Do you expect the fourth quarter to be as volatile as the previous three?

I think so. There's no real consensus right now on our economy or elsewhere in the developed world. You can see that in the inflation or deflation debate being discussed. Much of what we've seen this year is what I'd call "headline volatility." A jobs number comes out, the Fed or another significant central bank makes a pronouncement, and the stock market has an extreme reaction. The market had a great September, the best in the history of the Russell 2000 and the best for the S&P 500 since 1939. Yet it's hard to see that trend continuing with the drumbeat of varying policy initiatives coming from central banks. We also have mid-term elections coming up whose outcome will probably create a sharp, short-term response. More importantly, there is a lot of residual anxiety from two years ago that will need more time to abate. The lack of risk tolerance remains pretty low.

 

What is your take on the current uncertain economic climate?

The current environment reminds me of a more toned down sequel to 2008. We have banks in crisis, only now they're in Europe as opposed to the U.S. We have had a flight to the safety of currency, this year to the U.S. dollar. We have endured increased fears of a double-dip recession, which created anxiety, though not at the panic level of late 2008. I think, having been through the previous crisis, it's a little easier to see how these issues may play out. In any case, our strategy hasn't changed during these difficult periods—we remain disciplined, bottom-up stock pickers. We are very pleased—we think that our time-tested discipline has been invaluable in helping us get through these difficult markets.

 

Do you think that inflation or deflation is more likely to occur?

 

We are very pleased—we think that our time-tested discipline has been invaluable in helping us get through these difficult markets.

In my mind, that debate has been settled. Never in my career have I seen a government so overt in saying that it wants more inflation. And governments have historically been very successful at that endeavor. With the mountain of debt that the government is carrying, the choices aren't so wonderful: We can pay it back, but that involves serious and politically unpopular spending cuts that would create a lot of social pain; we can default, which of course no one wants; and we can devalue currency, which appears to be the road that the government is choosing, at least for now.

One reason that I've been increasingly drawn to hard asset stocks over the last seven years is because I expected these kinds of companies to succeed in an inflationary environment. For me, the rise in the price of gold is the canary in the coal mine with regard to inflation. Inflationary pressures work their way into the economy at different rates. For example, when the price of iron ore increases, it takes time before it's reflected in the price of a car. As the price of gold continues to rise, I am more convinced that we are headed toward inflation.

 

The portfolios that you manage have significant investments in precious metals and mining companies. What is your take on the precipitous rise in gold and silver prices?

We've liked these companies for a long time. Our initial interest was based on their sound fundamentals. Commodity metal prices had been in the doldrums for some years when we began to build our stakes in mining businesses. Of course, the financial crisis helped the price of gold to rise as many investors were looking for safe havens. More recently, gold's role as an inflation hedge has also given prices a significant boost — in fact, gold and silver have both reached new highs this year.

What's interesting is that the stock prices of many mining companies are still shy of the highs they reached in 2008 before the crisis hit, in some cases 30-50% below those 2008 peaks. So we're happy to hold right now, though in some cases stock prices have risen to the point that we've pruned positions back to prevent the industry from becoming too dominant in a portfolio. However, most of the action in the mining industry has not come from investors, who are still mostly avoiding stocks. It's come from M&A (merger and acquisition) activity, with larger companies buying up smaller properties. Our enthusiasm as a firm is undiminished—in our view the industry has a lot of companies with strong fundamentals and room for growth. What's also interesting is the ongoing transition from these businesses being viewed strictly as asset plays to being understood as enterprises that possess solid earnings, generate free cash flow and, in time, should boast attractive dividend yields.

 

Has Technology become a significant source of investment in 2010?

Yes. We have a number of Technology holdings with terrific balance sheets and growing businesses. We increased our exposure over the summer when share prices were particularly low. Tech stocks in general have been very inexpensive for several years—they've essentially been in a 10-year bear market, which has allowed us to find what we think are extraordinary opportunities in companies across a variety of industries. Based on stock market performance, it looks as though many investors have lost sight of the fact that technology companies continue to innovate with products and services that save labor, cut costs, etc. Many companies have deferred normal technology upgrades due to the difficult economy, but upgrades are inevitable because ultimately no business can afford to fall behind in technology. And in an inflationary economy, the need for cost savings becomes even more critical. In addition, there is growing demand for all kinds of technology in emerging market countries that simply didn't exist 10 years ago. We're very confident about the Technology sector.

It's interesting that back in the late '90s, tech was viewed by many investors as a permanent growth category that wasn't subject to the same business cycle dynamics as every other industry. Today, it's nearly the opposite, with investors overly sensitized to tech's cyclicality. This has helped us to find numerous bargains.

As we've been seeing with precious metals companies, investors are staying away while larger companies are rushing in to buy out smaller peers and competitors. Both areas have seen a lot of M&A activity in 2010, which is one reason we feel so confident about our investments in these companies. It's generally a good time to invest when people closest to these businesses are investing.

(c) Royce Funds

www.roycefunds.com