How did the Small-Cap Opportunistic Value Strategy perform in 2Q22 and the first half of 2022?

Brendan Hartman The mutual fund we manage in the Strategy, Royce Small-Cap Opportunity Fund, declined 18.2% for the quarter, lagging its benchmark, the Russell 2000 Value Index, which was down 15.3% for the same period. This is consistent with the portfolio’s history—where we’ve underperformed in down markets but outperformed when the market rebounded.

How has the Fund done versus its benchmark over longer-term periods?

Jim Stoeffel Picking up on Brendan’s comments, we weren’t surprised that the Fund lagged the small-cap value index for the year-to-date period ended 06/30/22, down 22.1% versus 17.3%. Longer-term relative performance, however, was much better. The portfolio outperformed the Russell 2000 Value for the three-, five, 10-, 15-, 20-, 25-year, and since inception (11/19/96) periods ended 6/30/22.

What were the Fund’s results in 2Q22 on a sector basis?

Jim Harvey Eight of the portfolio’s 10 equity sectors made a negative impact on quarterly performance, with Industrials, Information Technology, and Consumer Discretionary making the biggest detractions. The only positive impacts came from Energy and Consumer Staples while Communication Services made the smallest detraction.

What happened at the industry level during 2Q22?

Kavitha Venkatraman The biggest detractions for the quarter came from metals & mining in Materials; machinery, from the Industrials sector; and semiconductors & semiconductor equipment in Information Technology. These were among our biggest weightings in 2Q22 because we like each group’s long-term prospects. On the positive side, oil, gas & consumable fuels from the Energy sector and food products in Consumer Staples each made a positive impact while personal products in Consumer Staples was flat. So while it was a very challenging quarter, our long-term confidence is high.

How did the Fund perform on a sector basis versus the Russell 2000 Value in 2Q22?

JS Our disadvantage versus the benchmark came primarily from sector allocation in the quarter, although stock picks also hurt. We saw this dynamic in Financials, where our lower weighting detracted considerably more than our stock selection. In Industrials and Materials stock picking hurt more, though our respective overweights in each sector also hampered relative results. Conversely, stock selection gave us a relative advantage in Energy and Communication Services, and our cash position was also a positive versus the benchmark in the quarter.

Which sectors made the greatest impacts on performance for the year-to-date period ended 6/30/22?

BH Nine of our 10 equity sectors made a negative impact on year-to-date performance. The biggest negative impacts came from Industrials, Information Technology, and Consumer Discretionary. Energy made the only positive contribution—along with a marginal one from cash—while Consumer Staples had the smallest negative effect.

What about at the industry level in 2022’s first half?

KV As was the case in 2Q22, semiconductors & semiconductor equipment from Information Technology and machinery in Industrials were significant detractors, as was specialty retail from Consumer Discretionary for the year-to-date period. On the other hand, oil, gas & consumable fuels contributed—as it did in 2Q22. The Fund also got positive impacts from chemicals in the Materials sector and pharmaceuticals from Health Care in 2022’s first half.

What were the sources of underperformance versus the Russell 2000 Value for the year-to-date period?

JH Our disadvantage came almost entirely from sector allocation in the year-to-date period—stock selection had only a marginal negative effect. Our greater relative exposure to Information Technology and Consumer Discretionary made sizable detractions, as did stock selection in Industrials. However, stock picking was a strength in Materials, as was our substantially lower exposure to Health Care. Our cash position also contributed to relative performance in 2022’s first half.

What is your outlook for the Strategy?

JS The ongoing war, rising interest rates, and continued inflationary pressures presented challenges in 2Q22. I think how much the Fed tightens into a slowing economy and whether we enter a recession will be the key determinants as to when stock prices begin to recover. There is a strong possibility that inflation peaked in 2Q22, as yields and energy prices reached highs in mid-June. The University of Michigan Consumer Sentiment Index is at an all-time low—which is remarkable, considering it is lower than during the crash of the dot com bubble, the Financial Crisis, and COVID. Current uncertainties notwithstanding, we remain confident in what we are holding, with many positions having low-debt balance sheets, one of the main factors that should help businesses contend with the current tumultuous environment—even if inflation proves increasingly persistent. We have been trimming some inflation beneficiaries, most notably in areas such as materials and shipping. Infrastructure names continue to benefit from steady demand for steel and other materials to build roads and bridges, as well as to repair and maintain aircraft.

BH We’ve also seen shares of homebuilders tumble as interest rates rise, but many of these companies are very well run, and we think opportunities will emerge. The need for communications equipment throughout the world has not diminished, despite current conditions. The same is generally true for many healthcare companies—so we are adding to existing names and researching potential new ideas. Conversely, we see Consumer Discretionary as likely to remain weak, at least until it is clear that inflation is stabilizing. Of our four investment themes, we continue to look most closely at undervalued growth stocks as many such companies are trading at 52-week lows. As always, we seek companies that we believe offer the best combination of attractively low valuations with strong long-term growth potential.

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