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

Lauren Romeo The mutual fund we manage in this Strategy, Royce Premier Fund, fell 12.8% in 2Q22, holding its value markedly better than its benchmark, the Russell 2000 Index, which declined 17.2%. Although negative performance is never our goal, we were pleased that our portfolio of high-quality small-cap lost less than our benchmark. 

Steven McBoyle A similar pattern held for the year-to-date period ended 6/30/22. Premier was down 19.2%— hardly a desirable absolute return. However, the Fund outperformed the Russell 2000, which lost 23.4% in the index’s worst-ever first-half performance by a wide margin. We were pleased that these better down market results allowed the Fund to maintain its longer-term advantages over the Russell 2000. Premier beat the small-cap index for the one-, three-, five-, 15-, 20-, 25-, 30-year, and since inception (12/31/91) periods ended 6/30/22. The Fund’s average annual total return since inception was 10.9%. We’re very proud of the Fund’s long-term performance record. 

What sectors had the biggest effect on 2Q22’s performance? 

LR With such a widespread decline in small-caps as we saw in the quarter, it’s probably not a surprise that each of the 10 equity sectors where Premier held investments made a negative impact on performance. Our two biggest—Information Technology and Industrials—detracted the most by far, followed by Financials. The smallest detractions came from Consumer Staples, Communication Services, and Health Care.

What made the biggest impacts among the Fund’s industry groups?

SM At the industry level, two groups in Information Technology made the first and third largest negative impact: electronic equipment, instruments & components and semiconductors & semiconductor equipment. Capital markets, from Financials, was second. Only two industries finished the second quarter in the black—auto components (Consumer Discretionary) and commercial services & supplies (Industrials). Supporting Lauren’s earlier observation, that gives you an idea of what a challenging quarter it was. 

Yet the news was more encouraging relative to the Russell 2000: what were some of the details on Premier’s relative outperformance in 2Q22? 

SM Our advantage over the benchmark came entirely from stock selection in the second quarter. It was especially strong in Industrials, Consumer Discretionary, and Materials—the sectors that made the most significant positive impact versus the Russell 2000. Conversely, both stock selection and our lower weighting detracted in Consumer Staples, as did our lack of exposure to Utilities and Energy. 

Turning to the first half of the calendar year, which sectors made the greatest impacts of performance? 

LR It’s a very similar story, given that this was the worst first half for small-cap performance in more than 40 years. As investors might expect, all the portfolio's nine sectors detracted from year-to-date performance through the end of June. This truly was a “nowhere to run, nowhere to hide” first half for small-caps. The Information Technology, Industrials, and Consumer Discretionary sectors had the biggest negative effect while the smallest came from Communication Services, Real Estate, and Consumer Staples. 

What did poorly at the industry level in 2022’s first half, and which areas contributed? 

SM Electronic equipment, instruments & components, from Information Technology; capital markets, which is in Financials; and machinery, from the Industrials sector, detracted most for the year-to-date period while insurance, which is also in Financials; metals & mining in Materials; and marine, another area in Industrials, were the largest contributors. 

Which holding detracted most from performance for the year-to-date period ended 6/30/22? 

SM That would be MKS Instruments, which makes equipment that’s used to control and analyze gases in the semiconductor manufacturing process. Its shares fell more than 30% in the second quarter. The SOX (Philadelphia Semiconductor Index) index was down 25.5%, so MKS’s decline in part reflects the general sell-off in semiconductor capital equipment stocks, which is rooted in growing evidence that inflation has begun to blunt spending on discretionary items, including smartphones and other consumer electronics. Trade press sources also reported that major foundries were beginning to push out equipment orders as inventories in some chip categories begin to normalize. More specific to MKS, the company faced ongoing delays in getting approval from China’s regulator for its proposed acquisition of Atotech, a global leader in electroplating chemicals used in the chip and printed circuit board manufacturing processes. Atotech would increase MKSI’s consumables revenue stream by 40% and reduce the overall cyclicality in its business. Despite the recent pullback and rising near-term cyclical headwinds—which include a possible digestion phase for semiconductor capital equipment—we believe MKS’s leadership in critical semiconductor capital equipment components and its efforts to replicate its successful strategies in adjacent markets both position the company to benefit from long-term secular growth drivers, such as the proliferation of semiconductors, increasing complexity in the structure and packaging of next generation chips, and increased miniaturization in microelectronics. 

What was the portfolio’s top-contributing position for 2022? 

LR Our top contributor was Meridian Bioscience, a profitable health care company that manufactures consumable reagents used in in-vitro diagnostic (IVD) tests and develops IVD tests and instruments. The company has a particularly strong niche position in various gastrointestinal diseases. Following a 27% gain in 1Q22 on a reacceleration in its diagnostic test volume growth and new product-driven share gains in reagents, its stock rose 17% in 2Q22 despite very little public, company-specific news. The reason behind its rise was revealed on July 7, when Meridian announced an agreement to be acquired by SD Biosensor, a South Korean healthcare company, and its private equity partner for $34 share in cash. While this was a minimal premium to the current price, it was 32% above Meridian’s stock price at the time the initial offer was made privately a few months earlier. 

How did the portfolio stack up versus the Russell 2000 in 2022’s first half?

SM As was the case in the second quarter, our relative advantage came exclusively from stock selection in the year-to-date period, with stock picking especially effective in the Health Care, Industrials, and Consumer Discretionary sectors, which made the most significant positive impact versus the benchmark. Conversely, Energy and Utilities again detracted because of our lack of exposure, while Consumer Staples hurt relative year-to-date results due to both stock selection and our underweight in the sector. 

What is your outlook for the Fund? 

LR It appears that near-term market sentiment will continue to be dominated by fear and uncertainty in the face of multiple—and some countervailing—macroeconomic trends that have varying implications for the stock market—especially inflation, rising rates, and a slowing economy. We believe these conditions will continue to favor small-cap quality as investors seek shelter in companies with durable business models, strong balance sheets, and consistent free cash flow generation. The financial flexibility to self-fund growth irrespective of near-term cyclical trends positions quality companies to capitalize on secular opportunities that are growth tailwinds for many of our companies—for example, those involved in automation, digital transformation, infrastructure spending, and semiconductor capital intensity. While our holdings aren’t immune from recessions, their strong financial characteristics should give them the ability not only to survive difficult macro conditions, but also to emerge stronger when conditions improve. They should be able to take market share from weaker, more highly leveraged competitors and/or acquire them at attractive multiples. We saw similar dynamics during the Global Financial Crisis and the recent pandemic. The case for quality within small-caps also has valuation on its side. At the end of June, small-caps were at their lowest relative valuation versus large-caps in more than 20 years. Within small-cap, quality—as measured by high ROIC (returns on invested capital)—continues to trade at a discount to profitable small caps and the Russell 2000 as a whole. We believe this combination of durable business models and attractive valuations makes the portfolio a potentially attractive way to receive solid relative downside protection while also generating attractive long-term returns on an absolute and relative basis.

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