Four Small-Cap Quality Innovators —Royce
article 11-22-2022

Four Small-Cap Quality Innovators

PMs Lauren Romeo and Steven McBoyle on four holdings that are addressing secular opportunities.


With earnings season having wrapped up and the market remaining volatile, what is your take on current opportunities for Royce's Small-Cap Premier Quality Strategy?

Lauren Romeo: Despite a strong showing through the recent rally, many small-cap quality companies appear attractively valued on an absolute basis and relative to small-caps as a whole. As a result, we still see opportunities where stock prices appear to have diverged materially from the value of the company’s underlying business. In these cases, investor focus seems to be on near-term earnings cyclicality rather than a company’s long-term earnings power and ability to compound value that is inherent in companies with sustainably high returns on invested capital (ROICs) and ample reinvestment opportunities.

Steven McBoyle: There is a disconnect between the share price and value creation that is embedded in our Premier small-cap companies. This provides opportunities for the investor as well as our portfolio companies as they may be able to take advantage of this dislocation through value creating activities, including capital investment, talent acquisition, and corporate events. Further, given that our portfolio companies are addressing secular growth opportunities and have strong balance sheets, times like these create strong reinvestment opportunities—an important ingredient to the long-term compounding effects we seek.

Can you discuss a key holding in the Strategy a piece that you see as an innovator?

“Given that our portfolio companies are addressing secular growth opportunities and have strong balance sheets, times like these create strong reinvestment opportunities—an important ingredient to the long-term compounding effects we seek.”
—Steven McBoyle

SM: One good example would be Avid Technology, which is a multi-media technology company. Avid has been a pioneer in innovation for decades when it comes to audio and video editing in collaborative content creation. Their software and integrated solutions for video and content creation, management, distribution, and storage are dominant in the collaborative content creation industry. Specifically, Avid’s flagship ‘Media Composer’ software is used by all the major film studios and leading streaming services to create movies, television shows, and commercials. Their ‘Maestro’ solutions provide for the integration of virtual sets and augmented reality into collaborative workflows. The company also provides Avid ‘Link,’ a mobile application to connect with other artists, producers, mixers, composers, editors, videographers, movie makers, and graphic designers. Importantly, Avid is agnostic as to whether content growth comes from traditional media enterprises or streaming services—in both cases their solutions are viewed as mission critical. We believe Avid is well positioned to capitalize on several long-tailed industry trends—the growing digitization of media assets, increasing content creation, and the rapid expansion and splintering of distribution platforms. Recently, Avid’s shares fared well in October’s robust rally for small-caps and its share price strength continued after the company reported strong third-quarter results in early November.

Avid Technology (Nasdaq: AVID) 12/31/21-11/16/22

AVID US Equity

Past performance is no guarantee of future results.

What about a holding that is taking advantage of the trend toward greater data usage and/or digitalization?

LR: I think MKS Instruments is a good example. The company holds dominant market shares providing critical, enabling instruments and subsystems to semiconductor capital equipment and advanced electronics markets. MKS is currently facing strong cyclical headwinds that will likely drive a double-digit decline in industry capex next year – e.g., industry supply chain issues causing shipment delays; a reduction in the pace of new orders due to slower spending on consumer electronics and more cautious enterprise IT budgets in the face of a recession; and recently expanded US export controls on advanced semiconductor capital equipment to China.

MKS Instruments (Nasdaq: MKSI) 12/31/21-11/16/22


Past performance is no guarantee of future results.

However, with MKS’s stock down more than 50% this year, we believe the impact of these factors on near-term earnings is fairly discounted and that the stock’s valuation gives very little credit to favorable secular tailwinds that, when combined with MKS’s competitive advantages, should enable the company to generate significant earnings and cash flow growth over the long run. Namely, as the “internet of things” drives semiconductor proliferation and as leading edge chips have become more complex to make and package, spending on new, and more, semiconductor capital equipment will continue to grow over each cycle. MKS is poised to continue taking advantage of higher capital intensity in chip manufacturing as the company’s scale advantages and broad product portfolio make it a one-stop shop supplier, with “sticky” sales because its proprietary technologies are designed into customers’ equipment.

In more recent years MKS has broadened and diversified its addressable market by leveraging its core technologies to the Advanced Electronics and Specialty Industrial markets, where similar miniaturization trends that drove semiconductor capital intensity are also occurring. It has supplemented this organic growth by acquiring and improving the performance of several companies with laser, photonics, and optics capabilities to address the growing need for laser-based precision manufacturing techniques by these non-semiconductor customers. Finally, the recent acquisition of a process chemistry solutions provider with a leadership position in advanced electroplating solutions will increase MKS’ recurring revenue from consumables and services to about 40% of sales.

Is there another holding in this category you can talk about?

SM: Another would be Forrester Research , a U.S. research and advisory firm with a global reach that serves leading companies across diverse industries and departments, including technology, marketing, customer experience, product, and sales functions, providing insights in order to accelerate growth. Specifically, customers use Forrester’s proprietary reports, real time survey data, and consulting services to analyze key technology trends—digitization being a must understand topic for most industries today. Digital transformation is incredibly disruptive, though it can also be a significant growth driver for so many industries, and, again, Forrester provides these customers mission critical insights. We like the recurring revenue nature of Forrester’s model as customers engage in annual research subscriptions with very high renewal rates. We also like the B2B nature of their business model and its asset light nature, which results in very strong free cash flow generation and high returns. Recently, and not uncommonly for companies selling enterprise solutions, Forrester’s revenue has been affected by elongated sales cycles, particularly in Europe, as customers wait to see how the economic outlook unfolds. Additionally, the company had higher-than-anticipated salesforce attrition in the U.S., reflecting the tight labor market as well as Forrester’s move to a “contract value” focused sales incentive plan over the past year. This could well be a temporary issue as the company now has a large cohort of newly trained salespeople that should become productive soon. Forrester also continues to acquire talent in order to expand sales capacity to support its goal of double-digit annual contract value growth.

Forrester Research (Nasdaq: FORR) 12/31/21-11/16/22


Past performance is no guarantee of future results.

Are there any holdings in the Strategy that are providing solutions to customers to increase sustainability?

LR: Specialty chemicals manufacturer Innospec has driven accelerated organic growth through new product development targeted at capitalizing on its customers’ sustainability concerns. This is most evident in its Performance Chemicals segment in which personal and home care product manufacturers, which account for roughly 75% of the segment’s sales, are in the early innings of a global effort to reformulate their products with more environmentally friendly and natural ingredients, without compromising performance. Innospec has fast-tracked several high-return-on-investment capacity expansion projects that will come on line over the next two years to meet demand. Similarly, both regulatory mandates and voluntary efforts by heavy fuel users to reduce emissions are driving demand for fuel additives, particularly in Asia where additive use is low, but fuel demand is growing at an above-average pace. Finally, Innospec’s management has a strong track record of disciplined acquisitions that strengthen its existing portfolio or broaden its product offerings into other high margin specialty chemicals. With no debt and strong cash flow, we think Innospec is primed to take advantage when valuation multiples contract or if a recessionary environment causes larger or more highly leveraged players to monetize specialty chemicals businesses they deem non-core.

Innospec (Nasdaq: IOSP) 12/31/21-11/16/22


Past performance is no guarantee of future results.

What is your long-term outlook for the Premier Quality Strategy?

LR: A little more than a year into the bear market that began with the last peak for the Russell 2000 Index on 11/8/21, the small-cap index was down 21.6% through mid-November, even after a more than 13% rally off the low on 6/16/22. The domestic mutual fund we manage in the Strategy, Royce Premier Fund, outperformed from the November 2021 peak through 11/15/21, being down only 13.8%. This performance was consistent with the downside protection the Strategy’s ownership of quality companies has historically provided. While a year of negative performance is never our goal, we believe that the Fund’s risk/reward profile has improved as we have been actively trying to take advantage of valuation inefficiencies created by indiscriminate selling and heightened volatility during the bear market. We’ve been averaging down on price while increasing our weights in our highest conviction holdings, as well as optimizing the portfolio by adding new positions that appear to have superior business models trading at attractive valuations. Assuming that our analysis is sound, these actions should help reduce overall portfolio risk and potentially improve returns since we are lowering the cost bases relative to our estimates of the companies’ intrinsic values, which we think will be reflected in the market as the companies compound shareholder value over the long term.

SM: I think it’s important to highlight that there exists not only a favorable absolute and relative valuation argument for small-cap quality companies, but, equally important, there is a disconnect between our Premier holdings’ stock prices and the embedded value creation that exists with those holdings. Time arbitrage of buying high-quality companies for the long term when they are out of favor in the near term due to cyclical or other temporary reasons has been a core element in Premier strategy since its inception more than 30 years ago.

Important Disclosure Information

Average Annual Total Returns as of 9/30/22 (%)

NET               GROSS
Premier -4.87 -16.29 2.67 4.95 8.16 10.65 12/31/91  1.17  1.17
Russell 2000
-2.19 -23.50 4.29 3.55 8.55 8.79 N/A  N/A  N/A
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 and Mr. McBoyle’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 9/30/22 (%)


Avid Technology


MKS Instruments


Forrester Research




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).

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. 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. The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also generally invests 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 in Foreign Securities" in the prospectus.)



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