Podcast: Small-Cap Quality, Value, and Fallen Angels
article , video 09-20-2022

Podcast: Small-Cap Quality, Value, and Fallen Angels

Miles Lewis and Joe Hintz join Steve Lipper to discuss the opportunities created by recent volatility and the attributes they see in three holdings in their Small-Cap Quality Value Strategy.


This podcast was recorded on 9/8/22. It has been slightly edited for clarity.

Steve Lipper: Hello and welcome, everyone. This is Steve Lipper, Senior Investment Strategist here at Royce Investment Partners. Thanks for joining us today. Our conversation today is with two of the portfolio managers from Royce’s Small-Cap Total Return Fund: Lead Portfolio Manager Miles Lewis and Assistant PM Joe Hintz. We’re going to both look back as well as look forward on the outlook and opportunities that we see for the Strategy. Let’s begin with you Miles. Looking back, let’s have your thoughts about the Fund’s performance so far this year.

Miles Lewis: Thanks Steve, and thanks for having us on. It’s great to be here. We’ve been pleased with our performance this year. If you look back over a one-, three-, five- and 10-year period as of the end of the last quarter, Total Return has beaten its benchmark, the Russell 2000 Value Index, in each of those periods. And we’re particularly proud of the one-year performance, which was in a down market and where we held up quite well. And that’s exactly what we’re supposed to do on Total Return—provide really good downside protection. In fact, if you look at the peak of the [small-cap] market around November 8th [2021] to the trough on June 16th of this year, our downside capture was about 79%, which is right in line with historical averages and slightly better than the last couple of big market downdrafts. When you risk adjust our returns, which we think is appropriate given the low volatility profile, we’re even happier with our relative returns.

“On balance, our companies did well and are expected to do better, and we can measure that quantitatively using estimate revisions. And so if you look at the portfolio in aggregate at June 30th and then you look at it through the end of last week, on average, our company's earnings estimates are expected to be higher now than they were at the end of the second quarter.” –Miles Lewis

Now that being said, I do want to be balanced. Q3 has been a challenge. It’s been frustrating, but not surprising for our style. Low quality has worked extremely well. In fact, for some of the factors that we look at, the spread between low quality and high quality is greater than 500 basis points. And there was also a pretty violent rally from mid-July to mid- August where the index was up 17%. And that is when the vast majority of our underperformance during the quarter happened. But as you look out further and further over longer time horizons, we’re very, very pleased with our performance on Total Return.

SL: That’s a terrific overview Miles. Thank you. Just to give people the actual percentage return, during that decline from November 8th to the bottom in mid-June the value index was down 22.9% and Small-Cap Total Return was down just 18%. So over 400, nearly 500 basis points of outperformance delivering, as you say, what people look to and what historically the strategy has delivered. Joe, could you give us an example of a company you’ve been able to invest in?

Joe Hintz: Absolutely. Thanks Steve. OneWater Marine, is a recreational boat dealer. And the opportunity for us exists because it is cheap for a reason, to some extent, because people are worried about how much the company over earned during the pandemic as consumers shifted to outdoor activities. However, this is a company that checks a lot of boxes for our investment process. So just to run through a few areas. For one thing, they have a fantastic M&A strategy that is both repeatable and differentiated in that they take a more localized approach, keeping the local brand value, etc., while improving profitability through operations. And we think that that strategy has a very long runway as they only have low single digit penetration into that market opportunity. The company has strong returns, strong free cash flow generation, and that free cash flow fuels the M&A strategy.

On top of that, they have other opportunities to diversify the business, has a great management team that is skillful at capital allocation. So again, just a lot of areas that we look for in our companies. But on the downside, they don’t pay a regular dividend. However, we feel that their capital allocation strategy still signals all the same things that we look for in Total Return, but they just signal it slightly differently through occasional special dividends and a recently announced share repurchase program. Again, it shows the confidence and management in the company, in the opportunity set and provides that crude proxy to quality while still giving the management team the flexibility to have cash flow used towards either capital returns or acquisitions.

SL: Joe, thanks for walking us through that. That’s a great example. Let’s talk a little bit about more currently the challenges of 2022, which is really a considerable amount of volatility. We at Royce view volatility as an opportunity. But can you update the people, Miles, on how you've been positioning the portfolio in response to all the tumult that we’ve seen this year?

ML: Sure Steve. It has been an interesting environment. There are a host of risks from inflation to recession, but the good news is that we think a lot of that is discounted in the market or at least in individual stocks, and to your point about volatility, that creates tremendous opportunity for long-term investors, like those of us here at Royce and for Total Return specifically. So what we’ve been doing, as I mentioned, the market peaked in mid November and troughed in mid-June. Sometime around May we began to make some slight, what I’ll call tactical shifts in the portfolio, and that was to position the portfolio for an eventual recovery in the market. And why did we do that? Clearly, we’re not trying to time the market. We simply can’t do that. But Royce’s research has shown that statistically the odds of having good attractive forward returns from that point in the market cycle were very much in our favor, and so what we did was, we began to trim, and in some cases exit, our more defensive holdings. These are names that just mathematically became bigger positions within our portfolio because they held up well on a relative basis. They either went down less than the market or in some cases they went up.

And so in the absence of us taking any action within the portfolio, these more defensive holdings would’ve been some of our biggest weights right at, or near the market bottom. And that’s not how we want to be positioned. So we used those as a source of cash and then used the proceeds to add to names that had really sold off in the market where we thought the risk / rewards was highly attractive and very asymmetrically in our favor. We also found a number of new opportunities to include in the portfolio. I’d say that if there was a theme that emerged there, it would be something that we call Fallen Angels. Fallen Angels are what we think of as really high-quality companies. Oftentimes they have compounder like attributes, but the valuations have compressed meaningfully into a zone that we think is attractive. All the while their long-term fundamentals and prospects in our opinion are largely unchanged. And so those are some opportunities that we saw.

JH: A couple of companies that I would highlight that fall into that Fallen Angels category are Yeti and Sapiens. Yeti is a well-known brand, relatively new entrant to the outdoor activity space. They started in hard coolers and have expanded into areas like drinkware. This is another company similar to OneWater where there are some concerns of potential over earning because of that shift to outdoor activities. However, our research suggests that Yeti has a structural and durable growth trajectory ahead of them and that these concerns are overblown. So the valuation has come in considerably on what we view as a very, very high-quality company, which lands it squarely in this is this Fallen Angel category for us.

So because it’s a consumer discretionary type of company, we recognize that this investment is essentially an investment in the brand quality. And so a significant chunk of our due diligence was focused on the brand. And again, we feel that this brand has true compounding type potential, but comes at that bargain basement valuation, hence the Fallen Angel. Our research shows potential for share gains, category innovation, margin structure, and customer loyalty, all suggest that the brand value compounding potential is strong here. And we think that they can extend that track record into new areas, new categories, like luggage, and also into the international market, which we think could ultimately end up being larger than their current dominant U.S. business. One final thing that we really like about Yeti is the resilience of the end market. Our research going back to through recent recessions is that spending in the outdoor activity area holds up very well, even through a severe recession. And so that's just one more attractive element to this company for us.

Shifting over to Sapiens, this is in the IT space. It is a global player in the software and services area providing core software to insurance companies. We think this is a fantastic market for a number of reasons, but first in terms of why the market opportunity exists, we think that at current valuations, which are very attractive, below 12 times EBITDA [earnings before interest, taxes, depreciation, and amortization] and a approximately 7% free cash flow yield, we think the market is essentially discounting an extreme deceleration in the growth potential, probably in more like the low single digit range versus historical organic growth over many years in the low teens range. So we think that’s unjustified and we like the opportunity for a few reasons. First, there is a considerable shift away from legacy technologies at the insurance customer toward these more modern software platforms. And the majority of insurance companies globally are still on legacy IT systems that are decades old.

And so this opportunity has many, many years of runway ahead of it. We also like that the implementations for customers are very bespoke and highly customized and complex. This leads to a market where we think multiple winners can succeed. Many times in software, you get kind of a winner takes all market, whereas we think this will support multiple small-cap winners. And on top of that, because of that complex nature, it leads to very high barriers to entry, very low customer churn and just very strong competitive advantages. And finally, we just love the management team here. They have exhibited very conservative tendencies around the balance sheet. The financials are extremely strong with great free cash flow generation and strong returns. And so we think that this management team will have success in continuing to build out despite some recent headwinds in the North American market, but we think they’re investing in the right areas to get their North American business really running on all cylinders.

SL: Thanks Joe and Miles. As I string those together—OneWater Marine, Yeti, and Sapiens—it’s really clear that your research goes after whatever is the case that people are concerned about in making the judgment whether it’s more permanent or more transient, and you’ve concluded it’s transient, and that combined with market volatility does give us the opportunity at these higher quality names and attractive valuations. So again, thanks for walking us through that.So we’re in the third quarter. We’re towards the end or nearly at the end of earning season. One of the things we’re always interested in is some of the more notable comments maybe you’ve heard from management teams. Miles, let’s come to you first. What has caught your ear on management commentary?

ML: I think generally speaking, what we hear in the media, reading the papers, is much worse than what we are hearing from our companies on a company-by-company basis, having listened to 75 or 80 earnings calls over the last month or two. And I’ll give you a few examples. So we own a lot of banks in Total Return. They had great earnings, but the reason that’s important is that banks are lending to small and middle market companies in the United States. This is the backbone of the U.S. economy, and those customers are healthy and they’re investing. You can see that in loan growth from the banks and you can see that in the loan pipelines, which you’re getting bigger. We also saw a ton of strength in our industrial companies, which are doing particularly well. And the forward looking commentary there, whether it be on things like backlog or demand or even guidance, was all quite strong.

The areas that we did see some weakness would be the areas that have probably been consistent with the media, so that would be housing, where higher mortgage rates have begun to slow the housing market, the lower end consumer where inflation is really making an impact, and then foreign exchange, particularly with companies that have European exposure as they translate those earnings back into U.S. dollars.

But on balance, our companies did well and are expected to do better, and we can measure that quantitatively using estimate revisions. And so if you look at the portfolio in aggregate at June 30th and then you look at it through the end of last week, on average our company’s earnings estimates are expected to be higher now than they were at the end of the second quarter. And so that tells us that even with some of those headwinds, the fundamental outlooks for our companies actually improved over the last—call it 60 or 90 days—and did not get worse, and that is pretty inconsistent with what we’re hearing in the media.

JH: One thing that we’ve found interesting recently is, we see a pretty significant disconnect right now between a lot of the macro data points, including the regional Fed survey data, which has been steadily weakening for some time now, while at the same time, many of our industrial companies, particularly industrial companies focused on more heavy manufacturing and heavy parts of the industrial economy, are talking about very, very positive end market demand. So specifically, we’re hearing areas of strength like infrastructure, automotive, and energy reshoring and nearshoring and electric vehicles. And then on top of that, you’re getting government support in some of these areas, which just further adds to that demand. We’re hearing our companies talk about their customers having record high backlogs and record low inventories that need to be replenished. So while you might have an initial gut reaction and say, “Well, okay, the survey data here, and some of the consumer focused companies in the economy are acting as more of the canary in the coal mine, and that the industrial weakness will come.” We think that there’s potentially a separate view here that could be argued, and we jokingly call this the great industrial bifurcation. I think you can see this, not just at company level, but even within the broader macro data.

So our companies have been talking specifically about a massive underinvestment within capital spending broadly, especially during COVID, which just needs to normalize. And you can look to things like CapEx to GDP as a perfect example, where we’re kind of below trend and that needs to trend back up. And a lot of our companies are even talking about being early innings in a very strong period that they would say is comparable to the ‘03-07 timeframe, which was very strong for industrials.

It makes sense, then, looking at it from that perspective that capital spending is not weakening as much because of this need for normalization within broader CapEx. So if we also then maybe zoom in on a micro level to some of our companies, we own several industrial distributors, and one is more heavily focused on the heavy industrial areas, like industrial machinery, metals, chemicals, cement, etc., whereas another one that we are invested in has a broader range of end customers and sells things more like storage and shelving units, janitorial and maintenance supplies, etc. And what we saw is that the company focused on the heavy industrial areas had a blowout Q2, whereas the more consumer-focused industrial still had relatively strong top line demand, but is seeing some challenges within their inventory because of a mismatch of demand and supply, because of some shifts at the consumer level, and ultimately, that’s impacting their margins.

So what’s the takeaway here? We think that essentially, we’ve obviously seen multiple time periods throughout the pandemic with extreme shifts in both consumer and employee behavior, and that’s wreaked havoc within the more consumer related economy, and we’re seeing that in other companies as well, where consumer companies have exhibited weaknesses because of that underlying fundamental shift in inventories and demand. On the other side with the heavy industrial end markets, they are somewhat immune to that part of the market, given this more structural need to catch up on capital spending throughout the economy.

SL: That’s great, Joe, thanks for walking us through that. And really, a very important insight about the distinction between the headlines or what people are maybe hearing from broad macroeconomic outlook versus what we’re hearing from the companies and this idea of a bifurcation and underinvestment—we’ve heard others analogize this multi-year period potentially to being the ‘03 to ‘07, which was really great years for small-cap, for small-cap value, many of the Royce strategies and many B2B businesses.

Perhaps I’ll leave our listeners with this observation that the top four industries in the Strategy: financials, industrials, IT, and materials, all B2B businesses, makeup between 75% and 80% of the overall portfolio, so a cyclical B2B continued surprise on the upside would absolutely benefit the portfolio. And I know with everything you’ve gone through about your research uncovers opportunities. I think that would give all the listeners and investors good comfort. Thank you both Miles and Joe for walking us through that, outlining the opportunities that you see ahead. Thanks all of you also for giving us your time and attention today. Have a good day.

Important Disclosure Information

Average Annual Total Returns as of 6/30/22(%)

Small-Cap Total Return -11.41 -13.63 -9.32 6.49 6.15 9.11 6.21 9.99 12/15/93
Russell 2000 Value
-15.28 -17.31 -16.28 6.18 4.89 9.05 5.58 9.28 N/A
Russell 2000
-17.20 -23.43 -25.20 4.21 5.17 9.35 6.33 8.41 N/A

Annual Operating Expenses: 1.25 (RYTRX)

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 www.royceinvest.com. 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.

The thoughts and opinions of Mr. Lewis, Mr. Hintz, and Mr. Lipper 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 6/30/2022 (%)

  Small-Cap Total Return

OneWater Marine






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.

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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. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The Russell 2000 Value and Growth indices consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 2000 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 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. Royce Small-Cap Total Return Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) In addition, as of June 30, 2022, the Fund invested a significant portion of its 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 one of these stocks would cause the Fund’s overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 25% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing Foreign Securities" in the prospectus.)



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