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Canadian Value
Canadian Value
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Royce Funds - Opportunity Out of Uncertainty - Finding Opportunities in a Rising Market

September 13, 2013 | About:
Given the market’s rise this year, is it hard finding investment ideas?

When we look at our universe through the lens of our three historical criteria—balance sheet strength, high returns on invested capital, and attractive valuations—it is definitely more difficult finding new ideas.

In fact, the market may be a bit ahead of the fundamentals since many of the stocks I know best are trading at, near, or beyond my price targets.

Low revenue growth is the biggest obstacle, and it remains in place despite company margins that are generally still solid and profitability that is still respectable. All of this says to me that the current economy is just OK, but not that great.

However, it’s possible that the market is signaling that better days are ahead.

What do you do in an environment of higher prices and fewer opportunities?

Despite rising prices, I don’t want to sell something that’s high quality but more expensive just to buy something that’s moderately inexpensive but has weaker fundamentals.

Markets rarely move in a straight line—either up or down—for extended periods, so some opportunities should present themselves, especially considering the amount of noise between now and the end of the year. October is looking to be a particularly macro-driven month.

The debt ceiling issue is going to come up again in October. We’re going to try and open up health exchanges and implement ObamaCare for January 1, and we don’t know how that is going to work out. We may be firing missiles into Syria. We still don’t know who’s going to be running the Fed next year. There’s going to be a lot of headline noise in the next 90 days.

However, opportunity can come out of uncertainty, and we pride ourselves in being ready to act when pricing is more attractive. There are investment candidates that we have identified and that will become interesting once near-term prices are more to our liking.

Over time you have had a great amount of success with retail stocks. Where are we now in terms of the cycle?

Many retail stocks looked very cheap coming out of the ’08 crisis, and until maybe the last six months or so really hadn’t gotten much of a valuation pop because of the perception that the retail consumer is ailing. The U.S. is a very large retail-driven economy. For significant success, we need a healthy consumer which begets a healthy economy. Over the last month, retail reports have been disappointing. Wal-Mart would be a prime example.

The three “A’s” of the mall, Abercrombie and Fitch, Aeropostale, and American Eagle—the latter of which we own—have also seen less business. They blame some of that on fashion trends, which I suppose is true, but it’s also an incredibly competitive area, and prices have been coming down.

The stocks that were on sale a while ago and saw some recovery have since come down quite a bit. It’s not clear to me yet whether they have come down enough, but we’ll see what happens at Christmas.

American Eagle, for example, had a difficult second quarter. And although the mall business is highly competitive, management shifted the blame for its recent poor results to the company’s products, which may be somewhat true, but it’s not the whole story.

They also said that they’re making changes to product, but these won’t hit stores until October. So not only was the second quarter disappointing, but July, August, and September are also likely to be difficult because the demand just isn’t there for the current products, and they’re lowering prices. So even if consumers reverse course and buy Eagle’s products, they’ll be buying at a lower margin.

It’s hard to know how compelling valuations for retailers are right now because we’re looking at either a turnaround by Christmas or a new and more challenging period for consumers. And we won’t know more until Thanksgiving. So I have not been increasing my weightings in that industry recently.

What are some companies in which you have high confidence?

I would name four stocks in which I hold large positions—two are Financials and two are Energy companies.

Reinsurance Group of America is a company that I’ve owned in different Royce portfolios for more than a decade. The company provides mostly life reinsurance in North America, though it has branches elsewhere across the globe.

It’s the sort of conservatively managed, well-run business that I think any prudent value investor would want to own. It endured some losses in its Australian division not too long ago, but is otherwise very profitable. The company also recently expanded its share buyback program. Its valuation still looks very reasonable to me, so I added shares during July and August.

I’ve also been buying shares in Genworth MI Canada, not to be confused with Genworth Financial. This is a Canadian residential mortgage insurance company, which is a segment that is not very well understood and is thus under-owned. I like its valuation, its business success, and its dividend. It’s also got solid earnings and little debt, so there’s a lot for a cautious investor like me to be excited about.

I’ve also owned Helmerich & Payne and Unit Corporation for more than a decade. Helmerich & Payne is, in my estimation, the finest land drilling company out there—I think it’s best in its class—and is an industry leader with innovative management and excellent fundamentals. Energy is a highly cyclical business, so we’ve typically added when there was softness in its share price, though my own stake has grown large enough that I’ve trimmed some shares over the last few months.

Unit Corporation operates three segments—exploration & production, contract drilling, and, more recently, midstream gathering & processing. The latter business is particularly interesting because most of the competitors are part of MLPs, which to me have very high valuations right now.

Unit Corporation also benefits from the fact that most of the analysts covering the company tend to be expert in only one of its business lines, which definitely contributed to its shares getting attractively cheap in the past. Its stock price has moved around a lot over the last few years, so we’ve bought on the dips and taken gains as it has risen, but on balance we hold a large position in this profitable, conservatively capitalized company.

Can you also discuss your experience with Nu Skin Enterprises?

It’s another company that we have known and been invested in for a long time. The stock went down hard in the spring of 2012 as the drumbeats of the short-selling community grew louder over public headlines about Herbalife being painted as a pyramid scheme.

As for Nu Skin, we were comfortable with it being a multi-level marketing business through which they sell premium-priced skin-care and nutritional products. Nu Skin relies on the recruitment of more distributors in its hierarchy to keep the business prospering.

Many American investors seemed to lose sight of the fact that only 10% of its business comes from the U.S. (it’s a very big business in Asia). So thinking about what was going on with Herbalife here in the States only applied a little bit, though getting painted with that brush maybe wasn’t good for Nu Skin’s share price.

In fact the company is growing as a whole, putting out earnings guidance that not only seemed reasonable but that went way beyond expectations, which killed the shorts.

So we saw big time short covering and a short squeeze, and the business is performing better than ever at the moment. And when all of that happens—a short squeeze and a really good, solid long-term business performing better than ever—the price goes up.

This was a situation where we had long and deep institutional knowledge that allowed us to view the company through a lens that differed from the one used by the media. This gave us a very contrary opinion to the headlines in the paper, which helped us to stay focused on what was important, and it paid off.

Management continues to innovate and launch new products—some of their potentially largest new product launches ever—and that’s also helping. Its stock is not as cheap as it used to be, but we still hold a large position in several portfolios.


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Canadian Value

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