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Royce Funds Commentary: Is It Time to Sell, Hold or Buy Small-Caps?

With last week's considerable market volatility, most of it on the downside, anxiety may be urging small-cap investors to take action. We would instead counsel a look beyond the headlines to see nuance and, perhaps, overlooked opportunities.

Although typically a quiet time of year for the market, July and August have already proven quite eventful. It started with the Fed announcing a 25 basis point cut, its first rate reduction since the Financial Crisis.

This was followed by series of developments, much (though not all) of them negative: U.S. manufacturing slowed to its weakest pace in nearly three years in July, as the fallout from the trade tensions with China continued to erode confidence and investment. The ISM (Institute for Supply Management) pegged the PMI (the Purchasing Managers' Index) at 51.2 in July, compared to 51.7 for June. (Any number above 42.9, however, generally indicates a growing economy.)

Then a very solid jobs growth report was released, showing that the U.S. labor market continues to tighten. On the heels of this news, however, the Treasury Department declared that China was a currency manipulator and a new round of tariffs was announced, this time affecting a wide range of consumer goods.

In light of all this uncertainty--and its potential effects on stock prices--investors might be wondering if it's time to abandon small-caps, particularly more economically sensitive companies, for ostensibly safer options.

Perhaps needless to say, we disagree. Our own course of action has been to pay attention to what companies are doing and reporting--and to tune out the noise of negative headlines. This has led us to add to several existing positions, hold fast to others, and to locate new opportunities. We would encourage investors to think along similar lines.

Much of our recent activity has been driven by earnings season, which is still in full swing. Here, the news has been the typical mix of good and bad. On balance, it's certainly better than a look at recent headlines would suggest, if only because it's been a lot more varied.

For example, we have definitely seen some disappointments and/or lower earnings guidance for certain companies in the industrial space, where exposure to global forces, especially China, is high. Yet even where this has been the case, the selling has been at times indiscriminate, and we are acting opportunistically where we see attractively low valuations for fundamentally sound companies that look capable of rebounding.

In many other areas, there have been positive surprises or companies meeting expectations. Equally important, most of these holdings have not revised their guidance downward or appreciably changed their outlook for the rest of the year. However cautiously, they remain constructive of their outlook.

We still believe that the mixed economic signals are indicative of a slower-growth U.S. economy, not a recession. And this view is almost entirely informed by what our research into companies and industries, as well as our conversations with management teams, tells us. As active, bottom-up investors, this is where we focus.

Having said that, we cannot rule out the negative scenario in which the current global manufacturing slowdown continues downward and becomes a global contraction. The escalated U.S.-China conflicts would seem to increase that probability. In this event, we would expect global equities, including small-caps, to experience more volatility and possibly some declines.

However, in this kind of stormy market weather, we train our sights on those companies that look best positioned while seeking to take advantage of temporarily depressed prices. As has often been our practice in market declines, we were actively buying in many of our portfolios last week.

We think it's also helpful to note that environments featuring increased uncertainty, turbulence, and market volatility often provide opportunities for companies with leading market positions and strong balance sheets to solidify or expand their market share. Volatile environments have also been historically favorable for active small-cap managers. As small- cap specialists looking beyond the current headlines, we believe this an environment better suited to selectively buy than to sell small-caps.

Stay tuned...

Important Disclosure Information

Mr. Gannon's thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.

The ISM Manufacturing Index (ISM) monitors employment, production, inventories, new orders and supplier deliveries.

The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. The purpose of the PMI is to provide information about current and future business conditions to company decision makers, analysts, and investors.

This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. (Please see "Primary Risks for Fund Investors" in the prospectus.)

This article first appeared on GuruFocus.