Three PMs on Small-Cap Volatility and Opportunities—Royce
article 08-31-2021

Three PMs on Small-Cap Volatility and Opportunities

Portfolio Managers Lauren Romeo, Jay Kaplan, and Andrew Palen on how they’re managing recent volatility for our flagship, Royce Pennsylvania Mutual Fund.


How has recent market volatility affected your portfolio positioning?

Lauren Romeo For me, the market’s recent volatility has been welcome because it’s created more attractive buying opportunities. We’ve added some new names in Penn where prices have come down to levels we find attractive. We’ve also seen some short-term movements in several existing holdings where investors’ focus on the near-term, negative pressures on financial results from various macro factors, such as continuing supply chain constraints and materials inflation, has created opportunities to increase our weights at valuation levels that we think don’t fully reflect the compelling secular growth drivers for businesses that have high returns on invested capital. One position we’ve added to in Penn is specialty chemicals provider Innospec. We’ve also increased our stake in Cohu—which designs and manufactures automated equipment and consumables used in the semiconductor testing process—as we believe the product mix-driven gross margin pressures behind the stock’s recent price pullback are temporary rather than reflective of the company’s long-term profit model. So while we’ve been actively buying and selling, current volatility hasn’t driven any dramatic sector or industry shifts: we continue to lean toward more cyclical areas.

Andrew Palen Volatility is an effective nudge to put cash to work, typically by increasing the weighting of high-conviction stocks with what I see as compelling risk/reward ratios. I’ve also added a few stocks that were on our watchlist where improving or compounding fundamentals aren’t reflected in the valuation. In addition, I'm constantly aggregating new information to stress test my assumptions about a given company, especially during volatile periods where it’s critical to distinguish the signal from the noise. More specifically, we recently increased positions in emerging quality businesses that are benefiting from reopenings in areas like healthcare and consumer spending, such as Mesa Laboratories and Shift4 Payments, as well as reflation in areas like Materials and Industrials, such as Eagle Materials and Rexnord. The biggest increase for the names I manage has been in Health Care while I’ve decreased my exposure to emerging quality names in Energy and Consumer Discretionary.

What’s caught your attention most on recent earnings calls?

Jay Kaplan What’s caught my attention most is the consensus that business is good. Management teams for the companies I hold have remained optimistic even amid increased volatility. Many of the companies I hold share two primary concerns right now: ongoing supply chain challenges and the tougher-than-usual effort to find qualified workers. The supply chain issues that we saw through the worst months of the pandemic—transportation being grounded, foreign markets closing down and factories being shuttered—were just beginning to abate before the Delta variant surfaced and created significant new logjams.

The semiconductor chip shortage is also a concern for many companies. It was initially considered to be a roughly six-month shortage, but—and this is admittedly anecdotal—one company I spoke to recently said we could be facing a 12-month shortage. That could be a problem considering that semiconductors are in virtually every device, appliance, and car. Inflation is also among their concerns—including labor inflation, where they’ve found they have to pay more once qualified people are hired. However, they’re confident that, at least over the short run, they can effectively manage inflation by passing on the increased costs. That’s something I’ll be watching very closely over the next several months. For all of these concerns, however, there were almost no downward revisions, which tells me that there’s still a lot of confidence in the recovering economy’s longer-term prospects.

What Stood Out In Earnings Calls

AP What’s been most interesting to me is how many of the emerging quality names I hold have been leaning into new customer acquisition and/or distribution channels. For “B2C” businesses, this means meeting customers where they are—which is online—with new engagement models, such as supplementing traditional digital methods like search and social media with more direct approaches such as email and text. On the “B2B” side, I’ve seen a major shift as enterprise buyers are completing their full purchase journey remotely, a pattern that begins with website research, followed by an informational webinar, Zoom sales calls, online paperwork, and back-end implementation completed with software. This has changed how many of our companies structure their sales & marketing teams and expenses.

Less encouraging is that the Delta variant is disrupting both semiconductor capital equipment manufacturing and semiconductor distribution, particularly in Southeast Asia. The production stoppages from last spring continue to make a negative impact, so this is a trend that bears close attention. The downstream effects of the Colonial pipeline cyberattack are also still being felt across the chemical and consumer products industries, though not in a way that presents long-term challenges. Overall, I’m still confident about the economic recovery.

In what areas of Consumer Discretionary do you see the most promising long-term prospects?

LR I have the most confidence in consumer companies with strong brand names. These are the businesses that appear best positioned to sustain their growth over the long run. The combination of strong brand equity and loyalty often gives companies a reasonable degree of pricing power, which in the near term should enable them to protect profit margins by passing through higher input and logistics expenses without dampening demand.

“The combination of strong brand equity and loyalty often gives companies a reasonable degree of pricing power, which in the near term should enable them to protect profit margins by passing through higher input and logistics expenses without dampening demand.” — Lauren Romeo

Over the longer-term, I suspect that share gains should accrue to those brands with loyal and expanding customer bases run by management teams with the proven ability to consistently develop new products and take advantage of expanding their digital presence. Companies that can manage this look poised to expand sales in both the continuing shift to e-commerce platforms and in the evolving environment where traditional brick and mortar retailers pare their supplier base to focus on—and allocate more shelf space to—brands that drive traffic and have high sell-through due to their popularity and product freshness.

JK I think the consumer area as a whole is pretty interesting right now, with a lot of factors in play. Industrial metals prices are rising as part of the overall inflationary climate, and that affects several consumer groups. Worries about another COVID wave, as unlikely as it is, still persist, with many restaurants and travel-related business feeling the pinch. However, recreational vehicle and boating companies, where Penn has several holdings, have almost no inventory and a lot of demand. The lumber shortage is just about over, which is a good sign for both homebuilders and consumers looking for furniture. The housing market still looks good, even as buyers have longer-than-usual wait times for furniture and appliances.

It’s notable that these extended waits for items have so far done almost nothing to tamp down demand. Liquidity is also robust, with government assistance helping lower-income Americans to stay afloat and participate in consumption. So we hold residential and office furniture maker La-Z-Boy, discount footwear retailer Shoe Carnival, and Rent-A-Center, which operates franchised and company-owned rent-to-own merchandise stores that sell under flexible rental purchase agreements. We also continue to hold recreational boat dealer OneWater Marine, boat equipment manufacturer Brunswick Corporation, and RV maker Winnebago Industries. All in all, and in spite of the fits and starts, the economy remains strong.




Important Disclosure Information

Average Annual Total Returns as of 6/30/21 (%) 

  2Q211 1YR 3YR 5YR 10YR 15YR 20YR 30YR 45YR
Pennsylvania Mutal Fund 2.75 53.88 12.89 15.75 10.55 8.86 9.87 11.10 13.31
Russell 2000 4.29 62.03 13.52 16.47 12.34 9.51 9.26 10.65 N/A

Annual Operating Expenses: 0.95

1 Not 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 that 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. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Ms. Romeo’s, Mr. Kaplan’s, and Mr. Palen’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 6/30/2021 (%)

Mutual Fund
Innospec 0.7
Cohu 0.4
Eagle Materials 0.0
Rexnord 0.1
La-Z-Boy 0.2
Shoe Carnival 0.5
Rent-a-Center 0.8
OneWater Marine 0.3
Brunswick Corporation 0.2
Winnebago Industries 0.4
Zoom 0.0

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.

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. The Fund invests primarily in small and micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets in foreign securities that may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)



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