Instead of betting on speculative or unsustainable growth, Portfolio Manager Chip Skinner looks for industry leaders being driven by a new product or technology that can potentially compound annually at 15% or higher. He and CEO Chuck Royce talk about the kind of emerging industries and attractive themes that Chip is looking at in Smaller-Companies Growth's portfolio.
Chuck Royce (Trades, Portfolio): Chip, I'm thrilled with how well your fund is doing this year. How did this fund come about, and where does it fit in the spectrum of funds here at Royce?
Chip Skinner: Thank you Chuck. Royce Smaller-Companies Growth Fund has been around about 12 or 13 years. It started as the growthier fund within the value shop and, if anything, has shifted towards more of a "growth at a reasonable price" fund. We've been doing a lot of work in sort of modifying that process. I think we're seeing much better performance as a result of that effort, but really right now I view it as the small-cap growth fund at The Royce Funds.
Chuck: This world we live in of lower rates would seem to be an ideal environment for a growth orientation. Analyzing growth companies is sometimes complex because you're looking way out in the future. Tell me how you focus on that.
Chip: Well I think rates do play a part. I think multiples can rise in a low rate environment, but I think the low-rate structure that we have right now in the economy is partly due to the fact that the economy has not been growing at a very rapid rate. So in some sense I think finding great growth companies in a slower growing GDP period has been more challenging.
Therefore, in our Fund, we have been looking for either segments of the economy that do offer higher growth rates or megatrends, as we call them: some sort of a technology or maybe an emerging industry that provides a backdrop tailwind for faster growth. So we've been trying to sort of dig deeper and identify these special areas that offer faster growth. And we define growth as 15% a year growth or higher.
Chuck: Tell me a little bit about growth themes. These are economic themes in the structure of the domestic economy?
Chip: Not as much areas of the economy, even though we do look at areas of the economy to see, perhaps, how we need to be weighted from a sector standpoint. The megathemes would be more like a change in technology.
One of the themes that we've been focusing on is "Machine to Machine" or also known as the "Internet of Things." This is where, if historically the Internet's been all about connecting people to people over the telecom infrastructure, the machine-to-machine theme is more about connecting individual items or products and collecting data through a sensor on an individual product, let's say a truck out on the road and communicating with another semiconductor chip back to the home office to generate data that helps companies make better decisions. Some of the big tech companies out there think this is the next big thing, and I actually do believe that we're going to see millions of devices that are going to be connected to our Internet system.
Chuck: How do you handle risk in this kind of growth investment? Sometimes I think of growth companies as being riskier, but on the other hand they could be more stable.
Chip: Well I think they are generally more volatile than, let's say, other areas of investing. Some of the things that we're doing would include trying to identify growth, and it's not the high-growth, momentum-type investing that maybe you see elsewhere. I'd say we're on the conservative side of the small-cap growth spectrum.
We're looking for more recurring revenues and repeatable sort of business models as opposed to some very high-growth, shot-in-the-dark, one-time product winner. We're looking for companies that established themselves and have a record and a big opportunity ahead of them. We think of it as a long runway of growth where they perhaps are the industry leader in an emerging growth area and have demonstrated that they have a differentiated product and can lead the industry.
We utilize a lot of the other Royce criteria to reduce risk, including a strong balance sheet. We're looking for quality companies that also include high returns on invested capital, and then valuation. Valuation is not what we lead with in this Fund but it is an important component, and I think we can manage risk by establishing a discipline there that perhaps we're willing to pay a higher multiple, but in exchange we'll be getting faster growth.
Chuck: What are your current areas that you're finding opportunities?
Chip: We have been doing a fair amount in the healthcare space in the last year or two. Drug discovery is one of the themes that we've been working on. That has added to the performance.
I'd say another sort of tailwind that we've been pursuing would be our growth retailer and growth restaurant theme. It's a very simple thesis. The oil prices have come down, gas prices have come down, more individuals are employed beginning sort of last year, and so these combinations of factors have given us confidence that, perhaps, consumer spending—which is the largest piece of the economy, as you know—will begin to pick up in a bigger way. So companies like Buffalo Wild Wings, which is a restaurant chain, it's a unit growth story, a very popular restaurant chain, has done very well.
A newer idea would be The Container Store. It's a retail brand that is well known. They have about 70 stores and they think they can have 300 stores across the U.S. So that's a long runway of unit store growth, plus they have some other strategic efforts underway that are going to add to the growth over time.
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The thoughts and opinions expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.
This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Royce Smaller-Companies Growth Fund invests primarily in small-cap and 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.) In addition, as of 6/30/15 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund's overall value to decline to a greater degree. The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index.The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.
