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Royce Investment Partners Commentary: Investing in Challenging Times

In these especially challenging times, we are very grateful to have such a highly experienced investment staff. Royce's portfolio managers average more than 30 years of industry experience. Our two longest-tenured managers--Chuck Royce (Trades, Portfolio) and Charlie Dreifus--together have more than a century of professional investment experience. We recently asked them how they were handling the current environment.


What's your take on the current crisis?

Chuck Royce (Trades, Portfolio) First, what's most important to us is the health and safety of our colleagues, investors, and clients. That's our primary concern during this very difficult and uncertain period. The human dimension of our current situation is very much on our minds. We also absolutely believe that our job is to remain active during volatile periods in an effort to make that volatility work to our long-term advantage--and that's what we've been doing.

This has so far been one of the fastest--and most unsettling--declines that we've seen, although its depth has been well within the range of previous downturns. So the current situation is something new and different but at the same time familiar. From an investment perspective, I see it as another instance of history not repeating, but rhyming.

In this environment, we are actively investing across all of our strategies. We can't wait for a bottom, which would be impossible to call, anyway. We're operating on two presumptions: first, that the bear market is going to last months or quarters as opposed to years, and second that we can be consistent with our long and successful track record in identifying what we see as excellent small-cap companies. As always, we're looking for those attributes, such as strong balance sheets, industry leadership, and innovation, that have historically helped companies both to weather difficult markets and to recover with strength when stocks rebound. We've always thought of active management as synonymous with risk management--and that's particularly critical in the current stormy climate.

Charlie Dreifus I want to echo Chuck's words about what's most important right now--safety, health, getting people well, and getting people tested. And I agree about the challenge of dealing with so much uncertainty in the market. Here at Royce, however, we're operating on the idea that, as serious as this pandemic is, it's also ultimately a finite event. At some point, the markets and economy will recover.

In other words, I have seen movies with similar plots before. While others cover their eyes--because this is certainly a horror movie--I'm not averting my gaze from the market's frightening scenes. I'm staying active. I've always thought that the most opportune time to invest is when others are in the grip of fear or are otherwise buying and selling very irrationally, and certainly for any patient, long-term investor, there's been little that's rational about much recent investor behavior.

We're living through an extreme example of the old line that Wall Street is the only place where people rush out of the store when the merchandise goes on sale. But I'm sticking around and buying what I think is undervalued quality while prices are falling.

What makes the current period different from other extreme bear market events you've seen?

CR There are an even larger number of unknowns than during other bear markets--many of which extend well past the stock market or economy. Even beyond the public health consequences, we simply don't know what the secondary or tertiary effects will be in terms of economic growth. Unlike most historical declines, this was initially and primarily driven by a public health crisis, an external event not directly tied to the economy or financial markets, other than the decline in oil prices, of course. But as serious as the oil price war is, it's exacerbating a downturn that was already showing considerable negative momentum prior to the Saudis' decision to significantly increase production and cut prices. So the closest comparison I can make is to the downturn that came in the aftermath of 9/11. Valuations were not nearly as elevated at the time of the attacks as they were in early 2020, however, because the markets had peaked 18 months earlier, in March of 2000.

CD I've invested through some extraordinary markets, including the Nifty Fifty in 1973-74, Black Monday in 1987, the dot.com bubble, the Enron implosion, and the Great Financial Crisis in 2008. In each of those bear markets, we saw the collapse, or near collapse, of major corporate players. We haven't seen that yet, perhaps because rates are so low, but that's something worth watching in the days ahead. There are a lot of highly levered companies today, particularly in small-cap. I have to think that, even with central banks lowering rates, many of these businesses will struggle to survive. I think it's also worth keeping in mind that the excesses of previous extreme markets are always easier to see in hindsight. Every bear market has its own considerable anxieties that make investing through them particularly challenging for inexperienced investors.

Is there anything you see that's being overlooked by other investors?

CR I think people always look back at the most recent crisis--which in this case was the Financial Crisis--to try to make sense of the current situation. Yet this is clearly not a financial crisis, even as its effects are rippling through to that and other areas. In 2008, we had an unfamiliar catalyst and extraordinary anxiety about the depth of the crisis.

Today, the unknown is the number of cases, especially here in the U.S., and the lack of a vaccine. So as testing improves, I suspect the market will begin to stabilize. But the sheer size of these unknowns is a factor that will continue to roil the markets. Few things trouble companies and markets more than uncertainty. However, as we inch closer to certainty, we'll see more stability. Needless to say, most investors are overlooking the fact that prior to the outbreak, the global economy was in good shape.

CD I think it's remarkable that so many investors were paying so little attention to so many important fundamentals. In mid- February, I took a deep dive into Apple (NASDAQ:AAPL), which on that date sported a market cap of $1.42 trillion. Over the past five years prior to the sell-off, its shares rose 237% cumulatively. Yet sales advanced only 11.3%, operating income (EBIT) was down 10.2%, net income had risen by only 3.5%, and shares outstanding had fallen by 19.8%.

So the valuations we're coming down from were unsustainably high. In my view, investors were also paying exorbitant prices for growth when they didn't necessarily need to. So while the extremes of this downturn are alarming, re-sets from the kind of excessively lofty valuations--most notably among the mega-cap names such as the FAANG group of Facebook (NASDAQ:FB), Apple, Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Google (NASDAQ:GOOG)(NASDAQ:GOOGL) --are healthy in the long run. Painful, but healthy.

Equally important to me is that a combination of fiscal and monetary stimulus could make the subsequent earnings recovery quite robust. If fiscal stimulus takes the form of tax incentives for new home or car buyers and/or an infrastructure bill, then we should see a powerful economic and earnings rebound. That's the light at the end of this tunnel, as it were, for me.

What are you doing in your portfolios?

CR We're doing what we always do, though obviously at a heightened level, given the state of small-cap valuations. In our premier strategy, for example, we're buying companies in which we've identified high quality--sustainable moats, financial strength, and the demonstrated capability to survive in a difficult environment. We're also squarely focused on the long-term potential we see.

In addition, I'm closely examining investor behavior, focusing on how people are reacting to these high-stress moments. There are two groups of companies that interest me right now--those that have so far lost more than the indexes and those that have lost less. For example, in one portfolio we've bought shares of companies in certain industrial and other areas whose shares have held up relatively well, largely because of high-quality attributes that we'd previously identified, while in another I added a few bank stocks that were beaten up beyond what seemed reasonable to me based on their financial and managerial attributes.

There are also companies that have lost roughly what the indexes have, but that look likely to me to recover nicely, in large part because we saw favorable long-term prospects at the end of 2019. That would include one that manufactures RV components--based on the idea that consumers will continue to favor experiences over goods. I've also bought more of a few specialists in professional staffing and skilled labor, which is an area that I anticipate will return to being in high demand as the global economy reignites. I think there are also businesses that can benefit from the downturn and short-term economic disruptions--the likelihood of more bankruptcies in the short run has led me to add shares in boutique M&A firms.

CD I'm staying mindful of my perennial investment criteria, including strong balance sheets, transparent accounting, and free cash flow generation. I've been buying cyclicals where there's been an evolution of capacity coming out and inventories coming down on the premise that demand will bounce back when the global economy begins to recover. Most of my activity has centered on adding to existing positions or buying names that I've owned before and that I know very well. Like Chuck, I've looked at companies that lost more than the averages. Even in quieter times I often conduct a similar exercise, making lists of companies that lose more than the market does.

Ultimately, I think success in the current environment comes down to being opportunistic, to trying to take advantage of all of the tumult. That's where any active manager adds value. Experience--and Chuck and I have a lot of it--has taught us that acting prudently and thinking long term at moments when others are panicking can provide our investors with a significant advantage over the long run.

Mr. Royce's and Mr. Dreifus'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. No assurance can be given that the past performance trends as outlined above will continue in the future.

As of 12/31/19, shares of Apple were not held by any of The Royce Funds.
This article first appeared on GuruFocus.