"Let us say, for the sake of this analogy, that economic profits are like basketball points, and the pressure of the shot clock (or lack thereof) in basketball requires shooting dynamism, just as the pressure of real rate of interest requires economic dynamism. Absent a ticking shot clock, the game can slow to a virtual standstill as an inferior team—in that 1950 stall-a-thon, the Pistons were up against the supremely large and talented George Mikan of the Lakers—may appear nearly the equal of a superior opponent in the low-scoring game that results. Likewise, absent the ‘ticking' (accrual) of a proper real rate of interest, poor investments can survive and even appear to be the equal of alternatives that could generate superior returns. No shot clock, fewer shots; no interest accrual, less monetary velocity."
—Matthew Klecker, "Shot Clock Capitalism," Grant's Interest Rate Observer, March 2013
It may feel like only yesterday, but it has been four years since the equity market bottomed in March 2009. Much has changed since that time—government debt and the Fed's balance sheet have exploded, bond yields have declined, and quantitative easing has become the norm.
At the same time, and perhaps not surprisingly, "There are currently three million fewer private sector employees than there were at the [March 2009 market] low, while both nominal GDP and the Dow are at all-time highs" (according to Strategas Research Partners).
More recently, the Volatility Index (VIX) dropped in the middle of March to levels last seen in April 2007. During the first quarter of 2013, the small-cap Russell 2000 Index hit new highs and advanced 12.4%. From its most recent low on November 15, 2012 through March 31, 2013 the Russell 2000 gained 24.4%.
The last few years have been incredibly difficult for active managers, and there is no shortage of evidence that the number of outperforming active managers has reached long-term lows. As small-cap asset managers, we were struck by Matthew Klecker's comments in Grant's Interest Rate Observer (quoted above) because to us they exemplify the ongoing battle between active and passive investing today.
From our perspective as active managers with a defined process of finding companies with a history of consistent earnings growth, strong under-levered balance sheets, and attractive absolute valuations, we have long thought that the ongoing efforts to reflate the economy through numerous quantitative easing and a zero interest rate policy would have unintended consequences.
These policies are distorting asset pricing and valuations in the equity market in a number of ways. Many of the fundamental qualities we hold so dear, for example, are largely out of favor.
While the appetite for risks seems strong given recent moves in the market, we remain steadfast in our long-term approach.
Historically, prudently capitalized companies have been solid investments. A recent study on leverage by Furey Research Partners confirms that for the 10-year period ending March 31, 2013, the lowest levered companies in the Russell 2000 gained 48.0% while the highest levered companies gained only 1.9%.
By contrast, for most of the past year the market has been rewarding more highly levered businesses in today's zero interest rate environment that are benefiting from the ability to restructure their debt, lower funding costs, and extend maturities.
In fact, our research shows that in the Russell 2000's most recent 15.9% rally from the end of March 2012 through the end of 2013's first quarter, real estate investment trusts (REITS) and commercial banks, two highly-levered industries, led the way.
In essence, highly levered companies are being given the luxury of time, which in a normal environment they would not have. This has obviously presented challenges for active managers such as ourselves who are not fans of financial leverage but prefer to focus on the operational leverage a business might possess.
Furey Research Partners further points out that for the one-year period ended March 31, 2013, the lowest levered companies in the Russell 2000 gained 5.4% while the highest levered companies gained 15.8%.
So while the appetite for risk seems strong given recent moves in the market, we remain steadfast in our long-term approach.
We think that the current environment argues for a more active and disciplined approach, one driven by fundamentally sound companies selling at attractive valuations.
At the same time, equities seem to be entering a period of declining correlation, one which traditionally rewards individual stock selection over passive strategies.
Important Disclosure Information
Francis Gannon is a portfolio manager of Royce & Associates, LLC. Mr. Gannon's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.
The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors. The Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index.
© The Royce Funds
