Royce Small-Cap Total Return—3Q22 Update and Outlook—Royce
article 10-11-2022

Royce Small-Cap Total Return—3Q22 Update and Outlook

Portfolio Managers Miles Lewis and Joe Hintz update investors on how Royce Small-Cap Total Return Fund performed in an up and down 3Q22, the challenging first nine months of the year, and their optimistic long-term outlook.



How did Royce Small-Cap Total Return Fund in 3Q22 and over longer-term periods?

Miles Lewis: The Fund, which is part of Royce’s Quality Value Strategy, declined 10.1% for the quarter, lagging its benchmark, Russell 2000 Value Index, which was down 4.6% for the same period. The portfolio also lagged its benchmark for the year-to-date period ended 09/30/22, down 22.3% versus 21.1%. Most of our underperformance occurred for both the quarter and the year-to-date period occurred during the rally that ran from July to mid- August. The Fund beat both the Russell 2000 Value and the Russell 2000 in 2022’s first half.

How did performance shake out at the sector and industry level in 3Q22?

Joe Hintz: It was a very challenging quarter in which nine of 11 sectors in the benchmark finished in the red while all 10 of the portfolio’s equity sectors made a negative impact on quarterly performance. The biggest detractions came from Information Technology, Financials, and Consumer Discretionary while the smallest negative impacts came from Health Care, Communication Services, and Energy. At the industry level, insurance (Financials), electronic equipment, instruments & components (Information Technology), and household products (Consumer Staples) detracted most, while our biggest contributors were banks (Financials), machinery (Industrials), and hotels, restaurants & leisure (Consumer Discretionary).

“Forward returns for small caps are again looking increasingly attractive due to the recent downdraft in the market while volatility is creating a myriad of opportunities in individual stocks as valuations compress and increasingly decouple from their underlying fundamentals.” —Miles Lewis

At the sector level, how did the Fund perform versus its benchmark?

ML: The portfolio’s disadvantage versus its benchmark came primarily from stock selection in the quarter, with Information Technology, Financials, and Energy making the most significant negative impact versus the benchmark. Conversely, our substantially lower weighting in Real Estate, a combination of stock selection and lower exposure to Communication Services, and Utilities contributed most to relative quarterly results.

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

JH: Nine of the portfolio’s 10 equity sectors made a negative impact on year-to-date performance. Financials, Industrials, and Information Technology had the biggest negative impact. Energy made the only positive impact, while Health Care and Communication Services made the smallest detractions.

ML: At the industry level, two areas in Financials—insurance and banks—were the largest detractors, followed by electronic equipment, instruments & components (Information Technology). Our biggest contributors were containers & packaging (Materials), energy equipment & services (Energy), and entertainment (Communication Services).

Which holding detracted most for the year-to-date period ended 9/30/22?

JH: That would be Franchise Group, which owns four consumer businesses: The Vitamin Shoppe, Pet Supplies Plus, and two discount furniture retailers. Its shares suffered earlier this year after its plans to acquire retailer Kohl’s—a deal that would likely have been highly accretive for Franchise Group—fell through. Its stock has also experienced the same weakness that recessionary concerns have inflicted on most other retailers. Our view is that its core assets are uncommonly resilient and therefore likely to see a more limited impact from a recession, specifically the Vitamin Shoppe and Pet Supplies Plus, which account for the majority of the firm’s earnings.

What was the Fund’s top contributing position for the year-to-date period?

ML: Interestingly, it was an acquisition target that was also our top contributor for both the first quarter and the first half of 2022. It was industrial packaging company Intertape Polymer Group, which makes Water Activated Tape, the black tape on Amazon boxes. When we first invested, we saw it as an effective backdoor play on e-commerce that was trading at a deeply discounted multiple. Our research and due diligence were then validated in early March when Intertape agreed to be taken private by a private equity buyer at an 82% premium to its prior close.

For the year-to-date period, how did the Fund fare versus the Russell 2000 Value?

JH: The portfolio’s disadvantage versus the benchmark came solely from sector allocation in the year-to-date period—stock selection was marginally positive. Both our lower exposure and, to a lesser extent, stock selection hurt relative results in Energy. Stock selection hurt in Consumer Staples as did our significantly higher weighting in Information Technology. On the other hand, stock selection was a strength in Materials, as were both stock picks and our lower weighting in Communication Services. In addition, our lower exposure to Real Estate contributed to relative year-to-date results.

What is your outlook for the Fund?

ML: It was certainly a wild quarter, with sharp moves up and down in the market. Stubbornly high inflation has led the Federal Reserve to be more hawkish in their quest to stomp out inflation using their primary tool, interest rates. Consequently, interest rates moved up sharply late in the quarter, while stocks did the opposite. Historically, when the Fed is tightening, particularly as aggressively as they are at present, quality stocks have outperformed. This was not the case in 3Q22, when small-caps with the highest returns on invested capital underperformed. However, we expect this to mean revert over time, and for high quality–which remains historically inexpensive–to again outperform. There are three positive aspects to the current market environment. First, forward returns for small caps are again looking increasingly attractive due to the recent downdraft in the market. Second, volatility is creating a myriad of opportunities in individual stocks as valuations compress and increasingly decouple from their underlying fundamentals. Third, we believe a plausible argument can be made that interest rates are likely to remain above the historically low levels of the post-Great Financial Crisis era. If this is the case, we expect Financials–particularly regional banks and P&C insurance companies–to disproportionately benefit, as more than four decades of downward trending interest rates created meaningful headwinds to margins in the sector. With valuations in Financials already at highly attractive levels, the rate thesis need not unfold for Total Return to do well, but we believe it adds one more reason to view the portfolio favorably.

Important Disclosure Information

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

Small-Cap Total Return -10.09 -22.35 -17.01 2.70 2.73 7.33 5.64 8.21 7.87 9.49
Russell 2000 Value
-4.61 -21.12 -17.69 4.72 2.87 7.94 5.70 8.81 7.43 9.02
Russell 2000
-2.19 -25.10 -23.50 4.29 3.55 8.55 6.40 9.36 6.73 8.25
1 Not annualized.

Annual Operating Expenses: 1.25

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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies.

Mr. Lewis’s and Mr. Hintz’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 9/30/2022 (%)

Franchise Group


Intertape Polymer Group


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.

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.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. 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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