MAGGIE LAKE: Hello, and welcome to the Real Vision Daily Briefing. It's Monday, February 7th, 2022. I'm Maggie Lake. And here with me today is Francis Gannon, co-Chief Investment Officer of Royce Investment Partners. Hi, Francis, welcome to Real Vision.

FRANCIS GANNON: Hey, Maggie, thank you for having me today.

MAGGIE LAKE: Yeah, I'm excited. And it's a great day. It's been a pretty rough beginning to the year, I think everyone will agree, a lot of people wondering on the direction of equities, and specifically, the direction of small caps, which is something that I know you focus on, and we don't get to talk about really in depth enough. But before we jump into all of that, why don't you give us a little overview of your area of focus and your investment approach?

FRANCIS GANNON: Sure. I worked at Royce Investment Partners. We have been around since 1972, really focusing solely on this beautiful, highly inefficient asset class called small caps. And we have a variety of different approaches to the asset class. But effectively, we tried to look at the small cap asset classes a risk manager. Typically, we tend to invest in what we consider to be very high-quality businesses.

And I know that is an overused word in today's investment world. But we have a series of metrics that we really focus on in trying to find these businesses. And then we put them together in portfolios. And so, we currently manage around 16 billion in small cap assets. And I think what makes us distinct is the fact that we really just invest within the small cap asset class. And then also, we've been doing this for a very long period of time.

So, we have average portfolio, tenured Portfolio Manager, tenure in the firm has been about 22 years, and then we eat our own cooking. So, we have a lot of our own individual money invested in the portfolios we manage, which I think is really important in terms of aligning yourselves with your constituents.

MAGGIE LAKE: Yeah, absolutely. And so, as we were coming on air, we both watched the equity rally that we had in place today fade into the close, which is something that we've seen happening in what has been a rough start to the year.

It's settling now. It looks like the Dow's flat, S&P down a third, NASDAQ down a half, but the Russell managed to hang on. It was up quite a bit today, managed to hang on to a gain of half a percent. But what is your expectation in terms of small caps? The Russell was disappointing for a lot of people, got hit hard at the end of last year. What are you anticipating?

FRANCIS GANNON: Well, the small cap market, the Russell 2000, in general, entered a bear market last week, down over 20% from its most recent high of November 8th. And believe it or not, even with that full year, last year was the third year in a row that we had double digit returns for the Russell 2000. And in the history of the Russell 2000, if you go back, that's only happened in two other periods both in the 1990s when we've had three years in a row of double-digit returns.

And I think we've never had a fourth year of double-digit returns. So, my expectations for small cap this year is to be much more muted in terms of its return. My guess is maybe single high single digit going forward. But I think that's still a good outcome given our dismal start to the year.

MAGGIE LAKE: Yeah, absolutely. And we're looking at-- this is very interesting, because we're thinking about what's going to drive that part of the market? Right now, a lot of people are also looking for someplace where they can find protection, where they can find diversification. And small caps, what do we need to understand about their relationship with inflation, because that's dominating everything right now?

FRANCIS GANNON: Yeah, the inflation headlines are pervasive, obviously, not just here in the United States, but around the world. The thing you have to know about small caps in the United States is that small caps have beaten inflation in every decade going back in time. We use something from the University of Chicago called the Center for Security Research pricing from a research perspective.

And you can see, going back using the CRSP data, as we call it, you can see that small caps have outperformed in every decade versus inflation. So, I think this is a great place for investors to look for an opportunity, especially given the fact that small caps are down over 20% from their most recent high. Gives investors a great place to look at something different and outside of the top five names in the S&P 500 where a lot of people have been investing over the past decade.

MAGGIE LAKE: Yeah. The performance of small cap, what influence has this passive investing had? We've seen so much momentum and so many flows into tech. It seems like if equities are going to rally, that's exactly what's going to happen again. Would that not just repeat itself? What do you expect to see? What's going to drive the flows into small caps now?

FRANCIS GANNON: I think one of the big things that we're hearing about is that the Fed is beginning to pivot or is going to pivot at some point in the not-too-distant future. And I think what that means for equity investors is that error of liquidity driven multiple expansion is over. And we have lived in a period of time, I'd say for five to seven years, if not longer, where people could value non-owning assets from a long duration standpoint, really down the road, given the fact that we were at zero interest rates or rates were so low.

Now, with rates moving up and the Fed being more aggressive in terms of its quantitative tightening and tightening, I think you're actually have to go back to this idea of actually investing with companies that actually have earnings that have underlying fundamentals. And so, I think the whole dynamic of how people should be approaching the next 10 years is going to be dramatically different than how they approach the previous 10 years.

Yes, the growth of ETFs and passive investing has been enormous over that timeframe, but I would argue that within small caps, small caps are such an inefficient asset class that I don't really think the ETF is the best way to approach small caps. If you look at the Russell 2000, for example, and you bought the ETF today, about 44% of the Russell 2000 is comprised of loss-making entities right now.

So, to me, in an environment where the Fed is going to be a little bit more restrictive going forward, where multiples are going to be driven by earnings growth, I think you want to be involved in an active management situation where the active managers are actually picking stocks. We know that in most periods of economic expansion, that value managers tend to do better, and you see it in the way the market works.

So, we've seen very concentrated performance in the market over the past several years. Now, I think you're starting to see that broaden out, and you're going to see other industries participate in a way they haven't previously, which is going to be, I think, great for investors in general, but specifically within the small cap space.

MAGGIE LAKE: That's so interesting. We really are entering this potential new regime. And I'm so glad you brought up the Fed pivot because this is going to affect every part of the asset markets. Jared Dillian and George Goncalves sat down recently and talked about this very issue, the risks, specifically around the pivot, and George was very concerned about the potential for a policy mistake. Let's have a listen to that clip.

GEORGE GONCALVES: Markets have this tendency to overshoot and overextrapolate. I think we're in that moment, but to judge when that's over, it's going to be really difficult, because on the one hand, I think the data is going to give the Fed the ability to eventually pause in the second half.

But what if that doesn't happen? And so, you have to assume that they're going to either go all the way and then wait to see what the impact is to financial conditions in the economy. But I do think that there's this view out there that we're back to a normal business cycle. Once COVID passes, we're going to go back to normal business cycle. In my view, I think if you exclude obviously, the COVID impact, it was a massive hit, but we've really elongated the old business cycle, which was going on 10 plus years anyway.

So, we're now dealing with an even more levered system than before, and the Fed wants to take away liquidity. Fine, they should, because actually there's excess liquidity, they helped facilitate some of the fiscal stimulus, which exacerbated this inflation. So, they're really in a difficult spot. I have the view that, look, they want to soft land the economy. So, they want to achieve Goldilocks, and everyone loves a Goldilocks environment, not too hot, not too cold.

I think that they could get it right. And it's possible, it's definitely one plausible scenario. But for me, I think there's a risk of a policy error eventually amplifying the mid-cycle slowdown, which I think is ahead of us. And this business cycle is going to be shorter, because it's really part of the old business cycle. And so, if that's the case, there's a risk that they'll do a policy mistake, and they actually tip us into a more sharper slowdown, and potentially, maybe a recession in 2023. So, we'll see.

MAGGIE LAKE: A potential for a recession. I would think that would be problematic for small caps. What is your growth outlook and how important is a robust pace of growth for small cap stocks to perform or even outperform?

FRANCIS GANNON: Could the Fed pivot, cause a recession at some point down the road? Could there be a policy mistake? The easy answer there is yes, of course. But I don't know if that's going to happen. All I do know is what I'm hearing from a bottom-up perspective for many of the businesses we invest in. I know that small caps as an asset class are very cheap on a relative basis to large.

And just in general, if you go back over history, especially over the past 20 years, I know at least from what I'm hearing, from a bottom-up perspective, very early on within this first quarter reporting period, that demand remains quite strong, that most companies' economic outlook is actually also quite strong. I know that from an economic standpoint, the law of large numbers, you're going to see some type of slowdown into 2023.

But I think a lot of that has been baked into the small cap space already. A lot of that is reflected in the past, we just had the one of the fastest bear markets that we've seen it a long time, it took us 49 or 50 days to go from the peak in November to the most recent low of last week. So, there's an enormous amount priced into our market. And I guess, when you see a 20% decline in the small cap space, the average stock is going to be down probably close to 40% if not more. There are going to be stocks down 30%, 40%, 50%.

So, the objective for me as an active manager in this space is to take advantage of that dislocation and think about the next three to five years and where the market, any economy should be over that timeframe, and hopefully invest in good businesses that can withstand any type of economic slowdown, be it short term in nature, or be it a full-blown recession.

MAGGIE LAKE: How are you approaching that? Do you think that small caps are going to outperform broadly? Or do you have to be smart about the sectors that you're looking at? Where would you be focused to be looking to pick up some of these bargains?

FRANCIS GANNON: It's a great question, Maggie. I think the way we've been positioning our portfolios of late has been around the more economically sensitive or cyclical areas of the market. So, think industrials, think boring technology companies, the non-sexy--

MAGGIE LAKE: What do you mean boring technology companies?

FRANCIS GANNON: It's just the non-sexy part. The sexy part of technology within the small cap space, software, companies, etc., typically don't have any earnings growth. Even around financials, it can be an opportunity, small cap banks obviously could do better in a rising rate environment. So, I think you just have to be thoughtful about how you approach the asset class and position yourself going forward. Obviously, that leads to probably the more value side of the market, if you will, if you're looking at the individual sectors within the value side of the market.

But I don't think you're going to see a lot of the growthier areas within the small cap space do well, just because I don't think they have the earnings power behind them that you might find in other large cap names. But I view this as if the economy continues to move along at a nice pace, which it seems to be at the moment, even if it slows down a little bit, I'm not scared of growth. I'm not scared of top line growth in businesses.

But what I love to see is bottom line earnings and cash flow, I think that's really important, especially in this environment. Companies actually have to show up and produce earnings in the environment today, where the market really didn't focus on that for a period of time. And so, that's part of the pivot that you're seeing from the Fed, but also the pivot that we're seeing in the market over these first couple of weeks of 2022.

MAGGIE LAKE: Yeah, it's a great point, because we do tend to focus on the ETF or on the Russell but the fact that there is growth and value, that rotation within the small cap sector itself, reflective of what's going on in equities overall, it's really good to keep in mind. We have on the RV site asking, what are some small cap stocks that Francis sees value in currently?

FRANCIS GANNON: Well, I think there's a lot and it varies by sector, especially given the fact that we've had such a large decline. Some of the things that we've been talking about, obviously, around inflation, there are names, like BOK Financial, which is one of the largest banks in Oklahoma that is also in Colorado and Texas. But last time we saw a rising rate, and the Fed was actually tightening, the earnings of this company actually doubled. And so, I think that's an interesting stock to look at in today's environment.

MAGGIE LAKE: It seems like there's a geographical play there as well.

FRANCIS GANNON: Definitely. Energy is another part of the balance sheet there. And so, what you'll see is they're one of the largest lenders into the energy sector in the United States, so obviously, oil prices and natural gas prices are up this year, and have been up over the past year, so they would benefit from that too. So, it's a two-way of playing inflation and inflationary pressure within the small cap space.

MAGGIE LAKE: I think we have a chart, you like real estate as well, is that right?

FRANCIS GANNON: Real estate's not been an area of focus of ours. Typically, we don't invest in real estate companies or utilities. I think the chart you're referencing just talks about the overweight of the value market, if you were to look at the Russell 2000, you would see that banks are overweight, there's a larger weighting in banks, real estate, and utilities.

And you'd see some of those software names, pharmaceuticals, specifically, biotech, the underweight. The healthcare area has been an area that's been under a lot of pressure within the small cap space in the fourth quarter of last year, and so far in this first quarter. And a lot of that has to do with the biotechnology companies.

Biotech, not surprising within the small cap space, is one of the areas that is comprised of non-earning entities. And so, you're seeing as the Fed pivots, and this idea of the era of liquidity driven multiple expansion being over, biotech is definitely getting hurt.

MAGGIE LAKE: This is a great question coming in from Achilleas from the exchange. I have a couple of small medium cap companies, they seem super cheap given the TM and growth prospects compared to their peers in large cap. My question is, what is a typical price discovery cycle for small caps?

FRANCIS GANNON: Well, I think it depends. I think small cap companies are so interesting in that lot of small cap companies do not grow up to become an Apple computer. They will remain small cap for the majority of their lifecycle. I think the other thing to think about when you're thinking about small cap companies, is we always tend to look at ownership, who is the owner?

Is it the owners, the family might be involved? Is it a professional management team, whatever it might be? So, when we're looking to add stocks, or add to a business, we typically have done our work ahead of time. The beauty of this small cap space is that these are typically single line businesses. They're not multiple lines of business. If they do have two lines, the second line really supports the first.

And knowing that our first purchase might be not our best, our hope is that by the time we finish completing our full position, we have a great average price. So, we try to use the near-term fear in the market or near-term misunderstanding. They might report a great quarter, but the market thinks it's terrible versus expectations. But if you're looking out three to five years, you can take advantage of that dislocation, and build that to help build your overall position.

So, when I think of price discovery, I think of it as being slow and steady, in that process of building a position, and then holding on to it for a long period of time. I think we all know the market is very short term focused, especially in today's market, and to be able to pick your head up and look out three to five years and think about the next three to five years and invest that way, I think gives you a little bit of a leg up when you're thinking about price discovery.

MAGGIE LAKE: Yeah. That's a great, the time horizon, it's a fantastic answer. And by the way, he was speaking specifically about it looks like an investment in KLR versus TWLO, TWLO. 1.5 versus 12. So, that's the discrepancy. And his question was, if it takes too long to discover, does that imply it's priced low for a reason?

It sounds like you're saying you really have to have a time horizon here, understand the underlying fundamentals of the business, the management, and then hopefully add to your position, even if you have to be patient. Patience matters in this market--

FRANCIS GANNON: Yeah, patience matters. But we're always worried about a value trap. Things might look ch