Bill Hench: lots of attention for the large caps totally no problem

Bill Hench, portfolio manager, Royce & Associates

What is your outlook for US and European stock exchanges / equity markets in the coming years?

There are more than a handful of reasons for my optimism about the U.S. small-cap market. For a long time, our holdings did not participate in the upswing that the S&P 500 and/or a lot of the big names, especially in technology, enjoyed. But over the last 18 months or so, our companies have done what you would expect well-managed companies to do— they’ve kept costs down, managed their balance sheets very effectively, and positioned themselves to really participate in what’s still a solid U.S. economy.

Combined with the current low interest rate environment, along with the major pullback in energy prices, which we often forget is a good thing, these developments have given us a lot of opportunity in a number of industries. I think the stage is set for the U.S. small-cap market to really do well going for the rest of 2016 and into 2017.

We don’t really invest in Europe, so we don’t have an outlook for that market.

Is it correct to say that there is not much attention for frontier markets? Wrongly?

That’s another area in which we don’t invest.

Is liquidity not a problem for your small cap funds?

Not really, no. First, if you’re investing in small-caps, you need to know going in that you’ll face liquidity challenges. We’ve been small-cap specialists for many years, and one of the important lessons we’ve learned is that staying diversified across holdings, as well as across sectors and industries, is probably the best way to deal with any liquidity issues.

Do you not find the attention for large capital weighted indices such as Dow and S&P500 exaggerated ? These only cover a fraction of the entire US market.

Not at all—the fact that so many of our holdings fly under the radar actually helps us, so we don’t mind the attention that U.S. large-caps receive.

Do you also see value stocks underperform in the US?

Far from it. Over the long term, small-cap value has been one of the strongest areas of the U.S. equity market. And we think now is a great time for investors to think about U.S. small-cap value because we’re just coming out of a long period of outperformance for small-cap growth. Value has been ahead since the Russell 2000’s most recent peak last June, and we think we’re in the early stages of what could be a long run for domestic small-cap value stocks. The valuations in many areas still look really attractive to us.

What are the most relevant valuation indicators for equities according to you?

We look at two metrics—price-to-book (“P/B”) and price-to-sales (“P/S”) because we think they are the best way to determine if a stock is really cheap. We’re very deliberate and disciplined in managing the portfolio—stocks don’t get in without having attractively low P/B and P/S ratios. Once we’ve established that, we try to identify a catalyst for future earnings growth in the form of new management, a more favorable business cycle, product innovation, and/or margin improvement. That’s the essence of our approach.

What is your comment on the impact of dividend pay outs by US small caps ? Is this significant, or do not many businesses pay dividends?

Most of our holdings are either just starting to become profitable or are resuming profitability, so dividends aren’t something we focus on. However, Chuck Royce and Jay Kaplan run two portfolios at Royce that specialize in dividend-paying small-caps, and they’d be the first to tell you that there are plenty of terrific small-cap companies that pay dividends. It’s a great opportunity set—but not one that we invest in.

US small caps : is there a dominance of certain sectors?

Sure, but it’s always changing. Health Care REIT , for example, dominated through much of 2014-15, but has corrected significantly so far this year. So we’re not looking to make plays on what sectors and industries may become hot down the road. We’re looking company by company with a bottom-up approach. Now, this often leads us to certain industries that have been beaten up because they’re in a tough business cycle, but even then it’s a matter of doing the research and uncovering what we think are the most promising companies trading at big discounts to book value.

How immune are small caps to the global economy? Or is there a difference by sector?

U.S. small-caps as a group are definitely less exposed to the global economy than large-caps, but many are extending their global reach and really have been over the last 15-20 years. I don’t think it breaks down by sector as much as by the decisions each company has to make about what’s best for their business. Our own preference is for companies that do most or all of their business in the U.S., mostly because it’s a market we think we know and understand really well.

The US small cap market is very large and companies often report maximum once a year. Is this not difficult for you to monitor all?

The U.S. small-cap market is enormous, but that’s part of what makes it fun. We’re always finding new businesses and enjoy researching and learning more about them. Our group meets each morning and reviews every company in our portfolios, so we’re really diligent about staying on top of things. Many of our companies aren’t covered on Wall Street so we rely on industry news sources and our own contact with management.

You are specialists in US small caps. Is the US small cap market different from the markets in Europe and other continents?

I think U.S. small-cap is more mature and has more institutional acceptance than non-U.S. small-caps do. But considering our own domestic focus, there’s not much more I can contribute to that question. Our specialty is really on U.S. small-caps—we’re not global investors.

Is the liquidity of small caps not an obstacle when many investors sell your fund?

It hasn’t been for us, no. First, we always keep a small amount of cash in the portfolio to meet redemptions. Second, we’re always trimming our positions in our best performers in order to seed new ideas in the portfolio. By staying constantly active, we’re generally able to avoid any issues with liquidity.

Do you agree that US small caps remain under the radar of major investors?

Many of them do, though it’s more common among micro-cap stocks—those with market caps up to $500 million. Once you go above that ceiling, you begin to find more mature businesses, many of which have analyst coverage and trade more frequently and efficiently than micro-caps. Needless to say, we do a lot of work in the micro-cap zone.

Finally, do US small caps not suffer from the huge interest for ETFs, which invest in large and mega-caps?

I think there’s definitely been a lot of interest and attention on the ETF space, but there are ETFs for everything, including small-caps. So I don’t think U.S. small-caps have suffered, but I do think markets are cyclical and we’ve recently seen a good run for U.S. large-caps. ETFs may have exacerbated it, but that’s about it. We think there will always be an audience for the kind of opportunistic deep value approach we use. It may not always be the hot approach, but we’ve seen it work for a long time.