How did the Small-Cap Premier Quality Strategy perform in 3Q20?

Chuck Royce Royce Premier Fund, the mutual fund that we manage in this Strategy, advanced 2.6% for the quarter, though it lagged its benchmark, the Russell 2000 Index, which was up 4.9%. I think this was mostly the result of a market environment that was not very supportive of our high-quality approach.

Lauren Romeo The best performances in 3Q20 generally came from small-cap stocks with lower profitability, higher valuations, and higher leverage. Our own preference is for stocks with higher profitability, lower valuations, and lower leverage, so we were somewhat out of sync. However, Premier beat the Russell 2000 for the three-, five-, 15-, 20-year, and since inception (12/31/91) periods ended 9/30/20. And we put a high premium on long-term performance periods.

Which areas of the portfolio made the biggest impacts on performance?

Steven McBoyle Industrials made the biggest contribution, followed by Financials. Leadership from these two cyclical sectors wasn’t surprising in a quarter that saw cyclicals lead defensives. Ritchie Brothers Auctioneers was the portfolio’s top individual contributor. The company auctions industrial equipment and exceeded expectations with quarterly results that showed its auction model was more resilient than investors were expecting. Its transition to online auctions also led to higher margins.

What hurt 3Q20 performance?

CR Energy detracted most at the sector level, with Consumer Staples coming second. Kirby Corporation was the largest individual detractor as it has considerable exposure to the energy sector—the company operates a fleet of inland barges and has been struggling with the negative effects of the economic slowdown and the reduction in oil drilling. Kirby serves the energy market in several different ways, everything from oilfield services to the transportation of black oil and petrochemical liquids by barge. These areas may see impaired demand for a while as conditions in the energy industry remain pretty challenging, but we’re prepared to be patient with Kirby.

How did the Fund perform versus the Russell 2000 in 3Q20?

SM Stock selection hurt performance most—our sector allocation was additive. Consumer Discretionary was the largest relative detractor, primarily because of our underweight, though stock selection hurt as well. The sector enjoyed a really strong rebound in the quarter as consumer confidence was recovering. More specifically, we saw a negative impact in the hotel, restaurants & leisure group in Consumer Discretionary—that was our largest relative industry detractor because we had no holdings in this area, which came back strong after seeing steep declines earlier in the year. Many of the businesses in this industry have thinner margins and are generally lower quality than we aim for in this strategy.

LR Information Technology was another source of underperformance due to subpar stock selection and, less impactfully, our larger exposure. We had an overweight in electronic equipment, instruments & components, which is part of Information Technology and was the second largest industry detractor in 3Q20. Our stock selection in that group also hurt relative results in the quarter.

What worked versus the Russell 2000 in 3Q20?

SM Financials was our largest sector contributor versus the small-cap index, mostly due to stock selection, though sector allocation also played a positive role. Utilities helped somewhat, as we held no positions in this trailing area. We also had an advantage by having no exposure to banks, which has often been the case through the Fund’s history.

How did the Strategy perform year-to-date through 9/30/20?

CR The Fund lagged the small-cap index for the year-to-date period, down 11.0% versus a decline of 8.7%. Industrials was our largest sector detractor, followed by Energy. As it was for 3Q20, Kirby was the largest individual detractor for the year-to-date period. Information Technology and Consumer Discretionary were the top sector contributors, while Health Care made a small positive impact. The largest individual contributor for the period was Pool Corporation, a wholesale distributor of swimming pool supplies, equipment and related products. The company has seen a surge in demand for its products as consumers have increased stay-at-home spending through both an increase in the number of pools being built and used, which leads to more demand for the company’s supplies.

How did the portfolio compare with the Russell 2000?

LR The Fund’s relative underperformance year-to-date period was entirely due to sector allocation, as stock selection was modestly positive. Health Care was the largest source of underperformance, mostly due to our underweight in this leading sector, though stock selection also hurt. In addition, Industrials hindered our relative results solely because of stock selection—our heavy sector allocation was additive.

Where did the Fund have an advantage versus the benchmark?

CR The Fund’s largest source of outperformance on a sector basis came from Financials. Stock selection primarily drove results, although sector allocation also helped. Real Estate was the next largest contributor as our underweighting this lagging area was the dominant positive factor—our stock selection lagged.

Can you discuss a high-confidence holding in this Strategy?

SM We really like Computer Services, which delivers core processing, managed services, digital banking, payments processing, print and electronic distribution, and regulatory compliance solutions to financial institutions and corporate customers. It offers exceptional service, dynamic solutions, and superior results for its customers. The company has also had 20 years of consecutive revenue growth, 23 consecutive years of income growth, and 48 years of increased dividends—yet it has no coverage on Wall Street. 

Computer Services (Nasdaq: CSVI) 

CR The Kentucky-based company is experiencing record backlogs as it expands geographically across the U.S. The company operates four segments: Core Banking Services, which offers customizable banking in the cloud and outsourced banking; Digital Banking, where its products include a mobile banking app, online banking solutions, and website hosting and design; Financial Management Services, which include a financial cloud suite, a security suite, and an IT systems suite; Bank Regulatory Compliance, which provides about a dozen products that help companies meet federal regulations; and Payment Solutions, which gives customers access to both Internet and mobile banking.

Is there another holding you can tell us about?

LR Forrester Research is a business in which we have great confidence. Forrester offers proprietary reports, real time survey data, and consulting services that analyze the key technology trends impacting businesses. The company works with its customers on the strategies and IT investments that are necessary for its clients to remain competitive and/or to harness those technologies to their advantage. We’ve known Forrester and its management for many years. It’s a direct peer of Gartner, a former holding in our Premier Quality Strategy. 

Forrester Research (Nasdaq: FORR) 

We think the ongoing digital transformation of businesses provides a strong tailwind for secular growth as companies invest more and more in IT to expand their e-commerce capabilities, run their businesses more effectively and flexibly—think work from home—and to differentiate through improved customer experience. In this context, we see a long runway of business opportunities for Forrester.

What is your outlook for this Strategy?

CR Based on what we see in small cap’s fundamentals, current valuations, and market behavior, we’re cautiously optimistic for attractive returns over at least the next several years. We agree with the consensus that’s expecting the economic recovery to continue broadening and deepening. A consistently strengthening economy should be highly supportive for small-cap stocks, as it has been historically, especially the economically sensitive cyclical sectors that this portfolio leans toward. More recently, we have been focusing the portfolio on companies that are profitably using their technology and/or intellectual property to help other businesses innovate or execute more effectively, including Computer Services. We also like companies that help businesses make smarter decisions about technology—which is a specialty of Forrester Research. During the quarter, we did some minor rebalancing, trimming our weightings in the portfolio’s two largest industries—machinery and capital markets— while increasing holdings in two moderately weighted sectors, Health Care and Real Estate.

Important Disclosure Information