April 15, 2012
by Chris Clark, Royce Funds
As we highlighted in last month's Contrarian View, a surprisingly underappreciated risk that we think investors are now confronted with is the potential for losses in their future purchasing power, especially those invested in low-yielding fixed income securities.
The combination of a highly stimulative Fed, artificially low interest rates, and a rapidly expanding monetary base is geared toward insuring both the stability of the global banking system and the upward trajectory of the fragile economic recovery, while also meaningfully shifting the balance of risks.
For some time now, investors have been understandably focused on the risk of deflation and therefore have been investing with a singular focus on the preservation of capital. In a deflationary world, results are measured in nominal terms, not real ones. With so many monetary programs being implemented around the world in response to the legacy effects of the financial crisis, our view now is that the longer-term preponderance of risk is skewed to the inflationary side of the spectrum.
Yet with so much lingering economic and political uncertainty, we understand investors' reluctance to suddenly embrace risk assets, especially given both the recent uneven performance of those assets and the remarkable record of gains that have been achieved by less risky vehicles such as U.S. Treasuries. We recognize that equities have demonstrated greater price volatility and are generally riskier investments than high-quality fixed income securities. However, it's also worth noting the variance in their relative risk can shift quite a bit over time.
When stocks have traded significantly above their long-term valuation averages, such as during the Nifty Fifty period in 1973-74 and the Tech bubble of 2001-02, they certainly carried more risk than they have at times when equities have been deeply out of favor due to recessionary economic conditions or other bear markets. By the same token, other factors can influence relative prices, such as investors becoming more enamored with one asset class over another.
"When stocks have traded significantly above their long-term
valuation averages, they carried more risk than they
have at times when equities have been deeply out of favor due
to recessionary economic conditions or other bear markets."
In any event, we are now in a period where stocks are deeply out of favor. One only has to glance at asset flows over the past several years to recognize that bonds have been the overwhelming asset class of choice and as a result have prices that carry very little margin of safety. In other words, what investors have lost by focusing on preservation of capital on a nominal basis is that those assets currently deemed safe have arguably very little or no margin of safety on a real basis.
In nearly four decades of investment management, Royce has always recognized the need for a margin of safety. Equities can be volatile, but they don't have to be risky, at least over the long run. In fact, risk management and the avoidance of permanent capital loss are not concepts exclusive to the fixed income world. A focus on risk āboth nominal and realāan absolute value approach, and a long-term investment orientation are all hallmarks of our investment discipline.
How do we attempt to build a margin of safety? In three very important ways: The first, and arguably most important step, is a detailed examination of a company's balance sheet. We want to be sure that a company has sufficient financial flexibility to both survive challenging periods and to invest in strengthening its business when the opportunity arises.
Second, we focus on finding high-quality companies where we can become comfortable with the long-term sustainability of the company's success. High internal rates of return and the ability to generate free cash flow are key metrics in this analysis.
Finally, we focus on what we pay. We have found that investment returns are primarily a function of entry price. Put simply, we like to buy what is out of favor with the crowd. Paying a discount to our estimate of intrinsic value is an important aspect of our investment approach, especially in an uncertain future.
The world is gradually healing, and with this slow-but-steady improvement has come a shift in the balance of risks. It is our belief that investors need to refocus their attention on investments that have the potential to provide both a margin of safety and the flexibility to navigate the uncertain pricing environment that lies ahead.
Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark'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.
