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Holly LaFon
Holly LaFon
Articles (8057) 

Searching for Super Small-Cap Companies Through the Macro Noise

June 21, 2013 | About:
While market pundits tell us to worry about everything from currency concerns and environmental challenges to the ongoing threat of nuclear assault and resource depletion, these ominous obstacles and the endless possibilities of their potential fallout have a tendency to draw attention away from what we believe really matters: the companies that have the ability to survive, adapt, and grow stronger in the wake of uncertainty.

Watching Man of Steel on its opening weekend, the latest movie based on the iconic Superman comic books, I was struck by the fact that one “tail risk” not regularly appearing on the seemingly endless list of macroeconomic concerns is the possibility, however slight, that a well-armed villain from another galaxy might unexpectedly show up and wreak havoc on our sometimes peaceful and unprepared planet. It may be the one global catastrophe that we have not been warned about by market pundits.

Without giving away the plot, let’s just say that some variation of this unlikely turn of events does indeed occur, and while the film made no reference to the impact this unfriendly visit had on financial markets (sadly for me), it’s no stretch to conclude that there would probably be more sellers than buyers during the initial period of panic and uncertainty.

Not wanting to miss the full effects of this thriller, I convinced my wife and daughters to see the movie in IMAX 3D, the closest thing to being there that also allows for snacks and bathroom breaks. In hindsight, this was probably not a great call on my part. To say that the whole experience overwhelmed the senses understates the continuous visual and audio assault that exhausted more than it entertained several moviegoers, my wife and youngest daughter included. In their case, they’d had enough about three-quarters of the way through before fleeing to the relative calm of the lobby to try and restore some semblance of order to their eyes, ears, and central nervous systems.

They were not alone. Other viewers had a similar experience, with several congregating outside the theater doors also attempting to regain their lost senses (and possibly to find a manager). I was able to make it through to the ending but felt disoriented by the whole experience. It took several hours for the effects to fully wear off.

Clearly the theater’s supersized viewing screen and deafening Dolby Surround Sound, combined with the movie’s exhilarating action and awesome 3-D imagery, had the desired effect of hijacking the senses. However, it also had the unintended consequence of numbing the viewer to the underlying plot. Tracking character development is somewhat challenging when entire city blocks are being obliterated in a zero sum battle for control of planet Earth.

Although no one will pay hard-earned dollars to watch the action on trading floors or Ben Bernanke’s press conferences, the corollaries to today’s investment climate are otherwise surprisingly close. Systemic risks abound and while clearly different and (perhaps) less fantastic than those depicted in the movie, they are no less unsettling when followed to their potential conclusion.

Like the best-drawn movie characters, companies can be resilient and dynamic entities that more often than not self-determine their long-term success or failure.

The most dramatic systemic risks imply the end of civilization due to natural resource exhaustion, civil strife over wealth disparity, wars over unpaid liabilities (people generally like to get paid back), and religious fanaticism. Of course, risks are one thing and outcomes can be entirely different—therein lies the true challenge for today’s would-be heroic investor.

The prognostications from market pundits through the various media outlets are overwhelming and constant. Much like the IMAX 3-D experience, the extreme noise can make the underlying plot tough to discern. And weighing the probabilities of any outcome is another challenge entirely.

One recent favorite of the pundits has been the inherently flawed eurozone currency structure and the inevitable implosion that will wreak economic chaos. Another doomsday scenario centers on Abenomics, Japanese Prime Minister Shinzo Abe’s attempt to target inflation through extreme monetary and fiscal policies. The conventional wisdom currently holds that these policies are too little, too late for that nation’s moribund economy and this will ultimately result in the default of the world’s third-largest economy.

A third recent view sees China struggling with demographic and environmental catastrophe while also facing an economic hard landing that will unleash massive social upheaval in the world’s most populous country. And there’s always the old favorite involving the respective pursuits of nuclear weapons by North Korea and Iran, as well as each nation’s stated goals of annihilating their adversaries (a list that often includes the U.S.).

Moving beyond national borders, there is the risk that resource depletion, climate change, and general environmental mismanagement will lead to famine, war, and global collapse—an apocalyptic scenario whose consequences resemble those of a visit from a hostile intergalactic imperialist.

Is it rational to conclude that any one, never mind several, of these situations is likely to actually happen? If so, what would the outcomes actually look like? One thing we know for sure is that there are powerful parties with deep vested interests working around the world every day to ensure that these disasters do not come to fruition (or at least that their effects would be largely mitigated).

Not surprisingly, the investment team at Royce is often asked to weigh in on macroeconomic issues and while we oblige, somewhat reluctantly, we always offer the same caveat—our expertise is evaluating and understanding companies, their value, quality, and future prospects, not predicting economic, political, or strategic outcomes, especially those that resemble the plot of a summer blockbuster. For us, the multitude of variables that go into that type of analysis would cause sensory and intellectual overload. Even more importantly, we might miss the underlying story.

This is important because we invest in companies, not headlines or economic statistics. Like the best-drawn movie characters, companies can be resilient and dynamic entities that more often than not self-determine their long-term success or failure. There is no question that macroeconomic factors provide relevant inputs. Yet from our perspective they are often far less important than investors believe.

So whether or not the investment community decides to sell everything because chaos and destruction appear imminent is less of a concern to us than which companies look likely to survive, adapt, and ultimately grow stronger in whatever the aftermath. That is our business, and we are sticking with it. All that loud noise is like Kryptonite to us.

Important Disclosure Information

Chris Clark is a portfolio manager and principal of Royce & Associates, LLC. Mr. Clark's thoughts in this essay concerning the stock and bond markets are solely his own and, of course, there can be no assurance with regard to future market movements.

Rating: 4.0/5 (5 votes)


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