Royce Smaller-Companies Growth Fund enjoyed a very impressive performance in 2020, advancing 49.3%. The Fund handily outpaced its benchmark, more than doubling the 20.0% gain for the Russell 2000 Index. It also beat the benchmark for the one-, three-, five, 10-, 15-year, and since inception (6/14/01) periods ended 12/31/20. We sat down with Chip Skinner, the Fund’s portfolio manager, to talk about his approach, his outlook, and two key holdings.

How would you describe the Growth at a Reasonable Price or “GARP” approach you use in Smaller-Companies Growth Fund?

I think of it as a true GARP approach in that I look closely at a company’s revenue growth rate and its valuation at the time of purchase, in addition to other metrics. My goal is to find companies that dominate their market and look capable of sustaining their growth over the long term. I’m also searching for companies that have the potential to become dominant players in their market or niche. This second group tends to be small- or mid-cap companies in industries that are going through some sort of major innovation-based transformation, shifts that are probably best understood as being analogous to what Amazon did to brick-and-mortar retail. These companies therefore tend to have a long runway of growth and a tailwind in the form of favorable industry dynamics.

Can you discuss a high confidence holding in the portfolio that’s been doing well?

One of the best performers in the Fund last year—and one that’s done well so far in 2021—is Sea. Headquartered in Singapore, Sea has been described as the Amazon of Southeast Asia because of its dominance in more established markets, which include Indonesia, Malaysia, and the Philippines.

Sea has two established businesses—a mobile game platform called Garena and an e-commerce site called Shopee—in addition to an emerging business in online payments platform/electronic wallet. When I first began building a position in January 2019, its market cap was in the mid-single digit billions, and Sea now has a market cap of roughly $128 billion. One of the biggest challenges in running a GARP strategy is determining whether or not to sell or reduce a position with the potential to be a long-term success—and Sea is a perfect example of the wisdom of letting winners run. The company reported $4.4 billion in annual revenues for 2020, with high margin cash flow from its gaming platform currently helping to fund the loss-making e-commerce business. In spite of its large market cap, it remains a top holding based on what we see as an ongoing runway for growth.

Why do you think Sea can continue to perform well?

Sea is still growing about 100% year over year. The company recently reported quarterly results, with $1.6 billion in revenues, a 102% increase year-over-year. That puts it on track for more than $6.5 billion in revenues for calendar 2021. Needless to say, it’s a rare beast that can grow revenues organically in excess of 100% on such a large revenue base.

We’re also confident in its e-commerce business. Once an e-commerce site establishes itself as a market share leader, it begins to attract more sellers, which in turn attracts more buyers to whom they can sell more products and services in a virtuous cycle, and Sea is beginning to enter Latin America and other large markets. Given Amazon’s ubiquity, it may sound surprising that e-commerce is still in its early phase—but online purchases are estimated to still be less than 15% of total retail sales for 2020. So the question is, how much higher can that go? I suspect that it’s much higher than 16%.

Can you discuss another holding in which you have high confidence?

Ambarella, which develops of a specific type of semiconductor called a ‘system on a chip’ (SOC) that is used in video cameras, is a holding that’s only recently begun to contribute positively. The company has been publicly traded for several years, and when I first looked at it, GoPro was by far its largest customer. GoPro went public with a heavily hyped IPO, as it made a video camera that could be strapped onto a skier’s helmet, used in remote-controlled drones, placed on your dog, etc. And with YouTube’s growth as a major social media platform, every kid wanted a GoPro. Once that fad disappeared, however, Ambarella’s revenues went down with it. To make matters worse, Ambarella’s SOC had less intellectual property than it does today.

However, the company knuckled down by investing in R&D and diversifying its customer base away from GoPro. The company embedded artificial intelligence in their solutions and today have a new technology solution called Computer Vision (CV). The first applications have been relatively mundane, such as professional security and consumer doorbell cameras. Yet these are fast growing areas as the company is displacing older cameras, and management has suggested that CV chips could account for 25% of 2021’s revenues, up from 10% in 2020—and that’s before a third suite of automobile products begins to roll out in 2022 and 2023.

With each new model year, we see an increasing number of camera sensors for Advanced Driver Assist Systems (ADAS). But these are largely “dumb” camera chips—and driverless vehicles are likely to require more advanced processing on their camera chips, which gives Ambarella an opportunity for its solutions to be designed into future models.

What else informs your long-term confidence in the company?

In addition to the current markets that use Computer Vision, there’s considerable potential for Ambarella’s video technology to be used in robotics, industrial manufacturing automation, and traffic management, just to name a few of the very large end markets that will need more sophisticated video applications in the next several years. CV could therefore overtake the company’s other products as the uses expand to these areas. These CV products are also higher margin, and once they’re designed into a company’s products, it takes time, effort, and money to design them out—which creates stickier customer relationships.

What's your outlook for the portfolio?

I feel very good about how the portfolio is positioned as I look ahead to the rest of 2021. Several industry themes that did well in 2020 are working so far this year, including cloud software, drug discovery tools and services, e-commerce, and industrial automation. I also continue to find exciting new areas to research—there’s no turning off the U.S.’s technology and innovation engine, which is now running fast and effectively. My only caution is that the market has moved up quite a bit since the March 2020 lows. Valuations are more stretched than they were during last February and March when the pandemic hit the US. It’s historically typical for a healthy small cap bull market to undergo periodic 10-15% corrections, and I won’t be at all surprised if we see one in 2021. Beyond that, I’m optimistic.

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