Deep Value Investing During the Market Downturn

Royce Investment Partners: Our deep value approach to small-cap stocks remains unchanged amid market volatility.

    Bill Hench

    Bill Hench

    Suzanne Franks

    Suzanne Franks

    Rob Kosowsky

    Rob Kosowsky

    Have you and your team changed anything about your investment process during the current sell-off?

    Our Deep Value process has intensified, but nothing has fundamentally changed. Even with our team members working from home, our schedule and practice remain the same. We meet every morning to review the entire portfolio in order to assess the valuations of current positions, sizing, and potential additions and subtractions.

    Have you been doing anything differently in this environment?

    I’d say that we’re doing things more intensively rather than differently. During times of extreme volatility such as what we’re now experiencing, we concentrate on setting up the portfolio to capture the most upside when the market recovers. Our current day-to-day process now includes more time spent on determining how to best position the portfolio for a recovery. We’re using cash from names that are close to fair value as the means to buy those that can provide better returns over the cycle, and we will not get defensive.

    Our opportunistic Deep Value process has been in place for more than 20 years, and the team has experienced many extreme markets—such as the 2008 Financial Crisis. Historically, during severe (and less severe) downturns, we have successfully taken advantage of falling share prices to enhance long-term results.

    What are your thoughts on how small-cap and large-cap will perform in the downturn?

    Outside of the human tragedy, the overall impact on equities has been, and continues to be, indiscriminate selling. As in the past, we expect that small-caps may decline more than other areas of the market because small- and micro-caps have less liquidity. We also think that a recovery would likely first favor large-caps before then broadening to encompass the small-cap companies.

    How have you been investing so far?

    As always, we make changes—some significant—by reducing positions where we think upside may be modest or limited and increasing or adding new positions that can maximize returns. It is common for us to add new names that show promise for significant appreciation as a result of increased volatility.

    As I mentioned above, we have a lot of experience in markets such as the one in which we now find ourselves. The kind of small- and micro-cap stocks that make up our portfolios have historically tended to fare poorly in extreme down markets. This is not just because of liquidity but also the fact that many of these names are turnarounds or are facing other short-term issues that give most other investors pause. But we work to take advantage of these situations. Many of the positions that we’re adding to are priced far lower than what we think is fair value, so we are using this time to increase the spread between what we are paying and what we suspect these companies will eventually sell for.

    Nearly everything in the small-cap market looks cheap these days, so we examine companies on a name by name basis. We do not think in terms of sectors but have more of what we like in housing, technology, and healthcare but not much that interests us in retail, energy, or banks.

    As difficult as the current period is—for reasons that go beyond the stock market obviously—we’re investing actively knowing that the situation, for all its uncertainties, is finite. And we’re trying to position the portfolio to enjoy a strong rebound when the markets recover.

    DEFINITIONS

    The 2008 Financial Crisis, also known as the Great Recession, the financial crisis of 2007–08, the Great Financial Crisis (GFC), and the global 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.

    Deep Value investors employ a more extreme version of value investing that is characterized by holding the stocks of companies with extremely low valuation measures.

    Defensive stocks tend to perform better than the broader market during recessions. However, during an expansion phase, they tend to perform below the market.

    In investing, fair value refers to an asset's sale price agreed upon by a willing buyer and seller, assuming both parties are knowledgable and enter the transaction freely. For example, securities have a fair value that's determined by a market where they are traded. In accounting, fair value represents the estimated worth of various assets and liabilities that must be listed on a company's books.

    Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smallest eligible securities by market cap.

    WHAT ARE THE RISKS?

    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.

    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.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.