Steve Lipper: I'm Steve Lipper, the Senior Investment Strategist at Royce Investment Partners. Thanks for joining us today with our podcast, Three Questions With. Today we're joined by Jay Kaplan, Portfolio Manager and Principal at Royce.
Jay manages the firm's Small-Cap Value mutual fund, and related accounts. And Jay pursues what we call a contrarian value approach, and you'll hear more about Jay's approach in just a moment. Jay has been at Royce for 19 years and has 32 years of professional experience. Jay holds a bachelor's degree from Binghamton University and a MBA from NYU. He is also a CFA charter holder. Jay, thanks for joining us today.
Jay Kaplan: Well, thanks Steve. Terrific to be here.
SL: So Jay, this is a challenging market for many investors, and certainly for those of a contrarian bent. How have you been meeting the challenge of investing in a robust market with a still struggling economy?
JK: Well, it's definitely been challenging, Steve. There's a disconnect between the market and the mainstream economy. The market is telling you that 2021 is going to be okay. And it'll look at least like 2019. And I think the answer to that is—maybe. Or maybe not. It depends upon therapies and vaccines and how effective they are, and when they come, and who can get them, and how many people can get them.
It might be a little premature to make that bet, but the market's making that bet anyway. And the market was pretty expensive in 2019, going into 2020. So it's now pretty expensive, even if you look at 2021. So I think what folks need to do, and be cognizant of is, maybe, say "well, if I'm looking at companies that I don't think have been permanently impaired by COVID, let me think about how they did in 2019." And maybe extrapolate that out to 2021—to kind of look over 2020, and maybe be able to do some evaluation based on that.
But when you do that, things look a little expensive. So, we'll see what happens. We don't know if there's going to be another wave of the COVID virus. Nobody really knows, so I'm a little wary of valuations, but I am finding things to do, but my cash is creeping up a little bit. And we'll sort of see how this plays out.
SL: Thanks for that overall context. Now let's turn our attention, perhaps, to your portfolio. And I know you've been very intentional about shifting the exposures within the portfolio during the course of the year. So can you walk us through your rationale, and the restructuring that you've done in your portfolios?
JK: Sure. Well, it started by owning three good-sized positions in airline stocks when airlines got grounded, and the world stopped flying. So that wasn't a great place to be. And those companies are going to look different in terms of their capitalization and their time to recovery. So from my perspective, they're a little bit un-investable, they're a little too risky for me right now. So that brought a lot of cash into the portfolio.
I've trimmed consumers, some brick and mortar apparel retail, and that's been replaced with things like rent-to-own, some boating stocks. People are very excited about boating now, you get out on the water, you're not near any other people. Boats are hot. I've entered a home builder. People are fleeing cities. They're fleeing cities and they're buying houses out in the suburbs.
Some changes within financials—I don't own as much in banks as I used to. And that's a function, number one, of interest rates. Rates are really, really low now with the Fed cutting and free money.
And the yield curve is kind of flat, so that's not great for profits for the banks. And the other thing is, we don't really know what credit will look like as we go through this cycle. The banking system has allowed for plenty of deferrals of payments. So right now everything looks just fine, and we won't know for another three months at least, when the rubber meets the road, what credit looks like. So the prospects for banks are okay in the long term, but a little tricky in the near term.
So took banks down, replaced that with insurance companies. There were some fine insurance companies, where they got thrown out with the banks. So they were at valuations we haven't seen in a while, so that was pretty interesting. And I did a fair amount in industrials, back to airlines—they are actually classified as Industrials. So they got replaced with some engineering and construction companies. Those companies got very inexpensive. The idea there is, we're not going to have a gigantic recession come 2021. And in fact, there'll still be building of infrastructure and essential services and utilities. So those companies should do just fine, I think.
SL: Yeah that's a great overview. And helping us understand the kind of things that you're moving away from, the kind of things that you've tilted the portfolio towards. I'm wondering if we can go, maybe, one level deeper. And if you could give us two examples that exemplify your current thinking.
JK: Rent-A-Center (RCII, Financial) is a name I'm using. For those who aren't familiar, it's a retail concept for folks that are kind of credit challenged, and they need to furnish their homes with furniture, furnishing, and appliances like refrigerators. And they don't have credit, so they can't purchase, flat out, some of these items. So they go, and basically they lease them from a rent-to-own store. And those stores were deemed to be essential businesses here in the pandemic, and Rent-A-Center is one of those.
It was a very successful business. I've owned it more than once in my career. But they got into a lot of trouble a few years back. The management team really levered up the balance sheet, costs were out of control, it didn't look that terrific. They got a buyout offer at a very low price that blew up, and the old management team came back in, cut costs, franchised stores, fixed it up, use cashflow to de-lever the balance sheet, got it in really good shape.
They have started to grow a business where you do rent-to-own for third-party retailers, like in big furniture chains in their case, where a customer doesn't qualify for a MasterCard, Visa, or even the store's credit card, but they can still do rent-to-own furniture. So that business should have a really good runway for them.
Now, one of Rent-A-Center's big competitors is Aaron Rents. They have a much bigger business in this third-party business. In fact, they're going to separate it out as a separate company by the end of the year. And the stock went up a lot when they announced that, and that should probably highlight some of the value that's also buried in Rent-A-Center. So as things get tougher, if banks start to clamp down on credit a little bit, that ought to be really good for the rent-to-own business.
Another example is a company called Evercore (EVR, Financial). It's one of the independent investment banks. Their biggest business is merger & acquisition advisory. They also have a good restructuring practice, a capital markets, capital raising practice, and an equity business. Merger & acquisition activity came to a grinding halt when the pandemic came, so that really impacted their numbers, but that's temporary. And as we get through this, that business should recover. In fact, there's some data out now that shows that in August, the merger & acquisition market started to come back. So a high-quality company like Evercore, with a temporary hiccup, I think provides a great opportunity.
SL: That's great, Jay, thanks for walking us through those two examples. We like to conclude these podcasts by pivoting to some non-investment questions. What is an example, Jay, of a non-investment book that you've read recently, that you enjoyed?
JK: I recently read a John Grisham book called The Guardians. If you read any Grisham books, they are usually about lawyers. This is no exception. And without any spoilers, it's about a guy who helps to exonerate wrongly convicted prisoners. That's got nothing to do with, really, money, or investing or business. So it's a really good escape, and I really liked it. I recommend it.
SL: That's great. So now let's take you back to college. And what would be an example of a non-financial college course that you really enjoyed?
JK: Well, we're going to bring out my inner geek. When I showed up at college in my freshman year, on a whim I took introduction to computer programming. And Steve will know this, because we are of similar vintage, but back then you used key punch cards. So I used to run around campus with this giant cardboard box filled with cards. You can Google that folks, and you'll see a photo of the cards. But I loved it.
As an upperclassman, I became a TA, and actually my first job out of school was as an IT consultant. But I'm not sure that's really one of the best things I learned in college. I was a bartender. You learn a lot about people when you're a bartender, but even more importantly, as I look and think back on that at my university, the food service was run by an independent not-for-profit company. That doesn't happen anymore. Now it's all outsourced. But back then it was a company with a board of directors, including students and administrators. And I was on the board for a couple of years. And I learned a lot about how businesses run, and actually, that was probably the most valuable part of my college experience.
SL: Well, that's great. What a great story. So let's conclude with, what would be your favorite activity outside of time with family and business?
JK: Well, I love to travel, but that's usually with family. So I guess we'll exclude that from this. That's out of bounds. But I do like to channel my inner musician when I have time. So I get banished down to the basement of my house, and I play the drums, where hopefully, nobody hears a lot because they wouldn't like what they heard anyway. But that is one way that I can sort of escape everybody. And I love it.
SL: What a great hobby. That's terrific. Jay, thanks for spending time with us, and updating us on your thinking, and sharing with us the perspective on the non-investment questions.
JK: It's my pleasure, Steve.
SL: Great. And thank you to all of you for listening.
Listen to the recorded interview here.
Mr. Lipper's and Mr. Kaplan'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. The thoughts and opinions expressed in the recording are solely those of the persons speaking as of August 12, 2020 and may differ from those of other Royce investment professionals or the firm as a whole.
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.
