Two Quality Small-Cap Cyclicals—Royce
article 05-25-2021

Two Quality Small-Cap Cyclicals

Portfolio Manager Lauren Romeo on why high-quality small-cap cyclicals look poised to do well in an expanding global economy.


Where are you finding the most interesting high quality small-cap opportunities?

I’m actually finding the best quality small-cap opportunities in the companies we already own. During 2020, we added several new names from our “on deck” list of Premier Small-Cap Quality companies as their valuations became more attractive, especially during the first half of the year when there was so much indiscriminate selling. The Russell 2000 Index rallied from the March trough to finish 2020 strong—which is typical in the first phase of small-cap recoveries. However, lower-quality companies drove this phase of the rebound, with nonearners in the Russell 2000 significantly outpacing small caps with earnings. Nonearners within the index rose 148.3% versus 80.2% for earners from 3/18/20-12/31/20.

In which sectors have you been most active?

Cyclical sectors continue to represent attractive areas to find high ROIC, durable business models at attractive valuations. Industrials, Information Technology, Financials, and Consumer Discretionary have consistently been among our top sector weights based on bottom-up stock selection. With rising vaccination rates, an accommodating Federal Reserve, and aggressive fiscal spending policy, U.S. GDP growth projections are robust for the next two years, which bodes well for more economically sensitive businesses. Valuations for small-cap cyclicals also remain below their long-term historical average, recently trading at the same multiple relative to the rest of the Russell 2000 as they did in October 2008, in the teeth of the Global Financial Crisis.

Are there any themes that you’ve been seeing as you examine companies?

One overarching theme is that many “quality business models” proved their durability and justified their reputation during the recession. Even those in industries hit hardest by the pandemic bolstered their competitive position and are now poised to emerge with greater earnings and cash flow power as the economy reopens. Many of the defensive measures that companies took to preserve cash flow have evolved into permanently reduced cost structures, such as smaller real estate footprints from permanent moves to hybrid or full work from home models. These actions, combined with the proactive moves many of our companies made while their smaller or more highly leveraged competitors were focused mostly on survival, have strengthened their moats, broadened their addressable markets, and/or increased their long-term, “normalized” operating margins relative to pre-pandemic levels.

Can you discuss what’s driven the share prices success of a company you hold?

One company would be Inter Parfums, which is a global developer and designer of prestige fragrances primarily under licenses of higher-end brands such as Mont Blanc, Coach, Jimmy Choo, and Guess. With most of its sales coming from traditional brick-and-mortar department or specialty stores or travel retail such as duty-free shops, revenue fell 24.5% in 2020. Yet operating margins fell by only 170 basis points to a still healthy 13% for 2020, reflecting the company’s high variable expense and capital light business model. So far in 2021, the stock is up more than 20%, with better-than-expected growth from improved store traffic as vaccinations are rolling out and pandemic restrictions are loosening.

What is your take on its prospects going forward?

After postponing most new product introductions throughout 2020, Inter Parfums has a particularly robust launch schedule for its major brands while product from new licensees is further accelerating sales. The company also continued to play offense during the pandemic by buying a 25% stake in a leading online perfume retailer in Europe that offers a solid platform from which to broaden e-commerce distribution. Additionally, Inter Parfums signed a long-term fragrance license with Moncler, the Italian luxury outdoor fashion brand. With the initial fragrance launch planned for 2022, Moncler has the potential to be Inter Parfum’s largest seller over time due to the brand’s appeal to the large Gen-Z demographic.

Can you tell us about a high confidence holding whose stock price has been down so far in 2021?

Multi-line industrial company ESCO Technologies operates three business segments: Aerospace/Defense, Utility Solutions, and RF Shielding and Test. ESCO has a leading position in a number of niche markets with favorable demand dynamics, 56% recurring revenue thanks in part to the Aerospace/Defense content that’s designed into long-life aircraft or submarines, and an increasing percentage of sales from higher margin proprietary products. However, the pandemic has temporarily depressed ESCO’s growth rate, largely due to declines in its commercial aerospace business, which accounts for approximately 25% of total revenue.

What do you think will help its stock recover?

One positive sign is that aircraft build rates are improving from the lows as air travel recovers. Airlines all over the globe are repositioning their fleets for a post-pandemic world while upgrading to newer models that are more environmentally friendly and cost competitive. ESCO’s sales should track this recovery over time. Meanwhile, lost in the focus on commercial aerospace headwinds is ESCO’s momentum in its U.S. Navy business. Orders for two submarine classes were released in recent quarters, for example, on which ESCO has more than $25 million in content per ship.

Are there other factors that underscore your confidence?

ESCO’s Utilities Solutions customers have had to push out infrastructure diagnostics and inspection work done by Esco. However, this is required and regulated maintenance, so there’s a limit to how long it can be deferred. There’s also the robust secular trend in higher spending on projects given the industry’s focus on grid-hardening, remote diagnostics, and cybersecurity software, as well as growth in the adoption of renewables. Finally, ESCO offers upside more generally from its history of supplementing internal growth by reinvesting a portion of its free cash flow into high-ROIC, bolt-on acquisitions. In fact, ESCO recently announced the purchase of a small Italian-based supplier of utilities test and diagnostic equipment that fills product gaps and opens distribution in areas in Europe and Asia that ESCO doesn’t currently serve.

“Along with the more favorable valuations in the cyclical sectors we prefer, I also suspect that small-cap returns are more likely to be tied to future earnings growth as opposed to multiple expansion.” — Lauren Romeo

Why do you think the current environment is well suited for high-quality small-cap companies to deliver attractive returns over the next few years?

Along with the more favorable valuations in the cyclical sectors we prefer, I also suspect that small-cap returns are more likely to be tied to future earnings growth as opposed to multiple expansion. Stock selection should begin to take precedence as investors focus on companies that have visible prospects for long-term earnings growth rooted in favorable secular demand trends, company-specific competitive advantages, and/or high return on reinvestment opportunities. These characteristics are inherent in the business models that our Premier Small-Cap Quality strategy favors.

What other potential advantages for quality do you see?

Inflation and rising interest rates, byproducts of robust economic growth, are a source of rising concern for investors. However, they should be less of a headwind for quality companies. If current inflation proves to be more than transitory, quality companies should fare well since pricing power is a key facet of many of their business models. Inter Parfums, for example, has a portfolio of franchise brands for which consumers are willing to pay up. Rising interest rates should provide a cost of capital advantage to a strategic acquirer such as Esco, given its low leverage and ability to self-fund growth through consistent free cash flow generation.




Important Disclosure Information

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

  Average Annual Total Returns (%)
  QTD2 1YR2 3YR 5YR 10YR 15YR 20YR 45YR/Since
Date Annual
Expenses (%)
Pennsylvania Mutual1 13.48 85.72 13.71 15.42 10.05 8.27 10.63 13.26 N/A 0.95
Premier 10.45 70.56 13.53 16.63 9.94 9.29 11.59 N/A 12/31/91 1.21
Russell 2000 12.70 94.85 14.76 16.35 11.68 8.83 9.76 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.
2Not 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 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 Class shares 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 Operating expenses reflect each Fund's total annual operating expenses for the Investment Class as of each Fund's most current prospectus and include management fees and other expenses.

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.

Ms. Romeo’s thoughts and opinions 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.

Percentage of Fund Holdings As of 3/31/2021 (%)

Premier Fund

Inter Parfums












ESCO Technologies



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.

Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

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 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 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.)



Sign Up