How did the International Small-Cap Premier Quality Strategy perform in 1Q20?

Royce International Premier, the mutual fund that we manage in the Strategy, fell 23.8% in the first quarter. It held up better than its international small-cap benchmark, the MSCI ACWI ex-USA Small Cap Index, which declined 29.0% for the same period. We were pleased that the Fund’s ability to better preserve capital in the tumultuous bear market also helped it to keep its performance advantage over the benchmark. The Fund beat the international small-cap index for the one-, three-, five-year, and since inception (12/31/10) periods ended 31st March.

However, each of the nine equity sectors in which the portfolio held investments made a negative impact on first-quarter results. Industrials, the Fund’s largest sector, detracted by far the most—more than three times the negative effect of Information Technology, which followed in second place. The Real Estate and Consumer Discretionary sectors detracted least for the quarter.

What were the sources of the portfolio’s outperformance in 1Q20?

Relative to the MSCI ACWI ex-USA Small Cap, the portfolio benefited from both stock selection and sector allocation, with the former having the bigger positive effect. On the sector level, our stock selection in Financials and a significantly lower weighting in Consumer Discretionary helped most versus the benchmark, as did our cash holdings. Conversely, our relative performance was hurt most by the lack of exposure to Consumer Staples, a defensive sector that held up relatively well within the index, and a combination of poor stock picks and a low weighting in Communication Services, another sector that escaped the quarter in relatively decent condition.

What kind of changes did you make to the portfolio in the first quarter?

Most important, we’ve remained consistent and disciplined in our approach—that’s very significant at times of market stress and extremes. We have been adding to existing positions, as well as cautiously and selectively buying a few new names. Some are old friends in sectors that we think will ultimately prove to be the most productive in a recovery—such as Industrials, Health Care and Information Technology—and whose price declines offered us ample opportunities to reinvest. Altogether, we added seven new positions in the first quarter.

Can you give us some examples?

Ossur is a new position that’s been in our database of potential purchase candidates for five years. It’s an Icelandic company, one of the two global leaders in the design and manufacture of prosthetic limbs and whose price became more and more attractive as the markets fell in the first quarter. We are especially attracted to the ‘customer for life’ relationship it has with its clients and also to the significant product upgrades that are taking place over time as the market gradually moves from carbon fibre to bionic limbs. We also see it as a way to gain entry into the diabetes-treatment area, which is growing rapidly—diabetes, unfortunately, often leads to amputations.

Nemetschek is a Germany company that makes software for the architecture and construction industries. We owned shares between 2011 and 2012, shortly after we launched the mutual fund, so it’s a company that we’ve known for a while. When its shares fell by 50% between the middle of February and mid-March, we saw an opportunity to buy what we think is a very high-quality company—one that in retrospect I wish we’d never sold.

What’s your outlook for your Strategy?

We believe the Fund entered this period of COVID-19-induced market volatility relatively well positioned, mostly due to our consistent and disciplined focus on high-quality small-cap companies—those with high returns on invested capital and conservative balance sheets. Equally important, all of our holdings exhibit certain characteristics rooted in a well-defined set of criteria, which we believe suggest that they will be able to sustain these superior long-run returns on invested capital. One byproduct of our discipline is that the Fund had little or no direct exposure to many of the sectors hardest hit by the economic lockdown. For example, we owned no airlines or retailers, and only one energy company (Norway’s TGS-NOPEC Geophysical).

That being said, the impact of the pandemic has of course affected portfolio companies that we would have considered quite sheltered from economic downturns in less extreme times. In addition, some of the selling has, we think, been quite indiscriminate. But even in these most exceptional times, we believe that our discipline allows us to view stock price volatility as an opportunity that will hopefully reward patient investors.

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