While solid on an absolute basis, quality stocks—as measured by returns on invested capital—have lagged their lower-quality peers. Chuck Royce explains why shifts in Fed policy should help to complete a reversal that’s already begun.
What did you make of the market’s reaction to the Fed’s announcement of tapering QE late in June?The correction wasn’t terribly surprising and was even somewhat expected—I think a lot of people were kind of rooting for a downdraft because share prices in general were running high.
The market was in a phase where almost any negative development seemed likely to cause a correction. There seemed to be a buzz in the air for a month or so prior to the June declines.
In fact, the bigger news than what the Fed said may have been the very sharp declines for so many emerging markets, many of which were off as much as 20% in June. Coupled with the data coming out of China and discouraging developments in Europe, there was more than enough bad news to justify a correction.
It’s also important to remember that bear phases are a normal, appropriate part of any market cycle. And we may not have seen the last of this one, which on a percentage basis through the end of June was really pretty mild for U.S. stocks.
Do you expect stocks to ultimately benefit from the end or tapering of QE?I do. When you listen to what Ben Bernanke actually said back in June, I think the news was entirely positive. Many of us have been waiting for the economy and the markets to return to more historically normal conditions for some time.
We’ve been especially eager to see interest rates rise, which would be as sure a sign as I can imagine that we’re operating at something like business as usual (and this period of QE and zero interest rates has been anything but that). Of course, rates are rising, as we’re seeing with the 10-year Treasury, which shot up nearly 100 basis points in June.
I think an environment in which the Fed is not as intimately involved in the economy would be a healthy one for stocks. So while many investors clearly saw the Fed’s plans to taper bond purchases as a cause for alarm, I think most of us here at Royce saw it as an affirmation that the economy is healing itself and within the next couple of years should be even stronger.
Along with more historically normal—that is higher—rates, I think that would be a very welcomed development for equities.
Do you think that interest rates need to rise or QE needs to end before quality stops lagging the market as a whole?I think the effects of those policies need to unwind, which I think is starting to happen. It’s been frustrating because what we define as quality stocks—those with strong balance sheets, free cash flow generation, and high returns on invested capital—have been lagging since at least 2010.
We’ve been arguing for a while now that one of the unintended consequences of multiple rounds of easing and zero interest rates has been that it made things too easy for lower-quality companies—they could re-finance debt at record low rates and thus not pay the usual price for being over-levered, which definitely reduced the attractiveness of the conservatively capitalized businesses that we look for.
Those lower-quality stocks have dramatically outperformed quality over the last two or three years. Quality small-caps have done fine on an absolute basis, but they’ve suffered on a relative scale.
However, we see the signs of a reversal beginning whereby we think the higher-quality companies that we favor should take on a leadership role. I think we saw definite signs in May and in the second half of 2012 that investors were thinking more about fundamentals.
Do small-caps look overvalued right now?As a group, I think you could make that argument. However, we see many small-caps, several of which possess the strong fundamentals that we covet, trading at highly attractive valuations, particularly in more cyclical sectors such as Industrials and Technology.
Quality, in our judgment, remains undervalued. We’ve seen some research on the Russell 2000 Index that showed 29% of the index’s constituents made no money through the end of May, even as many in this group boasted high year-to-date returns.
In addition, breaking the small-cap index down by returns on invested capital shows that many of the highest ROIC companies in the index had very modest returns through the end of May.
Why would a small-cap investor choose an actively managed fund in today’s environment?There’s no question that active managers have struggled through this period of high correlation and the proliferation of ETFs.
I still maintain that active management’s disadvantage has mostly been driven by the unintended consequences of quantitative easing and zero interest rates.
In market phases with very little differentiation, there were few opportunities for active managers to distinguish themselves. However, we think this is changing.
We are bullish on quality and think the next few years should benefit active managers with long-term horizons and an eye for quality.
Important Disclosure Information
Chuck Royce is President, Co-Chief Investment Officer, and a portfolio manager of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Royce's thoughts in this interview concerning the stock market are solely his 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 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. Russell 2000 Index 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.
What did you make of the market’s reaction to the Fed’s announcement of tapering QE late in June?The correction wasn’t terribly surprising and was even somewhat expected—I think a lot of people were kind of rooting for a downdraft because share prices in general were running high.
The market was in a phase where almost any negative development seemed likely to cause a correction. There seemed to be a buzz in the air for a month or so prior to the June declines.
In fact, the bigger news than what the Fed said may have been the very sharp declines for so many emerging markets, many of which were off as much as 20% in June. Coupled with the data coming out of China and discouraging developments in Europe, there was more than enough bad news to justify a correction.
It’s also important to remember that bear phases are a normal, appropriate part of any market cycle. And we may not have seen the last of this one, which on a percentage basis through the end of June was really pretty mild for U.S. stocks.
Do you expect stocks to ultimately benefit from the end or tapering of QE?I do. When you listen to what Ben Bernanke actually said back in June, I think the news was entirely positive. Many of us have been waiting for the economy and the markets to return to more historically normal conditions for some time.
We’ve been especially eager to see interest rates rise, which would be as sure a sign as I can imagine that we’re operating at something like business as usual (and this period of QE and zero interest rates has been anything but that). Of course, rates are rising, as we’re seeing with the 10-year Treasury, which shot up nearly 100 basis points in June.
I think an environment in which the Fed is not as intimately involved in the economy would be a healthy one for stocks. So while many investors clearly saw the Fed’s plans to taper bond purchases as a cause for alarm, I think most of us here at Royce saw it as an affirmation that the economy is healing itself and within the next couple of years should be even stronger.
Along with more historically normal—that is higher—rates, I think that would be a very welcomed development for equities.
Do you think that interest rates need to rise or QE needs to end before quality stops lagging the market as a whole?I think the effects of those policies need to unwind, which I think is starting to happen. It’s been frustrating because what we define as quality stocks—those with strong balance sheets, free cash flow generation, and high returns on invested capital—have been lagging since at least 2010.
We’ve been arguing for a while now that one of the unintended consequences of multiple rounds of easing and zero interest rates has been that it made things too easy for lower-quality companies—they could re-finance debt at record low rates and thus not pay the usual price for being over-levered, which definitely reduced the attractiveness of the conservatively capitalized businesses that we look for.
Those lower-quality stocks have dramatically outperformed quality over the last two or three years. Quality small-caps have done fine on an absolute basis, but they’ve suffered on a relative scale.
However, we see the signs of a reversal beginning whereby we think the higher-quality companies that we favor should take on a leadership role. I think we saw definite signs in May and in the second half of 2012 that investors were thinking more about fundamentals.
Do small-caps look overvalued right now?As a group, I think you could make that argument. However, we see many small-caps, several of which possess the strong fundamentals that we covet, trading at highly attractive valuations, particularly in more cyclical sectors such as Industrials and Technology.
Quality, in our judgment, remains undervalued. We’ve seen some research on the Russell 2000 Index that showed 29% of the index’s constituents made no money through the end of May, even as many in this group boasted high year-to-date returns.
In addition, breaking the small-cap index down by returns on invested capital shows that many of the highest ROIC companies in the index had very modest returns through the end of May.
Why would a small-cap investor choose an actively managed fund in today’s environment?There’s no question that active managers have struggled through this period of high correlation and the proliferation of ETFs.
I still maintain that active management’s disadvantage has mostly been driven by the unintended consequences of quantitative easing and zero interest rates.
In market phases with very little differentiation, there were few opportunities for active managers to distinguish themselves. However, we think this is changing.
We are bullish on quality and think the next few years should benefit active managers with long-term horizons and an eye for quality.
Important Disclosure Information
Chuck Royce is President, Co-Chief Investment Officer, and a portfolio manager of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Royce's thoughts in this interview concerning the stock market are solely his 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 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. Russell 2000 Index 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.
