Chuck Royce, small cap stock picker and pioneer, recently sat down with Consuelo Mack of WealthTrack to discuss his thoughts on the recent slump of value vs. growth stocks as well as his firm’s process for sourcing new investment ideas.

Royce, who has been in the investment management business since 1972, explains that small cap stocks can offer outsized long term returns, potentially with less volatility (assuming you are investing in value stocks) compared to other asset classes. Royce points out that value stocks have significantly underperformed growth stocks since early 2009. He theorizes this is largely due to firms that are not as strong being able to borrow funds at very low interest rates, which can make many businesses look stronger than they actually are. Because of value stocks’ lackluster results, many active managers have also underperformed the broader indices, thus making passive investing more appealing. But as Royce points out, passive investors that buy the index don’t know what they are buying. For instance, in the Russell 2000, says Royce, 35% of companies are not making a profit, but investors who blindly buy the index don’t know about these hidden risks within index funds. Royce believes that the trend of value over growth is likely to reverse course and revert. This, he believes, bodes well for active stock pickers.

Royce’s firm investment process tends to focus at the “intersection of quality and value”. Most of the opportunities Royce is finding are in cyclical areas, which are a large part of the market that has underperformed. The constant worries of an economic contraction, or recession, has muted the values of many cyclical companies and Royce believes that barring a recession, these types of stocks offer the best current opportunities.

Royce does not try to make macro calls, but in discussions with portfolio companies he says that most of the feedback he receives does not point to a recession in the near to mid-term horizon.