Interview with RYPNX Team—Royce
article 08-13-2020

Strategist’s Spotlight with Royce’s Small-Cap Deep Value Team

Senior Investment Strategist Steve Lipper interviews Lead Portfolio Manager Bill Hench and Assistant PMs Suzanne Franks and Rob Kosowsky on how they’re positioning Royce’s Small-Cap Deep Value strategy in the pandemic.

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Steve Lipper: Royce's Deep Value strategy, which this team manages with the able assistance of analyst Adam Mielnik, is one of our more distinctive approaches. In this piece, I talk to Bill and his team about their value-oriented approach to buying statistically cheap small-cap stocks that face transitory or fixable issues and also possess a catalyst to close the valuation gap. They often do this by investing in sectors that most other value investors tend to avoid, which I discuss with them later in this interview. The current market offers a fascinating time to be looking at investments in small-cap value. Many asset allocators often overlook an important point when they’re thinking about small-caps. Because of the size and variation within the asset class, there are always companies selling at much higher and much lower valuations than the average small-cap stock. The below chart shows the bottom three deciles, which sell as of June 30th, at 35%, 45%, and 62% discount to the average small-cap stock. These three deciles account for hundreds of small-cap companies. This shows the a enormous potential opportunity that exists at nearly all times within the small-cap universe. However, there’s also a more timely observation.

Many Small-Caps Sell at Significant Discounts
Bottom Three Deciles in Russell 2000 Median LTM EV/EBIT1 ex negative EBIT as of 6/30/20

r2k-declines

Last Twelve Months Enterprise Value/Earnings Before Interest and Taxes
Past performance is no guarantee of future results.

The spread in valuation today between small-cap value and growth stocks is at its most extreme point in nearly 20 years. The chart below shows the relative price-to-sales of the Russell 2000 Value versus the Russell 2000 Growth dating back to the internet bubble. The only time when small-cap value was selling at a bigger discount to small-cap growth was near the peak of that internet bubble in mid-2000, which ended up being a great time to have invested in small-cap value.

Valuations for Small Value vs. Small Growth Lowest in Nearly 20 Years
Russell 2000 Value/ Russell 2000 Growth Price to Sales
From 6/30/00 through 6/30/20

r2k-val-gro
Past performance is no guarantee of future results. Price to Sales is calculated by dividing the company’s market cap by the revenue in the most recent year.

With that as a backdrop, Bill, how do you see the opportunities in your market today?

Bill Hench: The first thing that happened, Steve, was that the opportunity set as far as the number of names grew dramatically after the big upheaval due to COVID-19. A lot of names dropped dramatically in valuation, so market caps came down. Several of what were considered growth stocks came into our range and their statistics, whether it be price-to-sales, price-to-book, or any of the other traditional metrics we look at, became names that we could look at. Now that also meant that a lot of names that we owned, because we do buy turnarounds where we look for certain conditions in the economy to help those along, had to be eliminated from the portfolio.

But overall, the number of names that we could look at has grown dramatically. And the potential to make money in these names, I think, is greater now than it was at the end of 2019. The advantage that we have is that our group was able to find names that look incredibly cheap but just as important should come out of the current situation looking very good, and not just on traditional value metrics, but on earnings and cash flow growth.

We see our job as trying to take advantage of things where there are a lot of unknowns, and use our process to calculate a company's more normalized valuations and earnings, and make good returns. And it’s always great to start out when you’ve got valuations that are so attractively low. The valuations in our part of the market versus growth, large-cap, or the momentum stocks are much different than what you’ll hear watching television or reading the financial press.

So it’s a great opportunity now. We don’t know when this will end, but we do know that we are getting to buy things and invest in things these last couple of months at prices that we think really put the risk-reward in our favor.

Lipper: If we do look out two years and toward a recovery, we have some great values and opportunities to benefit from that. Rob, how is that affecting the attributes you prefer in companies? How does that affect the type of stocks you want to own more of and less of in this environment?

Rob Kosowsky: To reiterate what Bill was saying, the process stays the same for our fund in good times and in bad. We look for cheap stocks on a price-to-sales or price-to-book basis, with some reason that things are going to get better, are going to lift margins, or accelerate the sales growth rate. So you get the investor who’s more disposed to be buying higher-quality companies, buy the companies with better margins, or a growth investor coming in, trying to buy the improving growth stocks that we own.

However, you also have a huge event with COVID-19 and the freeze in the economy. What that really meant for us is that all the facts and all the assumptions that we made have really changed.

We really had to take a new look at the portfolio, just retest our theses and see which type of stocks we want to own more and less of. But the factors are unchanged, so we really needed to first look at what we owned and maintain the conviction in.

The first thing you have when you get a dislocation in the economy like we saw, is to check the balance sheets and make sure the companies are going to be able to make it to the other side. We do buy companies that have debt, and so we needed to make sure that the capital structure and the cash flow are there to get them to the other side. It might be a current revenue business that has ongoing cash flow, or maturities further out and a covenant-light structure where you feel pretty good that even if you get a slowdown or dip in earnings, you’re going to survive.

As we were going through our portfolio in March, oil prices went into free fall. We started to feel less comfortable about the balance sheets of a lot of the oil and gas and E&P companies that we own. We decided to reduce them, because we just didn’t know how low oil prices were going to go. Obviously nobody saw them going negative, but it was pretty apparent to us that we were in a lower oil price environment, and some of these E&Ps that we had bought were predicated on $60 oil, so those investment theses no longer made sense.

Secondly, you look at the business prospects going forward. Certain sectors see some stiffer headwinds going against you, and specifically we looked at the community banks that we owned. Interest rates were going lower, so it’s not really good for the net interest margin right now. Loan growth is going to be pretty weak, so that’s not good for growth, and the provisions are going to go up. So it’s kind a witch’s brew against the small-cap banks, and so we reduced our exposure there, because as we’re trying to reposition the portfolio, we want to have companies that are going to give us the best upside for when we get a better economy.

At the same time, we started to pivot into business models that looked capable of adapting and thriving in a COVID-19 environment. We then looked at what stocks looked really cheap relative to normalized earnings power in a more typical, post-coronavirus economy. That’s predicated on a vaccine coming out, but you can find some good stocks with low valuations versus normalized earnings.

Tech has done well broadly, but even in some spaces you don’t think are doing well, you can still find business models that are positioned to thrive.

One example Noodles, a quick-service restaurant that makes $10 price point noodle dishes. The management team was able to adapt their go-to-market business model to find customers by embracing digital. Their food travels well, so they’re able to really lean into the whole takeout eat-at-home craze and shift in how consumers behave. They recently said their digital sales were actually up 138% in Q2 versus Q1, and sales were approaching pre-COVID-19 levels. This is a business model and a management team that was able to pick up a lot of new customers. The business is doing well right now in this really weak environment. Our thought is that the company could really thrive once we get back to a more normalized business environment.

We also look for companies that are cheap relative to normalized earnings power, and we’re seeing some of the best opportunities in health care right now. No one really knows the extent to which sectors are going to come back, but people are still going to need their back fixed, people are still going to have to go to behavioral health clinics, and people are still going to have to go to the hospital. So we’re able to find a lot of healthcare companies that investors are valuing based on an idea of permanent impairment as opposed to the amount of volume that they’re going to see once we have a vaccine. We’re pretty confident that those procedures are going to come back ,and we should see a nice increase in earnings growth when they do. But for now, we’re able to buy these companies at good prices relative to what they were expected to do just 8-9 months ago.

Lipper: Suzanne, can you walk us through how you’ve been adjusting the portfolio?

Suzanne Franks: Yes, we’ve reduced our exposure to banks and energy companies, and we’ve have been redeploying that capital to take full advantage of the severe market dislocation and volatility that we’ve seen in the last several months, which really presented three primary opportunity sets for us. These were trends that were really in place prior to the pandemic that have only accelerated. One would be increased demand for remote and mobile connectivity, as well as content delivery, which has accelerated considerably as many of us are working from home. That’s a phenomenon with strong potential staying power.

We’ve also seen increased demand for streaming, such as Netflix and other services. Opportunities here would be in the semiconductor or semi-cap equipment space, as well as communications technology companies. Prior to the pandemic, we had seen growing demand for housing from first-time home buyers, and during the pandemic we have seen an increase in demand from people wanting to move away from cities into the suburbs and rural communities. We’ve been capitalizing on this trend by investing in homebuilders and pre-fab home manufacturers that cater to this market. We’ve also been investing in companies that provide the raw materials for this new build, or for renovations that a lot of homeowners have had ample time to take on during the pandemic and related lockdowns.

The second opportunity set that we’ve positioned the portfolio for is trends spurred by the pandemic such as pantry-loading and sanitation, which has led us to look at grocery stores, alcohol and sanitizer manufacturers, and cleaning services. We’re also looking at companies that can take advantage of the fact that folks are no longer flying, but driving. The opportunity there would be RV companies, like Winnebago, for example.

Lastly, we have positioned the portfolio for increased exposure to companies that will benefit from reopening the economy. Some of the opportunities here include hair salons, restaurants, and airlines, just to name a few. We have been investing across these opportunity sets over the last several months.

Lipper: So the Opportunity strategy is known for focusing on four different themes. Two of those themes, turnarounds and undervalued growth, seem to be the biggest areas of focus. Rob, can you walk us through a turnaround situation that you’re excited about?

Kosowsky: Actually, a turnaround that we continue to like is Jeld-Wen. This is a stock we added to the portfolio in January of this year, which was obviously a little bit before the coronavirus hit. But Jeld-Wen is a leading manufacturer of doors and windows.They’re a number-one or number-two player in pretty much all their door markets. This is a nice, simple building products company. It was trading at attractive price-to-sales ratio, and we bought the stock pre-COVID-19 on a margin expansion thesis. There are two central points to that: One was cost cuts and the other was pricing. They dived into the cost cut side. New management came in a couple of years ago with a plan to cut almost $200 million of costs out of the business, which could arguably raise earnings up towards $2.50-3.00 of earnings.

The new CEO was going to consolidate a previous roll-up, which we see this all the time. Management teams go in and build empires, but the companies aren’t really integrated appropriately. So a new management teams comes in, and there’s usually a great opportunity to cut costs. Jeld-Wen has something like 130 facilities, so they could just cut a significant amount of that and take $100 million out of the P&L, which is a great opportunity to reduce costs.

On the pricing side, Jeld-Wen and its main competitor, Masonite, have about 80% of the North American door market. Masonite had a new CEO come in a year ago, saw their really good market structure, and started raising prices. Jeld-Wen then followed those price increases. So you have a nice kind of combination of cost cuts and pricing opportunity.

Over the past six months or so, we’ve been able to add shares at very attractive prices. Jeld-Wen has debt, and when you get these big dislocations in the market, the market doesn’t really discern or distinguish capital structures or maturity structures--the market just sells everything with debt. This stock went from $24 to $7 or 8, where were able to buy. We believe that they can potentially do $2.50-3.00 of earnings, so we were buying the stock at 2x to 3x potential earnings, which was just a great price for a building products company like this.

This is a name that we still like, and we’ll see how it evolves during the recovery in homebuilding and if its margin expansion potential emerges. But we see a lot of opportunity here.

Lipper: Suzanne, can you give us an example of an undervalued growth stock that you like?

Franks: The broad indiscriminate market decline back in March produced a great number of opportunities in our undervalued growth theme. To illustrate this, let me walk through our investment in the low-cost domestic airline, Allegiant Airlines.

Our investment in Allegiant was an opportunity to capitalize on the reopening of the economy, where the leisure traveler is expected to be the first to return to the skies. Revenue at Allegiant is expected to be down 50% this year, but is also expected to rebound next year by 50%. The stock valuation has yet to reflect this expected revenue rebound, and consequently Allegiant has traded as low as 1.4x price-to-book, which is outside the typical trading range of 3.4x to 5x.

At this inexpensive valuation level, the potential for 50-100% upside is considerable. Now in order for this upside to be realized, the company’s operations only need to partially return to normal, which is the beauty of investing in a stock as cheaply as possible, which we do regularly. The upside substantially outweighs the downside. We do not need perfect; we do not need a heroic effort by the company to realize this compelling upside. And, in fact, Allegiant is slowly realizing a partial return to normal. In June, capacity utilization was 57%, which is up from 13% in April. At this 57% level of utilization, Allegiant is approaching an estimated free cash flow neutral position. Most airlines need at least 80% or more to be free cash flow neutral.

Allegiant can generate cash at relatively low capacity utilization because of its low and highly flexible cost structure. Unique to Allegiant, 80% of its routes are non-competitive, which means they’re flying routes from Austin to Ashville, or from Charleston, South Carolina, to Louisville, Kentucky, for $100-$150 round trip. They’re not in the competitive markets of New York, L.A. or Dallas. Even at a stock price of $113, we still see Allegiant as a compelling example of an undervalued growth opportunity.

Lipper: A common question we hear when we meet with analysts and consultants is what can I tell those on the investment committee who are skeptical about a turnaround for small-cap value.

Hench: One of the hallmarks of the process that Buzz Zaino started about 40 years ago was that in difficult times the fund would not position itself defensively. We wouldn’t try to hide out in certain industries, buy gold, or do something like that, but rather position ourselves to get the maximum return as things get better. We think that we’ve executed on that again. The names that Rob, Suzanne, and Adam have helped me put in the portfolio during this period have continued in that tradition. Whether or not small-cap value comes back for whatever reason, I couldn’t tell you. I’ve been waiting for it to come back for a few years and it hasn’t. But the more relevant point is that it doesn’t have to come back for our approach to be successful.

Our stocks should be able to do well in an environment where we start getting back to normal. We don’t need to have great growth or exceptional results. We just need to get back to something resembling normal, and if we can bridge that valuation gap to where we are now over to what’s more historically typical, I think we’ll accomplish what Buzz Zaino tried to do when he started this process. Hopefully, we’re well positioned for that.

Lipper: If we look at your portfolio, you take a very different approach to value than others, which gives it a very different sector profile. Some of the people we’ve met with are hesitant about small-cap value; they’re concerned about financials for some of the reasons that Rob referred to earlier about the banks or about real estate. As you the chart below shows, this portfolio has much less exposure to these areas versus its peers while having much more to non-traditional value sectors such as tech and health care.

Highly Differentiated Portfolio vs. Small-Value Peers

 hc-techfin-re
Past performance is no guarantee of future results. Source: Morningstar. The latest available data in Morningstar was used. Sector information as of 6/30/20. Past performance is no guarantee of future results.
For the Morningstar Small Value Category:© 2020 Morningstar. All Rights Reserved. The information regarding the category in this piece is: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Morningstar Small-Value Category portfolios invest in small U.S. companies with small-cap peers. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).

Hench: All the tech and health care names were bought with the same consideration for valuation and other metrics that we take with every other name. The beauty of the tech sector for us is that the balance sheets tend to be much better than what you get in a lot of other classic value areas. We tend to get a lot of cash and no debt versus some of the more highly cyclical names. In health care, we have seen great opportunities because of the tremendous dislocation not only in that sector but in the economy as a whole.

We’ve been very light on financial stocks. When we look at small banks, we see some similarities to what’s happened in retail, where there are too many stores and not enough revenue or revenue diversification. The traditional strongholds for income have come under attack from other areas. Banks are facing competition from Square, PayPal, Rocket Mortgage, and businesses that really weren’t a factor in the last cycle.

We always tend to have a lot of industrials. These are classic value plays, if you will, and we play the cycle. We act on those ideas that present themselves because of market factors or particular circumstances with companies. We’ve been doing this for long enough that we know where and when to look and have hopefully as we should. We’ll see how it all works out over the next year to two.

Lipper: I think Bill’s being a bit modest. If I were in front of an investment committee talking about this strategy and responding to someone’s skepticism about small-cap value, I would say that historically this approach can succeed even when small-cap value index isn’t leading. To me, the best two examples are 2016, which was a value-led year, and the strategy was up nearly 30%, and in 2017, which was a growth-led year, and the strategy was up 22%. So I think the history shows that our approach can succeed when value does well and when it doesn’t. Hopefully, that gives people some facts to combat any skepticism.

 

ROYCE OPPORTUNITY FUND

 

Important Disclosure Information

Average Annual Total Returns as of 6/30/20 (%) 

  3Q201 1YR 3YR 5YR 10YR 15YR 20YR SINCE INCEPT. DATE
Opportunity 30.37 -9.13 -1.78 2.70 8.97 6.58 8.42 10.48 11/19/96
Russell 2000 Value 18.91 -17.48 -4.35 1.26 7.82 4.97 7.65 7.82 N/A
Russell 2000 25.42 -6.63 2.01 4.29 10.50 7.01 6.69 7.65 N/A

Annual Operating Expenses: 1.22

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.

Mr. Lipper, Mr. Hench, Mrs. Franks, and Mr. Kosowsky’s thoughts in this interview concerning the stock market are solely their own as of June 16, 2020 and, of course, there can be no assurance with regard to future market movements.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Percentage of Fund Holdings As of 6/30/2020 (%)

  Royce 
Opportunity Fund

Noodles & Company Cl. A

0.3

Winnebago Industries, Inc.

0.4

JELD-WEN Holding, Inc.

0.3

Masonite

0.0

Allegiant Travel Company

0.5

Netflix

0.0

Square

0.0

PayPal

0.0

Rocket Mortgage

0.0

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.

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.

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.

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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. 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. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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