2 Key Holdings For RYPRX—Royce
article 01-14-2020

Two Misunderstood Premier Quality Small-Caps

PM Lauren Romeo gives a comprehensive review of two key holdings in our Premier Quality Strategy.

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We often find ourselves gravitating to companies that we think are misunderstood by most investors. We have two companies that we think are improved quality businesses that fall into this category—the first is transforming by repositioning itself for higher-quality and longer-term growth while second has been hurt by negative sentiment for the industry it serves, which would appear to be deterring investors from recognizing its important innovations.

Colfax (CFX) provides orthopedic care and fabrication technology products and services to customers around the world, principally under the DJO and ESAB brands. It’s a new position that we initiated in Royce Premier Fund’s portfolio in 1Q19 and was a strong performer in 2019.

Colfax (Nasdaq: CFX) 2019

colfax

Their blueprint is to acquire good businesses and turn them into great ones through a system of continuous operational improvement and reinvestment in product innovation that drives organic growth and margin expansion. The transformation of Colfax’s business portfolio has been the result of a former Danaher executive coming on as CEO and then a top-tier CFO (the latter whom we know from his senior roles at three other companies in which Royce has invested).

To reduce cyclicality and increase profitability, Colfax sold off two cyclical, lower-return businesses over the last two-plus years while keeping its largest industrial segment, Fabrication Technology, which is the leading global provider of welding consumables and equipment. In late 2018, Colfax also made a key acquisition, buying DJO Global, a leading orthopedics devices and solutions company.

While these three actions reduced Colfax’s total adjusted operating income by about 5%, DJO’s orthopedics business has historically generated much higher operating margins than the businesses Colfax sold. DJO also grows more consistently, keyed by macro factors such as an aging population while growth in the divested businesses fluctuates with industrial activity.

We believe management has additional strategic levers it can pull to drive further value creation—which bolsters our conviction about Colfax’s ongoing prospects. We see its Medical Technology segment, for example, on a path to double revenues over time as management implements initiatives to return to sustained mid-single digit organic sales growth, supplementing these efforts with bolt-on acquisitions that broaden its business platform.

Finally, true to the Danaher playbook, management is implementing a Colfax Business System (CBS) of operational, productivity, pricing, and service tools at DJO in an effort to drive at least 50 basis points of annual EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) margin expansion.

Colfax’s existing Fabrication Technology segment operates under the ESAB brand name. We have known ESAB for years as it is a direct competitor to long-time Premier holding, Lincoln Electric (LECO). As with Lincoln, we like ESAB’s “razor/razor blade” model, where the bulk of its sales come from consumables with recurring sales that are less subject to cyclicality. Colfax has been accelerating the pace of ESAB’s consumable product introductions for welding and automation. All of this gives Colfax what we think is a highly attractive runway for growing its business.

Of course, not every stock we hold in our Premier Quality portfolios enjoyed a rising share price in 2019. Within the Russell 2000, the Energy sector not only declined in 2019, it also produced the worst total return in each of the last three years (oil prices rose around 11% over the same period). This has created opportunities for us to build or initiate positions in what we believe are high-quality energy businesses, mostly in the services area.

Headquartered in Calgary, Pason Systems provides instrumentation and data management systems for drilling rigs. Pason saw its near-term outlook weaken in 2019 as North American drilling activity declined through the year on supply/demand concerns exacerbated by slowing global economic growth.

Pason Systems (Nasdaq: PSI.TO) 2019

pasons

We think the market has more than sufficiently discounted the impact of declining drilling activity on Pason’s recent near-term fundamentals while also seeming to ignore strengths that look obviously attractive to us: a durable, high-ROIC business model, an innovative and robust technology pipeline, and a debt-free balance sheet. We also like its currently generous dividend yield (which has admittedly risen as a result of the stock’s decline).

“When analyzing companies for our Premier Quality Strategy, we pay particularly close attention to innovators (as well those that benefit from innovation). We think that we can benefit from the bias many investors have that innovative businesses are mostly either large-caps or emerging companies in the small-cap tech sector.” – Lauren Romeo

Pason has been an early enabler of the ongoing digitization of oil fields—its products improve drilling efficiency and reduce costs. It accomplishes this by developing and renting systems and software that acquire and manage drilling data at the wellsite. This information is then delivered in real time both to onsite operators and, via datahubs and the cloud, to its customers’ key offsite personnel such as data scientists.

A testament to the high value-add of Pason’s products is that even during energy downturns, when the number of drilling days has fallen precipitously, the company’s revenue per electronic drilling recorder rig has remained fairly steady. When drilling activity begins to recover, Pason has a full pipeline of innovative products to drive growth thanks to the 10% of revenues it’s consistently devoted to R&D. In recent years, management has been focusing its development efforts on higher-margin software solutions that automate various rig processes or enable enhanced data analytics. The firm is also just beginning to gain traction with the U.S. rollout of unique and field-proven drilling automation software that reduces drilling time by 10-15%.

When analyzing companies for our Premier Quality Strategy, we pay particularly close attention to innovators (as well those that benefit from innovation). We think that we can benefit from the bias many investors have that innovative businesses are mostly either large-caps or emerging companies in the small-cap tech sector—leaving businesses like Pason relatively neglected. This gives us the opportunity to find what we think are innovative, fundamentally strong companies at prices that we think substantially discount those attributes.

 

ROYCE PREMIER FUND

 

Important Disclosure Information

Average Annual Total Returns as of 12/31/19 (%) 

  4Q191 1YR 3YR 5YR 10YR 15YR 20YR SINCE INCEPT. DATE
Premier 8.54 34.13 14.15 10.52 11.30 9.69 11.01 11.77 12/31/91
Russell 2000 9.94 25.52 8.59 8.23 11.83 7.92 7.59 9.57 N/A

Annual Operating Expenses: 1.17

1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.royceinvest.com. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Mrs. Romeo’s thoughts and opinions concerning the stock market are solely her own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

Percentage of Fund Holdings As of 12/31/2019 (%)

  Royce 
Premier Fund

Colfax Corporation

2.6

Lincoln Electric Holdings

3.0

Pason Systems

1.7

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization-weighted. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. The Fund also generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 25% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)

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