Royce Micro-Cap Fund delivered strong absolute and relative returns in 2020, advancing 24.5% and beating both of its benchmarks, the Russell Microcap and the Russell 2000 Indexes, which returned 21.0% and 20.0%, respectively, for the same period. We talked to Lead Portfolio Manager Jim Stoeffel and Portfolio Manager Brendan Hartman about their risk-aware approach, two key holdings, and their outlook for micro-caps stocks —one of the most vibrant asset classes in the market over the last 12 months.

How do you go about selecting micro-caps stocks?

Jim Stoeffel We begin by looking at micro-caps, mostly in the $50 to $500 million market capitalization range at the time of purchase, that we believe can ultimately become multi-billion-dollar companies. This entails several significant considerations. Among the most important are the ultimate size of the company’s addressable market, the competitive advantage in its market, and, perhaps most important, is the management team’s ability to execute against its strategy. This last consideration is particularly important in micro-cap organizations, and our confidence in management builds enterprise conviction. The intersection of enterprise conviction and valuation generally determines position sizes in the portfolios.

Brendan Hartman The opportunities that we find typically fall into three broad categories: The first are companies that are in nascent industries, such as e-gaming, that have the promise of strong growth over the intermediate term. The second are more established companies with a strong competitive position in established industries that still have the opportunity to generate solid compound annual growth. Finally, we look for more traditional true value opportunities, where we see a catalyst for change, whether it be a new management team, a strategic acquisition, regulatory change, etc., that will allow the company to grow.

How do you deal with some of the higher risk and volatility inherent in the asset class?

JS We start by holding a broadly diversified portfolio of around 125 stocks. While we’re generally agnostic about sector and industry weightings, we’re also diversified along that vector as well. That said, one industry where we’ve historically been notably underweight, given its lack of companies with steady earnings, is biotechnology—which in itself is among the more volatile market segments. Cash flows and balance sheets are another critical element in our process for developing enterprise conviction. Operating leverage is an inherent risk in micro-cap companies, which often lack scale. We try to offset this by minimizing financial leverage.

It’s also important to recognize that we see volatility as one of the key factors that makes micro-cap investing attractive. Because we’re long-term investors, volatility often allows us to more effectively choose entry and exit points. For example, we like a few conservatively capitalized, well-managed niche players in the semiconductor equipment space that serve the industry’s faster growing segments. During the height of the pandemic, our conviction in these stocks never wavered even as their prices fell. We continued investing and maintained our overweight, which was a critical element in the portfolio’s success in 2020.

Can you tell us about a high confidence holding that demonstrates how you select companies?

BH One that particularly exemplifies our investment process is Magnite, which provides technology that helps publishers across all forms of media maximize the value of their digital inventory with advertisers. The company is one of the largest third-party providers of these services, acting as an independent option to the “walled gardens,” such as Google and Facebook. Magnite was formed through the merger of digital advertising infrastructure company Rubicon Projects and software business Telaria. We held Rubicon in the past but sold our shares because we lost conviction in management’s ability to execute its strategy. Not long afterward, the Board of Directors replaced them with a highly experienced new team.

JS Because we’d been so intrigued by the original opportunity, we spent a lot of time with the new management team to better understand how they intended to fix what had gone wrong. We were impressed with their strategy and reinitiated a position in Rubicon not long before the merger—and at a time when the company had negative enterprise value. The new management team began executing successfully, which bolstered our enterprise conviction enough to make the company a large holding before the upside potential in the stock was fully recognized. More recently, we’ve been trimming our stake as its price has been climbing.

When we first looked at Rubicon, it was part of a nascent, rapidly growing industry. Our second look took place as it was falling into the deep value category, though with a growth catalyst in the form of the new management team. This is a pattern that’s not uncommon in the micro-cap universe. Going forward, we expect Magnite to continue performing well as the number of third-party providers is consolidating rapidly, and publishers increasingly want to monetize their advertising space outside the Googles and Facebooks of the world.

What about a holding that hasn’t yet taken off but where you still have high confidence?

BH A good example is Haynes International. Haynes is a specialty metals manufacturer that has a lot of exposure to the aerospace, chemical, and industrial gas turbine markets. We initially saw it as an out of favor value investment when CEO Mike Shor took over a few years ago. Mike is a very experienced metals executive with a track record of success at Haynes’s larger competitor, Carpenter Technologies.

While he and his team have made great strides improving the operating processes and culture at Haynes, they were also struck by a black swan event when the FAA grounded Boeing’s new 737 Max plane after several high-profile crashes. Then came COVID-19, which grounded global travel. These unforeseen events have significantly curtailed demand in Haynes’s end markets, but we believe the recovery is underway with the recertification of the 737 Max. We’re also confident that the vaccine rollout will help air travel to rebound, with considerable pent-up demand resulting from more than a year of lockdowns. All of these developments should allow Haynes to be a more consistently profitable company.

What is your outlook?

JS Even in strong markets like the one we’ve experienced over the last 12 months, we can find opportunities, whether they be in developing industries, companies successfully executing and thus opening up much larger opportunities, or businesses going through company-specific changes. So, while markets can become cheap or expensive, there is rarely a dearth of opportunities for us in the micro-cap space. In the same way that we used the downside volatility of the early stages of the pandemic to take bigger positions in our highest conviction ideas, we’re currently using the upside volatility associated with the reopening to partially rotate out of our bigger winners into areas where we see compelling opportunities, such as banks, energy, and industrial materials, such as Haynes. As a result, the number of stocks in the portfolio will likely creep up as we’re developing enterprise conviction in our newly added holdings. This is a great example of the ebb and flow in the portfolio that comes with our investment process.

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