Royce Investment Partners Commentary: Reconciling a Robust Market and a Weak Economy

Were you expecting such a strong rally in 2Q20?

Chuck Royce (Trades, Portfolio) Based on my experiences investing through many different cycles, I was anticipating a positive recovery, particularly for small-caps. The strength of the recovery, however, was even greater than I was expecting—just as the depth of the decline was. The second quarter was a really good one for small-cap stocks—the third-best quarter in the history of the Russell 2000. Of course, since the first quarter was the worst in the more-than-40-year history of the index, an almost equally extreme recovery was not unusual.

Do you think the Fed’s actions have made a difference this year?

Francis Gannon Absolutely. I think the Fed’s decision to act quickly and effectively to keep the financial system liquid, and therefore help keep companies in business, played an important role in the strength and speed of the market’s recovery. I would also say that the Fed’s decisive, unprecedented, and, in my view, necessary interventions may not yet be fully appreciated—in particular, its decision to provide funds to Main Street. Even in this unique context, however, stocks behaved in a historically familiar fashion. Performance was consistent with previous rebounds from recessions and other bear market periods. Micro-caps beat small-caps in the second quarter, and small-caps beat large-caps, which was a mirror image of the first quarter’s results. So I agree with Chuck—the returns were higher than we were anticipating while the pattern of returns was in line with what we’ve seen historically.

Did other factors play out as you thought they would?

CR Yes, we saw a familiar return pattern extend to other factors in the second quarter, such as cyclicality and perceived riskiness. Cyclicals beat defensives, higher-leverage stocks outperformed lower-leverage issues, lower-quality stocks (which we measure by return on equity and return on invested capital) edged higher-quality names, and non-dividend payers outpaced dividend payers.

Were there any exceptions to this pattern?

FG We did see one, which I think was a consequence of the Fed putting all of that liquidity into the system. With more than enough capital available for investment, investors first flocked to higher-growth companies, leaving cyclical stocks to play catch-up, which they began to do from mid-May through the end of June. This was somewhat surprising in that we would usually expect cyclicals to make a strong move off the bottom. They did, however, do very well from mid-May through the end of June. From May 15th through the end of June, small-cap cyclicals nearly doubled the return for defensives, up 18.1% versus 9.5%. And of course a double-digit result over six weeks is a really impressive move.

What do you make of the current disconnect between a weakened economy with high unemployment and a robustly recovering stock market?

CR I understand why this disparity makes so many people anxious, especially when you add in other factors such as those parts of the country that are seeing growing numbers of coronavirus cases. We’re also in an election year when people are even more politically divided than usual. The acute uncertainty of the times has inspired extreme views about the prospects for a sustained economic recovery. So I can see why many people, including a number of talented and experienced investors, look at the big picture and conclude that the market is floating on thin air. My view is more sanguine. I think the economy will catch up to market, which means that small-caps could mark time for a couple of quarters. But my confidence in their long-term prospects is high.

Why do you think this view isn’t shared by more investors?

CR In my experience, investors often make two mistakes when analyzing what drives stock prices. The first is that stocks aren’t priced for what’s happening today. The market looks forward to what’s likely to happen one, two, or even three years down the road. And I think it’s highly likely that the economy recovers over the next couple of years and, equally important, that most companies’ profits will be higher, which should make their shares worth more.

What’s the second mistake?

CR I think at times many investors forget that stocks are financial assets and so their prices are affected by conditions in the financial markets. With interest rates at all-time lows, stock should sell at higher prices. Moreover, the Fed’s recent decision to provide so much liquidity to the financial markets should be very supportive of stock prices. There’s a reason why “Don’t Fight the Fed” is such a reliable adage.

So you’re not concerned about current valuations?

CR We devote the overwhelming majority of our work to develop well-founded, substantive views of individual companies. So while we look at the overall small-cap market and are always aware of the broader valuation picture, at the end of the day we buy small-cap stocks—we don’t buy the small-cap market. And even with that caveat, I’m not worried about valuations. Of course there are small-caps that look overvalued and unattractive, but we see numerous companies where their current prices don’t reflect what we see as quality attributes and strong prospects.

FG Investors should also be aware that the Russell 2000 finished June 14.9% below its August 2018 peak while the Nasdaq hit new highs. We think this divergence shows that, while other parts of the market look overheated, small-cap does not, particularly when we look at individual companies. In another signal to us that small-cap prospects remain strong, the Russell 2000’s average annual five-year return through the end of June was just 4.3%. When five-year average annualized returns for small-cap have been this low historically, subsequent five-year performance has been very attractive, though past performance is obviously no guarantee of future results.

Do you see any positives that bolster your confidence in a recovery?

CR Stocks often respond positively, and rightfully in my view, to economic news that’s not as bad as expected. So positive news is obviously always welcome, but the market often needs only for the data to be improving, even if it may not look great on an absolute level. And certain metrics are improving. The still-strong housing market is a good example. The June ISM (Institute for Supply Management) number, which rose by 9.5 points from 43.1 to 52.6, was even more encouraging. Any number more than 50 indicates growth in manufacturing orders and production. So there are definitely green shoots taking root.

Do you expect small-cap stocks to keep outperforming large-caps?

FG We’re very confident that over the long run small-caps will sustain their relative performance edge. Their long-term advantage over large-caps has eroded a bit over the last several years, but we expect it to mean revert for two reasons: First, small-cap have historically outpaced large-caps coming out of bear markets, especially during economic rebounds. Second, we also expect cyclical stocks to outpace defensives in a re-energized global economy, as they’ve done historically—and small-caps are typically more cyclically sensitive than large-caps.

What are you focusing on currently when you’re investing?

FG Across all of our strategies, we’re still most heavily weighted in cyclical areas, most notably in Industrials and Information Technology. In the former sector, we have a lot of machinery companies as well as many involved in housing and construction. In tech, our largest weightings are primarily in the semiconductor & semiconductor equipment industry and in the electronic equipment, instruments & components area. We also have larger exposure to Materials in many strategies and have been looking at select opportunities in Health Care, mostly in companies that provide services, equipment, and/or devices.

CR In the portfolios that I manage, we’re looking closely at how management teams are adjusting to adversity. We want to see that they can execute effectively through such an uncertain time because our experience shows that the ability to cope well with difficulties and enjoy success when more stable conditions return are closely correlated. More specifically, we‘ve been active in areas such as e-commerce, the Internet of Things, and work-from-home technology. We also like select companies that manufacture RV and boating components, which are benefiting from changes in travel and vacation habits where physical distance is needed. Additionally, we think that companies involved in M&A and corporate restructurings are very well positioned for an acceleration of growth through the rest of this year and into the next.

Can you discuss a high-confidence holding in your Premier Quality Strategy?

CR I think Manhattan Associates is a very interesting company that designs and installs supply chain software solutions. On the back end, their products help to improve warehouse management systems, and on the front end they manage customer-facing omnichannel activities. This diversity gives them a broad niche. Although Manhattan serves multiple industries, their activities in retail offer maybe the best example of why we think its business looks so well positioned. For the 10-years ending in 2019, ecommerce grew from approximately 6% to 16% as a percentage of U.S. retail sales. Year-to-date in 2020, it’s accelerated from 16% to almost 27%. This increase was partly geared by the pandemic, so the rate may not be sustainable, but the growth trend appears real. The solutions that Manhattan offers for ecommerce—order management, digital self-service, in store and curbside pickup—are all seeing robust demand that we think is likely to continue. We see it as a business with all the quality attributes that we like that also appears to have the products and services at just the right time.

Manhattan Associates (MANH, Financial) 6/30/19-6/30/20

Past performance is no guarantee of future results.

Can you tell us about another holding that looks well-positioned to thrive in the currently uncertain environment?

CR I like the long-term prospects for Lazard. It’s the world’s biggest independent investment bank, providing investment banking, asset management, and other financial services mostly for institutional clients. The firm has a long and successful history as a specialist in mergers and acquisitions, restructuring, and corporate strategy while its asset management business encompasses both traditional and alternative products in global, developed, and emerging market portfolios. While the near-term outlook for the company is admittedly murky, our thought is that the opportunities for both M&A and restructurings are going to be significant as the economic picture becomes clearer. Moreover, a recovery in the global economy would benefit its asset management arm, which is weighted more toward international developed and/or developing economies. Finally, the firm has ample cash on its balance sheet, and through most of 2020 its shares have looked attractively priced to us, even more so relative to its peers.

Lazard (LAZ, Financial) 6/30/19-6/30/20

Past performance is no guarantee of future results.

Mr. Royce’s and Mr. Gannon’s thoughts and opinions concerning the stock market are solely their 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.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.