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Investors ‘have to start looking out’ to find bear market opportunities: Strategist

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Royce Investment Partners Co-Chief Investment Officer Francis Gannon joins Yahoo Finance Live to discuss rate hikes, stock futures, bear market opportunities, inflation, the state of the economy, recessionary risks, and the outlook for the Fed.

Video Transcript

BRAD SMITH: Now let's bring in our next guest, joining us now for more on the market conversation. We've got Royce Investment Partners co-chief investment officer, Francis Gannon. And Francis, I want to get your perspective on everything that we've heard from the Fed this week, including more commentary that's moving markets today.

FRANCIS GANNON: Yeah, it's been a-- as you said, it's been a very interesting week. And in our world in small caps, the past seven days-- seven trading days, the Russell 2000 is off about 14%. So a lot of damage has been inflicted on the market.

BRIAN SOZZI: Francis, where do you hide? Where can you go? Is there any place to hide?

FRANCIS GANNON: Well, I mean, in a week where the S&P 500 entered a bear market officially, small caps entered that bear market in January of this year. And we are down about 32% from our peak last November. The average stock in the Russell 2000 through last night is off about 48%. So I think at this particular point in time, you have to start looking out about three years to the opportunity set that's being created in the market today.

Look, bear markets are not fun. But the good thing about bear markets is they don't last. And our job is to take advantage of those particular dislocations. So I think one of the best places to hide in an environment like this is actually small caps. If you go back and look at the data since 1930, small cap-- the small cap asset class is the only asset class that has actually outperformed inflation in every decade. And I think that's something to-- in an environment where people are so uncertain about so many things, I think we have to kind of use history as our guide.

BRIAN SOZZI: Well, look, three years is a long time. When you try to-- if you're an average investor out there, you're down 40% or 50% on your holdings today. What do you do? If you own a portfolio of well-capitalized companies with good balance sheets, do you buy more of those stocks, or do you sell those names and just raise cash?

FRANCIS GANNON: So, in my opinion, in this particular moment in time, with so much damage being inflicted in the market already, if you can find high quality companies within the small cap asset class, this is the time to actually high grade your portfolio to add to those particular names. You've been living in a market for a period of time that is so focused on kind of those top end in terms of market cap. And that's unwinding. And we're seeing that.

And then for all intents and purposes, those stocks, I think, could actually be the ATM of the market for a period of time, where other markets can benefit. And small caps are clearly going to be one of those areas. What I think people are missing in some of the themes that are happening, be it reshoring or the end of what we've seen, the expansion outside the United States, as companies come back to the United States, there are many small cap companies in the United States are going to be benefiting from increased manufacturing activity here in the United States.

So almost think of the new-- the kind of the middle of the country as being that new, kind of emerging market. And those are areas I think people should be focusing on, industrial areas that are really going to be benefiting from a lot of the reshoring that's taking place.

BRAD SMITH: Francis, what's to say is that small caps wouldn't be even more adversely impacted by any signs of or-- and, indeed, oncoming recession, considering their balance sheets are not typically as strong as some of the larger cap players, or at least, on a revenue basis and some of the margin bases there as well is up for discussion, too?

FRANCIS GANNON: Well, I think that's one of the great myths about small caps. And I think people miss that. Yes, 43% of the index doesn't have any earnings at the end of the first quarter of this year. So a big swath of companies don't even make any money. But I think when you actually spend time, as we do as active managers in the small cap space, what you find there, there are great businesses that have very solid balance sheets. And you can actually sleep at night owning these fantastic business with solid business sheets-- balance sheets.

And I'd say, we're big fans of operating leverage, not financial leverage, in the companies that we own. So you can find great balance sheet companies in this particular environment. And kind of, to put the correction that we've seen this bear market into, kind of, to frame it a little bit, which I think is important, we're down 32% from our highs of last November. The Russell 2000-- in the history of the Russell 2000, there have been 12 corrections of greater than 20%. And this is one of those, obviously.

But as we were going into the COVID correction, around the economy completely shutting down during COVID, the correction in the Russell 2000 was 41.8%. Today, we're in an economy that is slowing clearly. But we're not necessarily in a recession as of yet. And we're down about 32%. So I think it's a different time. Every bear market is different. But I think you have to look out to find the opportunities right now.

BRIAN SOZZI: How do you find or unearth some of these small cap opportunities, Francis? What type of screens have you been running of late?

FRANCIS GANNON: Well, we tend to focus, as we have for a long time in terms of our business, on these better businesses within the small cap space. We call them serial compounders, if you will. And so we look for companies that have very high return on invested capital. We look for companies that have-- that generate actually-- not only have earnings, but generate a lot of free cash flow and have the ability to return that free cash flow to shareholders.

And so in looking at businesses, like we have, for a long period of time, we unearth these wonderful businesses and can hold on to them for three to five years. And that's kind of our goal as an active manager in this environment. We've lived in an environment where 0 interest rate policies, those long duration assets have benefited, clearly benefited from-- valuation wise, at least, from what has happened.

And now I think as that pivots away from those long duration assets, you're going to see within the small cap space, I think, real businesses. And it's kind of strange that you have to say this, but real businesses with real cash flow, with real earnings. That is where the market is really going to gravitate.

BRAD SMITH: OK, so which sector within small caps particularly are you focusing on there?

FRANCIS GANNON: Yeah, sure. Mentioned a couple here. One is industrials. I think industrials is a wonderful place to find opportunities over the next several years today. I would focus on information technology. And when I talk about information technology, I don't mean the sexy part of information technology. Focus on kind of the very simple parts of tech that, in our world, are really important from a B2B standpoint. It means many of these products are built into other products that the world needs. And in that respect, you see constant cash flow and revenue and demand, which I think is really interesting.

Other area of the market that we find interesting in this moment of time would be financials. Some of the financial markets, obviously, have gotten hit quite hard. But financials is such a big area. It doesn't necessarily have to be the banks. It can be insurance companies. And there's an interesting insurance cycle taking place today.

So I think there is opportunity if you have the ability to do your work in the area right now for the next several years. And when we look at it from a valuation perspective, EV to EBIT, which is kind of our favorite way of looking at it, we're selling at a significant discount to what the Russell 2000-- the market is selling at a significant discount to what it's been now over the past several years.

BRIAN SOZZI: Royce Investment Partners co-chief investment officer, Francis Gannon, good to see you. Have a good weekend.