Royce Value Plus Fund has enjoyed a solid year though the end of November. In this piece, Portfolio Manager Chip Skinner discusses some of the investment ideas that have boosted the Fund's year-to-date results. He also describes the subtle re-tooling of the portfolio's stock-selection process that began in 2011.
After the Fund underperformed its benchmark in the second half of 2010 and into 2011, I began to subtly re-tool the portfolio. These efforts were essentially focused on strengthening the existing stock-selection discipline rather than a wholesale change in process. Specifically, I sold a number of investments that were in the turnaround or special situations category where the thesis had not played out as modeled. I also shifted back to more of a GARP (growth at a reasonable price) focus, in which I target companies with greater current growth prospects while still remaining vigilant on valuation.
An important example was my interest in companies participating in domestic infrastructure spending, especially those focused on the electrical grid and energy pipeline development. The U.S. and Canada are making significant investments in the electric utility transmission grid to add capacity and upgrade antiquated transmission lines. The same is occurring in the pipeline industry, which has been driven more by the need to transport oil and gas from some of the new shale discovery basins and from Canada.
Hurricane Sandy made us all aware, especially those of us in the Northeast, that a lot more needs to be done, since most of our infrastructure is first generation, built in the middle of the last century. Examples of companies that could continue to benefit from infrastructure upgrades include Valmont Industries (VMI, Financial), a leading galvanized steel utility pole manufacturer and Quanta Services (PWR, Financial), a leading contractor of electrical utility and energy pipeline projects.
My "underwear" theme, which sought to take advantage of falling cotton prices and included several apparel manufacturers, was another important theme. Companies benefiting from lower cotton prices that have performed well this year include Carter's (CRI, Financial), which designs and markets infant and children's apparel, and Gildan Activewear (GIL, Financial), which makes cotton tee shirts, underwear, and socks. Both companies have seen their margins expand significantly this year, as a result of top line growth and lower raw material costs.
The recovery in residential housing also attracted my attention as the initial rebound from a deep five-year downturn appears to have gained substantial traction. I was also attracted to several basic industrial companies that were newly benefiting from applied technologies—I've called this the "better mousetrap" theme. I also made the decision to hold on to longer-term winners when growth and/or quality factors warranted.
In addition, I also worked to increase exposure to the Healthcare sector in 2011 by returning to a couple of old favorites of Royce, including Myriad Genetics (MYGN, Financial)—a genetic testing lab, best known for its breast cancer tests—and Thoratec Corporation (THOR, Financial)—a medical device company that designs and markets ventricular assist devices, or heart pumps, as a way to bridge patients waiting for heart transplants and now also makes devices for patients suffering from chronic heart failure.
The portfolio also holds companies in the commercial building area that have performed well this year, but which could do even better when new projects move forward in 2013. That list includes Carlisle Companies (CSL, Financial), which manufactures commercial roofing products along with several other business lines, and Acuity Brands (AYI, Financial), a commercial lighting fixture maker that has exposure to LED lighting adoption. Each of these companies managed their way through the downturn via renovation and replacement demand, as well as by reducing costs. I think they're poised to do even better when the recovery more firmly takes hold.
I've reduced the Fund's weighting in semiconductors somewhat, as the global economy has really weighed on that group's valuation and recovery prospects, though I suspect that a stronger economy in the back half of 2013 would be good news for this group. I've also been adding names in the enterprise software group.
In July, I began adding shares of Bankrate (RATE, Financial), which aggregates and distributes personal finance content on the Internet and owns several financial services websites and lead-generation properties. The stock has underperformed this year, but I think it represents good value and could rebound in 2013.
I've also been rebuilding our position in long-time holding FARO Technologies (FARO), a conservatively capitalized company that makes robotic measurement arms and scanning equipment. As its business has slowed, its shares have become cheaper.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money.
As of September 30, 2012, Valmont Industries accounted for 1.6% of Royce Value Plus Fund's net assets, Quanta Services 1.0%, Carter's 1.6%, Gildan Activewear 1.4%, IPG Photonics 1.4%, Myriad Genetics 2.0%, Thoratec Corporation 1.0%, Eagle Materials 1.1%, Quanex Building Products 1.1%, Carlisle Companies 1.1%, Acuity Brands 1.2%, Apogee Enterprises 0.7%, Bankrate 0.8%, and FARO Technologies 0.8%.
Royce Value Plus Fund invests primarily in micro-cap, small-cap, and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). The Fund may invest up to 25% of its net assets in foreign securities, which may involve political, economic, currency and other risks not encountered in U.S. investments (Please see "Investing in Foreign Securities" in the prospectus). 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. The Russell 2000 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.
Are you pleased with the performance of Royce Value Plus Fund thus far in 2012?
I'm reasonably pleased with the Fund's year-to-date performance, especially as it represents a more-than-two-year effort to get the portfolio back on track. However, I won't be really satisfied until both absolute and relative results show more improvement over a longer time span. Year-to-date through November 30, the Fund was up 11.50% versus a gain of 12.35% for the small-cap benchmark.After the Fund underperformed its benchmark in the second half of 2010 and into 2011, I began to subtly re-tool the portfolio. These efforts were essentially focused on strengthening the existing stock-selection discipline rather than a wholesale change in process. Specifically, I sold a number of investments that were in the turnaround or special situations category where the thesis had not played out as modeled. I also shifted back to more of a GARP (growth at a reasonable price) focus, in which I target companies with greater current growth prospects while still remaining vigilant on valuation.
What investment themes have worked best so far in 2012?
Considering the slow pace of the economic recovery, it seemed prudent to drill into themes or industries that had multi-year growth dynamics that would thus provide more tailwinds than headwinds.An important example was my interest in companies participating in domestic infrastructure spending, especially those focused on the electrical grid and energy pipeline development. The U.S. and Canada are making significant investments in the electric utility transmission grid to add capacity and upgrade antiquated transmission lines. The same is occurring in the pipeline industry, which has been driven more by the need to transport oil and gas from some of the new shale discovery basins and from Canada.
Hurricane Sandy made us all aware, especially those of us in the Northeast, that a lot more needs to be done, since most of our infrastructure is first generation, built in the middle of the last century. Examples of companies that could continue to benefit from infrastructure upgrades include Valmont Industries (VMI, Financial), a leading galvanized steel utility pole manufacturer and Quanta Services (PWR, Financial), a leading contractor of electrical utility and energy pipeline projects.
My "underwear" theme, which sought to take advantage of falling cotton prices and included several apparel manufacturers, was another important theme. Companies benefiting from lower cotton prices that have performed well this year include Carter's (CRI, Financial), which designs and markets infant and children's apparel, and Gildan Activewear (GIL, Financial), which makes cotton tee shirts, underwear, and socks. Both companies have seen their margins expand significantly this year, as a result of top line growth and lower raw material costs.
The recovery in residential housing also attracted my attention as the initial rebound from a deep five-year downturn appears to have gained substantial traction. I was also attracted to several basic industrial companies that were newly benefiting from applied technologies—I've called this the "better mousetrap" theme. I also made the decision to hold on to longer-term winners when growth and/or quality factors warranted.
What are some other notable companies or sectors in the portfolio?
IPG Photonics (IPGP, Financial) is an example of an industrial company that has grown nicely despite the slow-growth economy. The company manufactures fiber lasers and provides components for marking, cutting, and welding applications on a global basis. It has both a cost and technology advantage that should allow it to continue to grow market share well into the future.In addition, I also worked to increase exposure to the Healthcare sector in 2011 by returning to a couple of old favorites of Royce, including Myriad Genetics (MYGN, Financial)—a genetic testing lab, best known for its breast cancer tests—and Thoratec Corporation (THOR, Financial)—a medical device company that designs and markets ventricular assist devices, or heart pumps, as a way to bridge patients waiting for heart transplants and now also makes devices for patients suffering from chronic heart failure.
With the Fund enjoying more success, where have you been finding value, especially in the second half of the year?
I continue to use the same bottom-up process and strategies that I've used historically. One area that still seems to be building momentum is the housing industry, where we have increased exposure with holdings such as Eagle Materials (EXP, Financial), a Texas-based dry-wall and cement producer, and Quanex Building Products (NX, Financial), which makes window and door components.The portfolio also holds companies in the commercial building area that have performed well this year, but which could do even better when new projects move forward in 2013. That list includes Carlisle Companies (CSL, Financial), which manufactures commercial roofing products along with several other business lines, and Acuity Brands (AYI, Financial), a commercial lighting fixture maker that has exposure to LED lighting adoption. Each of these companies managed their way through the downturn via renovation and replacement demand, as well as by reducing costs. I think they're poised to do even better when the recovery more firmly takes hold.
What qualities do you see in Information Technology, the Fund's largest sector weighting at the end of the third quarter?
The Fund is overweight in Information Technology. The sector has so far not made a significant contribution to 2012 performance, mostly due to the portfolio's large exposure to the inexpensive semiconductor segment and less exposure to more high-flying enterprise software businesses.I've reduced the Fund's weighting in semiconductors somewhat, as the global economy has really weighed on that group's valuation and recovery prospects, though I suspect that a stronger economy in the back half of 2013 would be good news for this group. I've also been adding names in the enterprise software group.
What portfolio positions have you been adding to most recently?
Since initiating a position in April 2012, I've been building a stake in Apogee Enterprises (APOG). The company has a new CEO with what I think is an exciting long-term vision for the company.In July, I began adding shares of Bankrate (RATE, Financial), which aggregates and distributes personal finance content on the Internet and owns several financial services websites and lead-generation properties. The stock has underperformed this year, but I think it represents good value and could rebound in 2013.
I've also been rebuilding our position in long-time holding FARO Technologies (FARO), a conservatively capitalized company that makes robotic measurement arms and scanning equipment. As its business has slowed, its shares have become cheaper.
Do you still anticipate more M&A activity in small-cap stocks?
I do. We keep hearing that there are a lot of family-owned businesses that may lack succession plans and want to sell before the end of the year ahead of likely tax law changes. This would be good news for acquisitive-minded companies in the small-cap space. I also think that in a slow-growth economy, companies will continue to use acquisition strategies as another leg of growth, which means small public companies should see more activity, particularly given the low interest rate/financing environment.Important Performance and Expense Information
All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.roycefunds.com. Operating expenses reflect the Fund's total annual operating expenses for the Service Class as of the Fund's most current prospectus and include management fees, other expenses, and acquired fund fees and expense. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds and other investment companies.Important Disclosure Information
The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Mr. Skinner at November 30, 2012, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Fund's portfolio and Royce's investment intentions with respect to those securities reflect Royce's opinions as of November 30, 2012 and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Royce-managed portfolio in the future.This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money.
As of September 30, 2012, Valmont Industries accounted for 1.6% of Royce Value Plus Fund's net assets, Quanta Services 1.0%, Carter's 1.6%, Gildan Activewear 1.4%, IPG Photonics 1.4%, Myriad Genetics 2.0%, Thoratec Corporation 1.0%, Eagle Materials 1.1%, Quanex Building Products 1.1%, Carlisle Companies 1.1%, Acuity Brands 1.2%, Apogee Enterprises 0.7%, Bankrate 0.8%, and FARO Technologies 0.8%.
Royce Value Plus Fund invests primarily in micro-cap, small-cap, and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). The Fund may invest up to 25% of its net assets in foreign securities, which may involve political, economic, currency and other risks not encountered in U.S. investments (Please see "Investing in Foreign Securities" in the prospectus). 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. The Russell 2000 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.
