Small-caps were undoubtedly back in play 2016, and leading the way was the Legg Mason Royce US Small Cap Opportunity Fund, which has landed a Best-in-Class award in the US Small-Cap Equity category.
Bill Hench, Portfolio Manager at Royce & Associates in New York – a US smaller companies specialist and subsidiary of Legg Mason – commented: “As is usually the case in a good year, most of the portfolio’s successes in 2016 resulted from opportunities we pursued in 2015 or earlier. This was a time when valuations looked attractively low, and the potential for earnings recovery was promising. And as is always the case, we were prepared to wait for catalysts, usually in the form of earnings improvement, to take effect. It helped that 2016 was a terrific year for small-cap stocks in the US, especially the kind of inexpensive small-cap stocks that we focus on.”
“Our investment process has been the same for as long as we’ve been running the Fund,” said Hench. “We look to buy companies that are cheap, based on book value and price to sales, and we try to see if over time that can be corrected to the point where they are starting to be looked upon as potential growth stocks, and therefore start trading at a higher multiple. If we’re successful in doing that, we can get good performance over the long term.”
While the Fund’s managers are fundamental, bottom-up investors who assess the market on a stock-by-stock basis, Hench admits to a long-term bias towards the technology and industrial sectors as areas of perennial interest. The small-cap specialist knows he can often find the kinds of bargains he likes to invest in among these broad and diverse sectors.
What’s more, stocks in cyclical sectors such as tech and industrial are perfectly poised to benefit from an uptick in American economic strength, about which, at least for now, Wall Street seems to be fairly confident. Consequently, in addition to inexpensive valuations and the potential for a turnaround, Hench and team are looking to identify catalysts for improvement with these companies, especially those that are likely to benefit from a stronger economy.
So are there any sectors that Hench deliberately avoids? Not as such: “We don’t avoid sectors as much as we simply don’t find the kind of bargains we like in particular areas of the small-cap market. We’re driven by our approach, which steers us to inexpensive small- and micro-cap stocks, and we are very much bottom-up investors. That said, the fund is usually underweight in consumer staples, energy, financials, healthcare, real estate, telecommunication services and utilities, but we do remain diversified throughout sectors.”
Mindful Research and Risk Management
The team at Royce believe its dedication to research provides an edge when it comes to uncovering hidden gems. As Hench told us, “We’re very careful readers of research and industry journals. We want to be on top of all of the news in our industries because we want to have a sense of where buying opportunities are coming from and when turnarounds look likely to begin. We think our relentless approach to information gathering definitely helps us.”
At any given time, approximately 60% of the Fund’s assets are invested in micro-cap stocks, which can be far riskier than their larger-cap counterparts. That is why Hench must ensure the Fund’s exposure to risk is managed effectively. There are three primary ways he goes about this. First, he keeps the Fund very diversified across sectors and industries; second, he begins to trim positions when they exceed or drop below targets (no more than 1–1.5% of total assets); and third, he buys stocks when they’re very inexpensive based on book value and sales. This helps to ensure that the share prices don’t have much further to drop, though that’s not always the case, of course, so the team also sell or reduce holdings when the price falls to dangerously low levels or when it becomes apparent that the anticipated turnaround is not materializing.
The management team also ensure that each of the Fund’s holdings falls within one of four distinctive themes: unrecognized asset values, turnarounds, undervalued growth and interrupted earnings. Hench’s disciplined value approach means that he is usually looking for stocks that trade at discounts of 50% or more to what he estimates their value to be, as a business that also has the potential to reverse their downward trend. It’s an approach that’s clearly worked for Hench during this small-cap rally, but how is the Fund positioned for the uncertainty on the horizon?
What Does 2017 Hold in Store for the Small-Cap Investor?
The new administration in Washington and the Republican-controlled Congress are expected to ease business regulations, which could have a significant impact on the smaller-company market. For his part, Hench thinks there may be increased momentum of business improvement, combined with a release of pent-up demand from the inhibited environment of the six months before the election.
“In addition,” he added, “employment is strong, and consumer balance sheets are in better shape. What’s more, expansionary fiscal policy should ultimately be implemented at a reasonable pace –assuming the conservative Congress restrains spending so as not to balloon the federal deficit. Along with a lower corporate tax rate, these changes would mean good things for small-cap companies.”
While there are still some unknowns about how the new administration’s policies will play out, certainly the performance of small-cap stocks in 2017 will depend on a growing economy and higher earnings. Hench is staying focused on areas that should ultimately benefit from economic tailwinds, including non-residential construction, industrial companies and technology companies—many of which were strong in 2016. Domestically focused companies may also stand to benefit from President Donald Trump’s “Buy American” theme, and the Fund is being positioned accordingly.
Hench believes the biggest headwind in 2017 will likely be higher interest rates, which as he put it, “is essentially a tax on consumers that reduces spending and creates higher interest costs for the government, which will increase the federal deficit.” A headwind may also result from uncertainty around federal spending: as Trump settles into the presidency and begins to enact legislation, it will be at least the second half of the year before specific spending plans start to be implemented. Lastly, there could be subdued international trade as the various participants hesitate until US policy is more clearly defined.
However, these headwinds should be more prevalent in the first part of the year, before giving way to a better environment in the second half, in Hench’s view. If anything, facing down the uncertain investment climate only reinforces his commitment to seeking out companies that are prudently managed, with consistent earnings, and inexpensive valuations. “In my opinion,” Hench said, “it is a good thing that investors are showing renewed appreciation for the fundamentals.” BM