2016 Second Quarter
After a "V" shaped first quarter, we saw another drop with a strong rally in the final days of the second quarter. Of course, we owe the latest volatility to the vote by Great Britain to leave the European Union - the so-called "Brexit" vote.
Regardless of where one stands politically on this issue, you cannot deny that there is some uncertainty about how some of the major issues will be resolved. How will Great Britain go about renegotiating their trading pacts with countries within and outside of the European Union? How will Brexit impact the workers who traveled freely between Northern Ireland and Ireland? I read the headline for one opinion piece recommending that Great Britain join NAFTA - the North American Free Trade Agreement between the U.S., Mexico and Canada! As you know by now, markets dislike uncertainty. Nevertheless, after a quick descent in the two business days following the Brexit vote, the market rallied in the last three days of the quarter. Oakmark International (one-quarter of our foreign stock allocation) has been hit particularly hard in the Brexit vote due to their European financial holdings, but our other two foreign funds, First Eagle and IVA International (a combined three-quarters of our international allocation) have held their own as you will see with the enclosed Position Performance report.
"We think returns for the next three-to-five years will be positive, but lower than, or close to, their long-term average. In this environment, we expect leadership to come from companies with low leverage, high returns on invested capital, and other financial and/or operational strengths, which should bode well for many of our holdings in more cyclical areas." - Royce Funds letter dated January 31, 2016 (emphasis added).
Obviously that quote was prior to the Brexit vote, but I doubt Brexit would have changed Chuck Royce's mind. Royce and his team believe investor focus in the future will go back to fundamentals: Companies with little to no debt ("low leverage") with good capital investment leadership ("high returns on invested capital"). These corporations are held in our indices (total stock market and S&P 500), but are also emphasized within our managed funds like Royce. I think it is interesting to point out that one of our worst performing fund families last year, Royce funds, is one of our best performers this year. That said, Royce has a long way to go to catch-up with our other small-cap holding: Schwab U.S. Small Cap ETF. I remain hopeful that our value-oriented active management will be able to find these high quality stocks that will ultimately provide long-term returns above the index. If they fail, we will have the indexes as a backstop.