Royce Small-Cap Special Equity Fund—3Q22 Update and Outlook
article 10-18-2022

Royce Small-Cap Special Equity Fund—3Q22 Update and Outlook

Portfolio Manager Charlie Dreifus updates investors on how Royce Small-Cap Special Equity Fund outperformed its benchmark in 3Q22 and in the bearish first nine months of the year.

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How did Royce Small-Cap Special Equity Fund perform in 3Q22 and over longer-term periods?

The Fund declined 3.6% for the quarter, outperforming its primary benchmark, the Russell 2000 Value Index, which was down 4.6% for the same period. Small-Cap Special Equity was down 16.0% for the year-to-date period ended 9/30/22, outpacing both its primary benchmark—which fell 21.1%—and its secondary benchmark, the Russell 2000 Index, which declined 25.1% for the same period. The Fund also beat the small-cap value index for the 1-, 3-, 5-, 15-year, and since inception (5/1/98) periods ended 9/30/22 and outperformed the Russell 2000 for each of these periods except the five-year period. This is consistent with the Fund’s history of strong down-market results.

“Smart, successful companies that will do relatively better in the environment we foresee are cutting costs significantly now. In addition, domestic small-caps remain at a significant discount to large-caps as measured by trailing twelve-month P/E’s. In fact, small-caps are relatively cheaper than they have been since before the Great Financial Crisis 15 years ago.” —Charlie Dreifus

How was performance at the sector and industry level in 3Q22?

Seven of the Fund’s eight sectors made a negative impact on quarterly performance, with the biggest detractors coming from Consumer Discretionary, Materials, and Real Estate while the only positive impact came from Industrials. Financials and Communication Services made the smallest detractions in 3Q22. At the industry level, three areas in Consumer Discretionary detracted most for the quarter: auto components; leisure products; and textiles, apparel & luxury goods while diversified consumer services (Consumer Discretionary), food products (Consumer Staples), and electrical equipment (Industrials) were our largest contributors.

Which positions had the biggest impact on 3Q22 performance?

The portfolio’s top detractor at the position level for the quarter was Standard Motor Products, which manufactures replacement parts and related items for the automotive industry, including ignition and electrical parts, emission and engine controls, and sensors, among others. The top contributor was H&R Block, which specializes in income tax return preparation and do-it-yourself tax return preparation services and products.

At the sector level, how did the Fund perform versus the Russell 2000 Value in 3Q22?

Our advantage over the benchmark was entirely attributable to stock selection in the quarter. Stock picking was a significant advantage in Industrials, as was our low weighting in Real Estate and stock selection in Communication Services. The portfolio’s cash position also contributed positively to relative performance. Conversely, stock picking detracted in Consumer Discretionary versus the benchmark while our lack of exposure to Health Care and Energy also hurt relative results.

How did the Fund perform at the sector and industry level for the year-to-date period ended 9/30/22?

Seven of eight sectors had a negative impact on year-to-date performance. The sectors making the largest detractions were Consumer Discretionary, Information Technology, and Materials. Communication Services made the only positive impact while Financials and Consumer Staples detracted least. At the industry level, auto components (Consumer Discretionary), semiconductors & semiconductor equipment (Information Technology), and leisure products (Consumer Discretionary) detracted most for the year-to-date period, while diversified consumer services (Consumer Discretionary), media (Communication Services), and commercial services & supplies (Industrials) contributed most.

Which holdings had the biggest impact on year-to-date performance?

Interestingly, the same two positions had the biggest impacts on 3Q22 and year-to-date performance—our top detractor was Standard Motor Products while our top contributor was H&R Block.

How did the Fund fare versus the Russell 2000 Value for the year-to-date period ended 9/30/22?

The portfolio’s advantage over its benchmark was again solely due to stock selection in the year-to-date period. Stock picking in Industrials, Communication Services, and Consumer Discretionary made the biggest positive relative impact. As was the case in 3Q22, our cash position again contributed positively to relative performance. Conversely, our lack of exposure to Energy and Utilities detracted most from relative year-to-date period results, followed by our substantially lower weighting in Financials.

What is your outlook for the economic and market environment?

We are still seeing too much so-called good news on strong data to expect to achieve a soft landing. Much more economic slack needs to be created. To reach the Fed’s self-imposed bar of needing to see “clear and convincing data” of a strong enough slowdown, we need much weaker employment, wage increases, and Personal Consumption Expenditure (“PCE”) inflation readings. The bottom line—in the Fed’s own words (and we will see if this translates to deeds)—is that it will take a hard landing to stomp out inflation. This is all happening when nominal growth is exclusively inflation driven. The resulting damage will lower revenues and earnings. The nastiest impact will be on those companies that have depended on price hikes to offset higher costs. Smart, successful companies that will do relatively better in the environment we foresee are cutting costs significantly now. In addition, domestic small-caps remain at a significant discount to large-caps as measured by trailing twelve-month P/E’s. In fact, small-caps are relatively cheaper than they have been since before the Great Financial Crisis 15 years ago.

Important Disclosure Information

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

  QTD1 YTD1 1YR 3YR 5YR 10YR 15YR 20YR SINCE
INCEPT.
05/01/98
Small-Cap Special Equity  -3.61 -15.98 -8.83 5.97 3.26 6.57 6.55 8.12 8.06
Russell 2000 Value
-4.61 -21.12 -17.69 4.72 2.87 7.94 5.70 8.81 7.14
Russell 2000
-2.19 -25.10 -23.50 4.29 3.55 8.55 6.40 9.36 6.58
1 Not annualized.

Annual Operating Expenses: 1.20

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.

Mr. Dreifus’s thoughts and opinions concerning the stock market are solely his 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 (%)

  Small-Cap Special Equity

Standard Motor Products

5.2

H&R Block

4.4

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.

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.

The Price-Earnings, or P/E, Ratio is calculated by dividing a company's share price by its trailing 12-month earnings-per-share (EPS). The Portfolio's P/E ratio calculation excludes cash holdings and companies with zero or negative earnings.

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 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. The 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.) As of 09/30/22, the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than 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.)

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