Chuck Royce: Why the rally will last

The following is taken from a Q&A with Chuck Royce, president and co-chief investment officer of The Royce Funds, that appears on the firm’s website. To read more from Royce, click here.

Can the current rally last through the end of the year?

I think it can. What’s interesting to me is that we’re seeing one of those rare occasions when one of our predictions for the market as a whole worked out almost exactly the way we thought it would. For a while now, we have been noting the disjunct between the very negative and alarmist headlines and the more optimistic view our own analyses and contacts with managements were revealing. It seemed to us as early as last September that the economy was in better shape than the conventional wisdom was suggesting.

There were—and are—problems that need to be worked out, but we were hopeful that eventually the world’s bankers and politicians would formulate solutions, at least for the most immediately pressing issues, such as Greek default. The announcement of a bailout plan for Greece created a great sense of relief throughout the capital markets. Once it became clear that Europe would not go bust, investors felt better about the growing stability in the world economy. This positive development, along with the improving economy and the underperformance of the stock market over the last five years, leads me to think that the rally can last. The year’s remaining quarters may not be as robust as 2012’s first three months, but I remain cautiously optimistic and still think that this decade will be better for stocks than the previous one.

So you’re still a strong believer in equities?

Absolutely. I think we’re on our way to a positive and satisfactory year. I also believe that we’re on our way to seeing three- and five-year average annual total returns that will look better than what most investors have seen recently. To me, it all comes down to equities remaining the most effective choice for assets that carry risk. I agree strongly with the notion that a carefully constructed stock portfolio is the best way to build long-term returns that can outpace inflation and preserve purchasing power.

Returns for the major U.S. indexes—and many around the globe—were closely correlated in the first quarter. When do you expect this to change?
It’s certainly more pleasant to participate in a correlated rally than it was last year to be part of a widespread bear market. I expect correlation to remain fairly high through the intermediate term, though I don’t see that refuting the argument that we still need to shop the market for what we think are the highest quality small-cap companies trading at attractive valuations. So as much as correlation has been a fact of life for most of the current market cycle, we continue to invest with an eye toward non-correlated equity results, particularly when looking at companies outside the U.S. We build our portfolios anticipating that they will outperform and, more importantly, provide strong absolute returns over the long term. At some point, we expect correlation to abate and more differentiated returns to materialize.

Do you still see quality stocks, regardless of market cap, as potential market cycle leaders?

We do. Quality as we define it—companies with strong balance sheets, positive cash flow, and high returns on invested capital—has done well on an absolute basis both in the current rally and since the small-cap high in July 2007. However, during the rally off the October 3, 2011 small-cap low, quality small-cap stocks have lagged. This hasn’t been altogether surprising since most rallies, especially those in the aftermath of the financial crisis, have not favored quality. However, our thought is that quality will likely begin to lead when we start to see more differentiated returns. When those investors who have been avoiding stocks return to the market, we suspect that many will be looking for those attributes that we typically seek.

Should there be room in asset allocation plans for global or international small-caps?

We think that any diversified asset allocation plan should include some global or international stocks. The reality is that we are in an increasingly global economy. Equity portfolios that hold mostly or exclusively domestic companies are invested in stocks that derive a substantial amount of revenue from outside the U.S. More important from our perspective is the vast size and return potential of the universe. We see it as too important an area to ignore.