On the long side we're doing essentially what Buzz and I have always done in Royce Opportunity Fund, so most of what changes are the names of the individual companies.
After a very strong 2012, what have you been doing with Royce Opportunity Select Fund's portfolio so far in 2013?
We have been reducing our positions in a lot of what worked in 2012, which were predominantly housing-related companies. We've cut back a little more on the homebuilders than we have in some other areas.
A lot of housing-related companies are still doing well, so we've been selling as they begin to hit our price targets. Housing is still a pretty robust area. There's just not a lot of inventory on the market and there's a bit of a buyer's panic, which is no different than what you see in the stock market from time to time.
So we continue to prune those ideas that have worked while we're buying Technology stocks, small banks, and anything related to natural gas.
What's been attracting you to Technology?If you look over the longer term, many tech stocks have done next to nothing with the exceptions of some well-known, large-cap names that have been huge headline grabbers like Apple, Google, and Priceline. But as you dig down into the small-cap world, it's been very, very slow as far as any interest from investors.
There is an important transformation going on, which is that businesses used to spend a lot of money on PCs—most would upgrade every cycle when a new version of Windows or a faster processor came out. That doesn't happen anymore. It's similar to younger people not having phone lines in their apartments—I don't think any of my nephews or nieces have a wire line. People are abandoning desktops for mobile devices or iPads, or even the new Google product, which is very good.
The device makers and the people that make components for all those products had to do a big changeover because they're losing their old PC business and they're having to retool and reshape for mobile devices. This is always a tough transition, whether you're in retail or any consumer-related product in technology.
When you're getting rid of an old product line and starting up a new one, inevitably the sales of the old products fall off fast while sales of the new products are much slower to ramp up. So we've been trying to taking advantage of that.
Like a lot of other industries—particularly housing—you run into a situation where there's going to be some catch-up, and if we're lucky we'll see some more incremental demand from recovering economies that benefit tech businesses.
Many of our tech-related holdings have traditional Royce characteristics, which is to say that the balance sheets are strong, they have a lot of cash, and they tend to make a great return on equity.
I think the "dirty little secret" about most tech stocks is that they're really no more than deep cyclicals now. So we've been buying a lot of technology companies.
Can you talk about your interest in banks?Unlike most of our colleagues here at Royce, we continue to buy a lot of small banks. We think there's going to be consolidation in the industry—a lot of the CEOs I've talked to recently believe this as well.
We're doing it a little differently in that we're not trying to buy the banks that look like takeover targets but rather the ones that are likely to be doing the buying.
The valuations among the likely buyout targets are OK—a buyer seems likely to get 10-15% on a takeout. However, we're looking for an uptick in earnings where there's potential for multiple expansion or a better return over time, and the way we think that's going to happen is that as small banks buy other smaller banks they get a bigger deposit base.
If we're right in our assumptions about the economy going forward we'll probably see interest rates rise a little bit, and when that happens these banks benefit from earnings on their deposits—their net interest margin rises.
We don't really have any geographic preference, although we have tended to look more closely at Florida and California because banks in both states were in tough shape but are now recovering.
The number of names in the portfolio has gone up a bit because it's difficult to get any firm conviction on any one name in the group, so we tend to diversify more broadly than with some other industries.
What kind of natural gas companies are you investing in?We are investing primarily in service companies instead of the companies that own the wells. We prefer the businesses that bring water, sand, chemicals, and equipment to the wells. We also have a little different play in that it's not just the natural gas that's important—it's also that oil continues to defy the odds by staying very expensive at more than $90 per barrel.
So for the first time in a long time we may have a good market for oil and gas, which would mean that rates—what the service companies can charge the people who own gas wells—go up and an extra dollar charged to your customer pretty much heads right to the bottom line, which allows for very good returns.
Natural gas is still very cheap, but what people tend not to focus on is that the actual usage of the commodity continues to rise. I was at a conference recently where I saw a company that is outfitting the U.S. with natural gas pumps.
They're almost done getting the line from the west coast to the east coast and from Mexico to Canada, which are the truck routes. That's going to create major changes.
What are some of the more important differences between Royce Opportunity Select Fund and Royce Opportunity Fund?Opportunity Select has a much smaller asset base, $5 million versus $2.2 billion as of March 31, 2013. The Fund can invest in both long and short positions.
On the long side Opportunity Select is a more concentrated version of the larger portfolio. As opposed to individual positions not exceeding 1% of net assets in Opportunity, we'll go up to 3% of net assets in long positions in Opportunity Select. We also held 89 names at the end of March in Opportunity Select while Opportunity held 319 at the end of the first quarter.
The ability to do short sales means that the turnover is high, and I imagine it's going to remain high because that's the way it works with the kind of shorting that we do.
There's no tax advantage to staying short for a year because it's a short-term gain or loss no matter how long you hold it. We like the idea that each long name can have a meaningful impact, but we also have to be pretty smart with our stock picks if we want to stay successful. Theme-wise it doesn't deviate too much from Opportunity.
Considering that Opportunity Select holds such a smaller number of positions compared to Opportunity, are there additional risk management considerations for those long positions?We put our highest conviction names in the portfolio. Of course that still entails risk, but we think that even if these companies have a hiccup they'll be in a position to recover.
Which is to say that if they miss quarterly earnings and the stock falls pretty dramatically, we have what we think are compelling reasons to keep holding the stock—terrific growth potential, new management, a strong balance sheet, undervalued assets, etc.
What is your approach to shorting stocks in Opportunity Select?Most of the shorts come out of the work that we're doing on the long side. For example, if we're reading Women's Wear Daily and we notice that new management wants to change the way 90 million people shop and investors expect it to happen overnight, we say, "That doesn't make sense," and that's why we shorted JC Penny in 2012.
They tend to be names that look overvalued on the same basis that we look for stocks to buy. They usually have really high price-to-book or price-to-sales ratios.
Because they tend to be things that are working now versus those things that we buy on the long side, they also tend to have very high P/E Ratios.
A lot of times we'll enter into a position and in the first three months or so it can be a little ugly for us. But we tend to hang in there and if we do it right, we see some pretty dramatic turns.
We want to keep the Fund very much in the small-cap family.
Of the 89 names in the portfolio, 13 were short positions at the end of March. So far we haven't held a significant portion of net assets in shorts—most recently, it's been around 10-12% of net assets. (The portfolio can invest up to 35% of its net assets in short positions.)
The percentage is pretty much a function of what's available and where prices are. Because we act pretty quickly with shorts, it can change dramatically: going from 20% to 10%, or vice versa, pretty quickly. But it all depends on what's available for us to short.