up, but in a down market investors are likely to be disappointed if these investments start costing them principal.
We prefer businesses that are self-financing and can grow on their own rather than paying out their cash and depending on capital markets activity for their growth.
Royce Value (RYVFX, Financial), Royce Total Return (RYTRX, Financial), and Royce Dividend Value Fund (RYDVX, Financial)
Average Annual Total Returns as of Quarter-End 3/31/13
Royce Value Fund Annual Operating Expenses: 1.45%Royce Total Return Fund Annual Operating Expenses: 1.15%
Royce Dividend Value Fund Annual Operating Expenses: 1.50%
* Not Annualized
Important Performance and Expense 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 Funds, 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. Operating expenses reflect Royce Value and Dividend Value Funds' total annual operating expenses for the respective Service Classes as of the Fund's prospectus dated 5/1/12 and include management fees, 2b-1 distribution and service fees, and other expenses for Royce Value Fund and management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses for Royce Dividend Value Fund. Operating expense reflect Royce Total Return Fund's total annual operating expenses for the Investment Class as of the Fund's prospectus dated 5/1/12 and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by Royce Dividend Value Fund and Royce Total Return Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies.
Important Disclosure Information
Jay Kaplan is a portfolio manager of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Kaplan's thoughts in this interview concerning the stock market are solely his 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 Value Fund invests primarily in small- cap and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. In addition, as of 3/31/13 the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund 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.) Royce Total Return 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.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund 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 Foreign Securities" in the prospectus.) Royce Dividend Value Fund invests 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 Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund 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.) Dividends are not guaranteed, and a company that pays or has paid dividends may not pay them in the future. In addition, while Royce Total Return and Dividend Value Funds seek current income as an investment goal, there is no assurance that there will be net investment income to distribute and/or that the Funds will achieve this investment goal.
