Small Caps and Inflation—Royce
article 06-22-2021

Small Caps and Inflation

We recently asked four of our small-cap value portfolio managers to tell us how increasing inflation is affecting the way they’re managing their strategies.


Charlie Dreifus, CFA®—Royce Special Equity Fund

Having managed portfolios during the highly inflationary 1970’s, I believe those experiences have prepared me to be especially attentive to inflationary forces.

To that end, I see some good news and some not-so-good news in the current climate of greater inflation. The good news is that inflation is often a result of economic strength and thus reinforces the attractiveness of the value/cyclical spectrum of the market, where we are heavily weighted. Historically, cyclical value tends to outperform when inflation and interest rates rise, particularly if caused by improved business conditions. The not-so-good news is the potential for inflation absent economic growth—stagflation.

Increased inflation should cause interest rates to rise—another environment in which cyclical value names tend to do better than growth, but the market also faces a headwind if rates rise as it boosts the relative attractiveness of fixed income over equities. In addition, if inflation rises as the growth of money supply is being reduced while the economy remains strong, financial assets could be liquidated to fund the real economy. This is the opposite of what occurred earlier this decade, and more recently during the pandemic, when there was a flood of money supply but little to no demand for the increased liquidity in the real economy, thus inflating the prices of financial assets. (Those interested in learning more about this mechanism can refer to “Marshallian K.”)

Inflation Beaters

Our goal in our portfolios is to own names that would potentially not suffer any ill effects from higher inflation. We use a disciplined value approach to buy inexpensive securities with little debt that generate ample free cash flow. These are also capital light businesses with a history of increasing their dividends—and all of these attributes have historically proven effective in inflationary periods. Last, but far from least, among these criteria, we look for companies in sectors where capacity has been reduced or removed—which gives them greater pricing power—another effective tool when inflation is rising.

Jim Stoeffel—Royce Opportunity and Micro-Cap Funds

At this point, we take the arguably contrarian stance that inflation is a temporary phenomenon related to the rapid reopening of the global economy and the attendant pressure on supply chains, which were effectively shut down by the pandemic. Two striking examples of the inflationary effect supply chain challenges are creating can be seen in the skyrocketing, record-high prices of lumber and used cars. We have holdings that have benefited from these increases. Pricing pressure—including labor, which remains in short supply—however, is currently pervasive across sectors and industries.

In the short term, we have been tactically adjusting position sizes based our view of a company’s ability to deal with increased pricing. The ability of our companies to increase prices and pass-through costs often depends on who their customers are. In general, we expect B2B companies to fare better than B2C over time as it’s possible consumers feel the pinch of inflation at some point. We have been net sellers of restaurant stocks, which face both labor and food cost pressures, while we view luxury brands, homebuilders, and advanced materials distributors as better positioned to pass through pricing.

B2B vs. B2C

So while inflation is very much with us, we look again to the lumber industry, where inflationary pressures appear to be subsiding a bit, as a possible harbinger. As such, we are already in the process of determining where we may see buying opportunities in the next three to six months as inflation fears abate.

Finally, we suspect inflation expectations could bifurcate. Industrial and precious metals, for instance, have been subject to years of underinvestment and have comparably long production lead times. As the global economy expands, we believe there will be significant increases in capital spending in these areas and therefore see select mining companies and their attendant suppliers as particularly interesting long-term investment opportunities.

Miles Lewis, CFA®—Royce Total Return, Pennsylvania Mutual, and Dividend Value Funds

Virtually every company we have spoken with recently seems to be seeing inflation—and all are talking about it. So, while we are bottom-up investors and do not make meaningful changes to our portfolios based on macro developments, we do listen closely to what the management teams of our holdings tell us.

Equally, if not more important, Total Return adheres to a disciplined philosophy of owning high-quality, dividend-paying stocks that we believe are undervalued. This bias typically leads us to companies with ample pricing power that are thus well equipped to handle inflation. For example, on a recent earnings call a company we hold mentioned ‘inflation’ 16 times and referenced ‘pricing’ 29 times in conveying confidence in its ability to pass on increased costs.

We believe that many holdings could benefit directly from inflation. We have been leaning into some of those stocks by adding to existing positions on the margin. Industrial distributors are one example. These businesses are poised to see a vibrant recovery as the economy expands but also tend to see their operating margins and earnings improve in an inflationary environment. Most distributors serve a smaller, more fragmented customer base and are thus able to quickly pass along higher prices from their suppliers—for example, industrial equipment manufactures. These price increases usually outpace the cost-inflation the distributor is experiencing, resulting in higher margins and earnings.

Holdings that May Benefit from Higher Inflation

Another area that we believe can benefit from inflation are the regional and community banks we own. The link here is less direct—higher inflation often leads to higher rates and signifies strong economic growth, both of which would benefit the industry. Though the banks have had quite a run, we think they still represent attractive risk-reward, largely due to the potential for higher rates, driven in part by higher inflation.

Jay Kaplan, CFA®—Royce Small-Cap Value, Pennsylvania Mutual, and Capital Small-Cap Funds

There’s no question that inflation is here and is likely to grow. Ample liquidity and a rebounding economy are a perfect recipe for inflation. My view is that Fed policy will be key to managing its effects. The central bank’s target goal of 2% inflation before the question of easing or tapering remains reasonable. If the process of tapering is gradual, then I suspect that both the economy and markets should ultimately be OK. However, there’s always the risk that the Fed may try to do too much too quickly, which would impede economic growth and negatively impact share prices.

As for the market more specifically, there are critical issues that are both stoking inflation and leading to uncertainty about the earnings picture in 2022—earnings for 2021 should remain strong as they’re being measured off 2020’s recession. Among the most important challenges are those facing supply chains—the waiting times for appliances and other household items are several months long across most of the U.S. There are additional issues surrounding the majority of us going back to offices and/or getting back to work. How many of us return to offices and how frequently we commute are still open questions that will create ripple effects for restaurants, retail, and real estate.

In my portfolios, I’m most heavily weighted in Industrials, Consumer Discretionary, Financials, and Information Technology. My holdings in Industrials include companies that look well positioned to deal with current supply chain issues as well as those that appear more than capable of passing on costs in our inflationary environment. Constricted supply and high demand have led me to companies involved in household goods and furniture, where I anticipate sales should remain robust.

Financials are little trickier in that rising rates and a steeper yield curve should help banks, which are awash in cash (in large part based on PPE relief). Loan growth, however, remains weak. Of course, that could shift as the economy strengthens. Within technology, the ongoing semiconductor shortage is creating a ripple effect in which demand is outstripping supply in many industries such as auto manufacturing.

Chip Shortage Opportunities

The chip shortage could last through the end of 2021. My tech positions are holding up well for now because they’re well capitalized and otherwise built to withstand the supply shortage. With demand unlikely to cool significantly, their long-term prospects look attractive to me.



Important Disclosure Information

Average Annual Total Returns as of 3/31/21 (%)

  Average Annual Total Returns (%) Annual
Expenses (%)
  QTD 1YR 5YR 10YR 15YR 20YR 45YR/Since
Date Gross Net
Capital Fund–Micro-Cap Portfolio 17.63 113.82 14.87 6.02 6.15 9.20 10.64 12/27/96 1.43  1.33
Capital Fund–Small-Cap Portfolio 20.92 85.01 7.36 6.80 6.29 9.26 10.11 12/27/96 1.15  1.08
Dividend Value 11.51 68.14 11.28 8.56 8.06 N/A 9.02 5/3/04 1.52 1.34
Micro-Cap Fund 17.66 114.67 15.58 6.15 6.70 9.65 11.38 12/31/91 1.34 1.24
Opportunity 25.06 151.72 20.28 12.24 9.64 11.75 13.16 11/19/96 1.23 1.23
Pennsylvania Mutual 13.48 85.72 15.42 10.05 8.27 10.63 13.26 N/A 0.95 0.95
Small-Cap Value 20.75 86.72 7.64 5.11 5.75 N/A 9.13 6/14/01 1.55 1.49
Special Equity 13.23 61.35 10.76 8.23 7.95 10.12 9.06 5/1/98 1.21 1.21
Total Return 17.12 74.37 12.31 9.52 7.69 9.48 10.77 12/15/93 1.25 1.25
Russell Microcap 23.89 120.33 18.10 12.20 7.93 10.13 N/A N/A N/A N/A
Russell 2000 12.70 94.85 16.35 11.68 8.83 9.76 N/A N/A N/A N/A
Russell 2000 Value 21.17 97.05 13.56 10.06 7.38 9.53 N/A N/A N/A N/A
Russell 2500  10.93 89.40 15.93 12.20 9.53 N/A N/A N/A N/A N/A

1For Royce Pennsylvania Mutual Fund, the average annual total return shown is for the 45-year period ended 3/31/21.

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 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. Investment and Service Class shares of Royce Dividend Value, Micro-Cap, Opportunity, Pennsylvania Mutual, Small-Cap Value, Special Equity, and Total Return Funds redeemed within 30 days of purchase may be subject to a 1% redemption fee payable to the Fund. Redemption fees are not reflected in the performance shown above; if they were, performance would be lower. Current performance may be higher or lower than performance quoted. Current month-end performance may be obtained at For Royce Capital Fund–Small-Cap Portfolio and Royce Capital Fund-Micro-Cap Portfolio, total returns do not reflect any deduction for charges or expenses of the variable contracts investing in the Fund. All performance and expense information reflects results of the Funds’ oldest share Class (Investment Class or Service Class, as the case may be). Gross annual operating expenses reflect the Fund’s gross total annual operating expenses and include management fees, any 12b-1 distribution and service fees, other expenses, and any applicable acquired fund fees and expenses. Net annual operating expenses reflect contractual fee waivers and/or reimbursements. All expense information is reported as of the Fund’s prospectus dated 5/1/20. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses, excluding brokerage commissions, taxes, interest litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business, and to the extent necessary to maintain net operating expenses at or below: Royce Capital Fund–Micro-Cap Portfolio; 1.08% for Royce Capital Fund-Small-Cap Portfolio; 1.34% for Royce Dividend Value Fund; 1.24% for Royce Micro-Cap Fund; and 1.49% for Small-Cap Value Fund through April 30, 2021. Acquired fund fees and expenses reflect the estimated amount of fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see “Primary Risks for Fund Investors” in the prospectus.) Certain Funds invest a significant portion of their respective assets in foreign companies that may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see “Investing in Foreign Securities” in the prospectus.) Therefore, the prices of securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of securities of U.S. companies. (Please see “Primary Risk of Fund Investors” in the prospectus.) Certain Funds generally invest a significant portion of their assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause their overall value to decline to a greater degree. A broadly diversified portfolio, however, does not ensure a profit or guarantee against loss.

The thoughts and opinions of Mr. Dreifus, Stoeffel, Lewis, and/or Kaplan concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

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.

There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

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.

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.

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 unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index along with the next smallest eligible securities as determined by Russell. The Russell 2000 Value Index consists of the respective value stocks within the Russell 2000 as determined by Russell Investments. The Russell 2500 is an index of the 2,500 smallest publicly traded U.S. companies in the Russell 3000 index. 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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