Investing in Challenging Times

Small-Cap Stocks

Investing in Challenging Times

Acting prudently and thinking long term at moments when others are panicking can provide a significant advantage over the long run.


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.
Chuck Royce
What’s your take on the current crisis?

Chuck Royce (CR): 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 (CD): 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.

Every bear market has its own considerable anxieties that make investing through them particularly challenging for inexperienced investors.
Charlie Dreifus
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, 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, Apple, Amazon, Netflix, and Google —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.


Definitions:

A bear market is a condition in which securities prices fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment.

Black Monday on October 19, 1987 was the date when a sudden, severe and largely unexpected systemic shock impaired the functioning of the global financial market system, roiling its stability through a stock market crash, along with crashes in the futures and options markets.

EBIT is an abbreviation for earnings before interest, tax, depreciation, and amortization and is a measure of operating income.

The dot-com bubble (also known as the dot-com boom, the tech bubble, and the Internet bubble) was a stock market bubble caused by excessive speculation in Internet-related companies in the late 1990s, a period of massive growth in the use and adoption of the Internet.

The Enron implosion refers to the Enron scandal, publicized in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the de facto dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was cited as the biggest audit failure.

The Great Financial Crisis (GFC), also known as the financial crisis of 2007–08, the global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.

Market capitalization is the total dollar market value of all of a company's outstanding shares; it is calculated by multiplying a company's shares outstanding by the current market price of one share.

Mega cap refers to companies with very large market capitalizations.

Mergers and acquisitions (M&A) is a general term used to refer to the consolidation of companies. A merger is a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed.

Nifty Fifty refers to the 50 popular large-cap stocks that were widely regarded as solid buy and hold growth stocks in the early 1970s.

A pandemic is the worldwide spread of a new disease.

RV is an abbreviation for recreational vehicle

The September 11 attacks (also referred to as 9/11) were a series of four coordinated terrorist attacks by the Islamic terrorist group al-Qaeda against the United States on the morning of Tuesday, September 11, 2001.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Discussions of individual securities are not intended and should not be relied upon as the basis to buy, sell or hold any security. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

Active management does not ensure gains or protect against market declines.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.