Portfolio Managers Chip Skinner and Carl Brown discuss a number of topics, including Royce Smaller-Companies Growth Fund's YTD performance, their Growth at a Reasonable Price ("GARP") strategy, managing risk through diversification, their outlook for Health Care, where they've been finding attractive opportunities in a more volatile market, and more.
Royce Smaller-Companies Growth Fund has enjoyed a relatively strong 2015 so far. Can you talk about what areas of the portfolio have been most successful so far this year?
Chip Skinner: We've had some notable successes so far in 2015, even with the increased volatility and bearish trend in the third quarter. Many of our holdings in Health Care, for example, have held up well in the face of the correction.
We've also seen both up market strength and solid down market results from holdings in the Industrials, Consumer Discretionary, and Financials sectors. In fact, much of what has been working so far in 2015 has been the result of effective stock selection and sector allocation.
So in spite of some very real challenges over the last few months, many of which are ongoing, we are happy with the way the Fund has held up. It finished the year-to-date period ended September 30 ahead of both the Russell 2000 and Russell 2000 Growth Indexes.
Why has it been important to keep the portfolio's Heath Care holdings diversified across several industries?
Carl Brown: The volatility in biotech and pharma stocks during September demonstrates that reliance on any single industry is risky.
Despite recent talk about closer government scrutiny of drug costs, we continue to see very promising opportunities in biotech and pharma, the two industries that have dominated the small-cap market over the last few years.
In addition to drug discovery, we've been finding a number of interesting growth opportunities in the diagnostic and medical device industry, where the growth potential is high and the valuations look reasonable.
We're very careful about keeping the portfolio as a whole diversified at the sector and industry levels as we pursue growth.
What is your outlook for Health Care as a whole?
Chip: We remain very optimistic about a number of areas in Health Care, and especially about some core holdings from that sector in the portfolio.
In addition to the areas Carl mentioned, we're seeing a great deal of innovation in the medical device area that has not yet caught investors' attention but in our view ultimately will, including medicated sinus stenting, catheter-based peripheral artery disease systems, and cardiac ablation to treat AFIB.
On the drug discovery front, we're seeing the expanded coverage from the Affordable Care Act for drugs that treat addiction and other mental illnesses. Demographic trends here in the U.S.—with our aging Boomer population—along with the still vibrant M&A trend in biopharma, are all helping to create what we see as at least a long runway for the sector.
Of course, the valuations in biotech and pharmaceuticals are generally pretty rich, so we're relying on our stock-picking skills to uncover those companies that are best executing on their growth opportunities.
We're trying to be very cautious in these industries in light of how fast and far share prices have risen in the current cycle.
What were some your core holdings at the end of the quarter?
Carl: A few of our core positions in Health Care include Cambrex Corporation (CBX, Financial), a life sciences company that provides active pharmaceutical ingredients ("APIs") for the pharmaceuticals industry.
This makes it an indirect beneficiary of the success of the drug discovery business. Anacor Pharmaceuticals (ANAC, Financial) continues to benefit from the recent launch of its first commercial product, Kerydin, a topical antifungal medication, and positive top-line results from two pivotal Phase 3 studies of Crisaborole, a topical treatment for atopic dermatitis.
Zealand Pharma is a Danish company that's partnered with Sanofi to produce a new diabetes drug that could be on the market in the U.S. as early as next summer.
Outside of Health Care, there's Columbia Sportswear, which was a terrific multi-year transformation story in which the company invested in new warming and cooling fabrics and made some strategic acquisitions that helped to both diversify and solidify its brand.
Two other core companies are Acuity Brands, which makes specialty LED lighting and control systems, and IPG Photonics, a high-powered laser specialist.
Where have you been finding the most attractive opportunities in the currently more volatile market?
Chip: Along with the Health Care areas we already discussed, we've also been pretty active in the Consumer Discretionary sector. In addition to Columbia Sportswear (COLM, Financial), we're very confident in the prospects for The Container Store Group (TCS, Financial).
We think the company should continue to benefit from its store expansion efforts in an economy with improved employment numbers, increasingly confident consumers, low energy prices, and higher levels of new household formation.
We're almost always finding attractive opportunities in technology, which is an enormous and very diverse area. Paylocity Holding Corporation (PCTY, Financial) is a key position in tech. We believe it has an excellent chance to keep growing its business providing cloud-based software for payroll and human resources.
What are some of the key characteristics you look for in companies?
Chip: Our task is to find growth at a reasonable price—GARP, as it's called. To us, this means finding companies with above-average growth rates that we believe can be sustained for three to five years at a minimum.
We like what we call "one decision stocks," those that have a great, often niche-type business, talented management, and a long runway for growth.
We also look for the kind of multi-year transformation story that Columbia Sportswear represents—companies with terrific growth potential that are in the process of improving operations and profit margins.
The smallest positions are generally more opportunistic companies that are in the earlier stages of their recovery. We want these businesses to have revenues backed by a business growing robust enough to create earnings, which should accelerate as the rebound continues.
We try to avoid three kinds of companies: "growth at any price" stocks, which is where our attention to valuations is critical; businesses stuck in seemingly permanent turnaround mode—sort of the growth investment equivalent of a value trap; and concept stocks, in which a company's share price relates more to what's trending in the market as opposed to its fundamentals.
What distinguishes the approach in Smaller-Companies Growth Fund from other Royce Funds and other small-cap growth funds?
Chip: Royce Smaller-Companies Growth Fund is the only growth portfolio in the Royce lineup—that's the most important in-house difference.
Compared to other small-cap growth funds, the particular type of GARP investing that we do also makes the Fund pretty distinct.
First, we want to invest in companies with long runways for growth that we can buy and hold for a long time and that we believe are capable of generating outsized returns for our shareholders.
Second, our goal is to "fish where the fish are," which means that we are interested in identifying and exploring those areas of the economy where there is an opportunity for above-average revenue and earnings growth.
We look for pockets of innovation, efficient process development, and above-average demand in places that are currently driving robust growth, such as drug discovery, "better mousetrap" businesses, cybersecurity, non-residential construction, etc. This also means that, with some exceptions, we typically avoid mature industries, price-regulated industries, or commodity-based products or businesses.
Finally, while growth is our primary objective, we also look carefully at valuations and balance sheets—two things that can help us avoid the kind of significant losses that can torpedo a portfolio.
All of these elements taken together make the Fund distinctive from our perspective.
Important Performance and Expense Information
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Important Disclosure Information
The thoughts and opinions expressed in this piece are solely those of Mr. Skinner and Mr. Brown 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.) The Fund invests 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 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.