Royce Funds Whitney George on Q2 2013 - Stocks Continue to Look More Appealing Than Fixed Income
Can you discuss a sector that currently appeals to you from a valuation standpoint?
I still like the Energy sector. Oil prices remain stubbornly high, probably due to tensions in the Mideast. More importantly, natural gas prices have started to recover from lows in the $2 per MCF range to not far below $4 per MCF at the end of June. I think there’s a great opportunity in the next few years for gas prices to converge globally. For example, in Asia natural gas prices have been in excess of $10, whereas in Canada the price has been closer to $3 per MCF. We’ve seen some early indications that an agreement can be reached about pricing gas globally. The Japanese would love to pay the Canadian price while Canadians would love to receive Japanese prices. If they find some middle ground, I think we’d quickly see the development of pipelines, liquefaction facilities, and an increase in activity here in North America—where supply is so ample—to meet the fast-growing demand.
The longer gas prices remain low, the more switching goes on as people like the more environmentally friendly nature of gas. Being economically sensitive, many natural gas businesses were out of favor in 2012, so we built positions in companies with fundamentals that we liked. We think we could see much higher gas prices over the next three to five years. More importantly, we see higher, sustained levels of service activity. We’ve been focusing more on service companies, particularly in Canada, where the technology is most advanced.
Is there another sector in which you’ve been seeing interesting opportunities?
Technology is another sector where we continue to have a great interest. The opportunities have been broad based, though semiconductor manufacturers continue to be among the most appealing companies. The number of applications for semiconductors keeps expanding on a global scale. Many of these companies learned to manage their businesses effectively during some very difficult cycles in the aftermath of the Internet bubble. In the more recent downturn semiconductor companies were able to reduce their inventories in the space of two months, where in prior years it would have required several months. Throughout the industry inventories are lean, so the current pick-up is driving terrific results. In addition, our semiconductor holdings in general have terrific balance sheets and strong managements, so we have a lot of confidence going forward as the environment continues to improve.
What are three stocks with attractive valuations and/or strong fundamentals that exemplify your approach?
Cirrus Logic is a semiconductor maker that is the sole provider of audio codecs for Apple’s iPhones and iPads. It also has what we think is an impressive array of other customers and products, including top LED suppliers for whom it makes dimmer and color control components. We reduced our stake last summer when its price was rising and this past spring began to rebuild a position after a slowdown in Apple’s business helped its share price fall back to levels we found highly attractive.
Calfrac Well Services, which is based in Calgary, provides well stimulation services to oil and natural gas companies, including hydraulic fracturing, coiled tubing, and cementing. It has an attractive balance sheet and great expertise in the services we anticipate will be in high demand in the next few years.
RV and small- and mid-size bus maker Thor Industries is a stock that we have owned in some Royce portfolios for more than a decade. It now has new management, including a CEO who rose through the ranks of the company and has worked to make Thor’s business more focused and efficient just as demand is picking up.
What did you make of the market’s turmoil in late June?
It's my opinion that the declines had more to do with the liquidity that China provides than it did with any of the interpretations of what Ben Bernanke said or did not say. China has been a major source of global liquidity for some time, but is now choosing to fix the problem of over-leverage in its shadow-banking system. China seems willing to accept the short-term pain of de-levering the system in favor of realizing the long-term goal of full acceptance of the yuan as a global currency. It’s almost as if they have found their own version of Paul Volcker and are exercising some short-term fiscal discipline.
Of course, if the 30-year bull market for bonds is ending we can expect some short-term volatility in a number of markets, including small-cap stocks. However, I think the re-emergence of free-market forces in the bond market will benefit the economy and the markets in the long run.
Why do you think stocks look more attractive than fixed income right now?
First, I think that earnings yields and in many cases dividend yields are generally more attractive right now for stocks than for fixed income. The 10-year Treasury was at 2.2% and trading at close to 45x earnings (priced as a P/E equivalent) at the end of the second quarter. If we get close to the Fed’s inflation target, there is no real return on that investment. By contrast, we have found many stocks with high single-digit or low double-digit free cash flow yields that are also growing, which makes them far more attractive to us than bonds.
What is the current case for active small-cap management?
I think the first thing to keep in mind is that small-caps have often outperformed large-caps in difficult to moderate markets, which gives me confidence in small-cap considering the uncertainty of our current economic situation. Passive vehicles have outpaced active small-cap approaches over the last few years, but with correlations beginning to decline at the sector and industry levels, we think the trend is showing signs of reversing, though admittedly the shift won’t be immediate but will happen more slowly. While valuations look solidly average for the stock market as a whole, at the company level there are enormous disparities, which have been creating excellent opportunities for bottom-up, active managers like us. As equity returns become more differentiated, we expect some of these opportunities to distinguish themselves.
In addition, the market’s stumble in late June showed many ETFs, particularly those investing in emerging markets stocks and fixed income, were "gated" as managers were struggling to keep up with outflows. It reminded me of the fiascos with portfolio insurance back in 1987, when an instrument that had been seen as useful for mitigating risk wound up exacerbating losses in a severe market decline.