How did the Small-Cap Special Equity Strategy perform in 1Q20?

The mutual fund I manage in the strategy, Royce Special Equity, was down 24.6% in the first quarter. The Fund lost less than both of its small-cap benchmarks—the Russell 2000 Index fell 30.6% (for the worst quarterly performance in its history) while the Russell 2000 Value Index was down 35.7%. The Fund has a long history of superior down market performance, which has been helped by having very stringent quality standards, particularly for pristine balance sheets.

Down Market Performance Comparison (%)

So these attributes served the Fund well once again, this time through one of the fastest and most alarming downturns small-cap stocks have ever been through, as companies with higher leverage fell further.

What helped to give the portfolio its advantage versus the Russell 2000?

The Fund’s relative outperformance came from both stock selection and sector allocation in the first quarter. The former had the bigger positive impact, which pleases me. A solid share of our relative advantage came from better stock selection in Industrials—one of our larger sector weights—and our lack of exposure to Energy, which was the worst-performing sector in the Russell 2000 by a wide margin in 1Q20. The Fund’s cash holdings also provided an edge versus the small-cap benchmark.

We were hurt somewhat by having no exposure to Health Care, which held up relatively well within small-cap, as well as some ineffective stock selection in Communication Services and lack of exposure to Utilities. Throughout the Fund’s history, which goes back to 1998, we’ve had low exposure to Utilities and Health Care stocks.

How have you been investing through the decline?

Given these difficult circumstances, I’m staying patient until there is greater clarity and more conviction in the economic, revenue, and profit outlook. I draw on my 52 years of experience. The approach I’ve taken ever since the first bear market I invested through—the “Nifty Fifty” downturn in 1973-74—is to dollar cost average. Declines often go on for extended periods, so I buy more when prices fall. This has served me and, more important, my investors, well over the years.

Of course, in these times, with no visibility into current earnings levels, I go back to my other hallmark metrics—low leverage, high free cash flow and cash conversion, and high return on investment, coupled with clean accounting and governance. And these attributes are even more critical in the current environment. I don’t know any more than anyone else does about how long the pandemic will last or what the ultimate effects will be. What I do know is what makes for quality, durability and survival in a company. I buy businesses that I think will not only make it through whatever comes next in these difficult days, but that also have the strength to be opportunistic during times like this.

What is your outlook on the market?

I don’t see market volatility subsiding until the number of coronavirus cases has peaked on a global level, and the confirmation of that peak is evidenced. Only then will we be able to chart the damage done to the economy and thus have some idea of what revenues and earnings might look like for individual companies (though still fraught with the possibility for huge errors). History also suggests that pandemics come in waves, so in the months to come, certainly by summer, investors will also need to incorporate that potential risk into their expectations.

All of this notwithstanding, it’s important to remember that when the stock market has a sale, it scares away the shoppers. One has to have a disciplined plan to execute on the sale price offerings, as I do. Equally important is the point that investing during frightening times can enhance future returns if one is prepared and if one has a proven strategy to benefit from the turmoil. For example, investors are paying much less today for a slice of future earnings than they did just seven weeks ago. The less one pays for future earnings, the more one should earn. It is really that simple.

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