Small-Cap Premier Quality Strategy—4Q22 Update and Outlook
article 01-17-2023

Small-Cap Premier Quality Strategy—4Q22 Update and Outlook

Co-Lead Portfolio Managers Lauren Romeo and Steven McBoyle discuss 4Q22’s upswing, a bearish 2022, and their confident long-term outlook for the Small-Cap Premier Quality Strategy.


How did the Small-Cap Premier Quality Strategy perform in 4Q22 and the calendar year?

Lauren Romeo: Royce Premier Fund, the mutual fund we manage in the Strategy, advanced 10.0% for the quarter, and outperformed its small-cap benchmark, the Russell 2000 Index, which was up 6.2% for the same period. The Fund also beat the Russell 2000 for 2022, down -15.5% versus -20.4% and outperformed the small-cap index for the 3-, 5-, 15-, 20-, 25-, 30-year, and since inception (12/31/91) periods ended 12/31/22.

What sectors had the biggest effect on 4Q22’s performance?

Steven McBoyle: Eight of the portfolio’s nine sectors made a positive impact on quarterly performance. Industrials, Materials, and Information Technology made the largest positive contributions while the only negative impact came from Communication Services. Health Care and Real Estate made the smallest contributions to quarterly performance.

What made the biggest impacts at the industry level in the Fund?

LR: Media in the Communication Services sector, auto components from Consumer Discretionary, and semiconductors & semiconductor equipment from Information Technology detracted most for the quarter, while the biggest contributors were machinery in the Industrials sector, chemicals from Materials, and capital markets in Financials.

Quarterly performance was better relative to the Russell 2000. What were some of the details on Premier’s relative outperformance in 4Q22?

SM: Our advantage over the benchmark was primarily attributable to stock selection. Although our sector allocation decisions were also additive. At the sector level, both our lower weighting and—to a lesser degree—stock picking helped in Health Care. Our higher weightings and stock selection in both Industrials and Materials also had sizable positive impacts versus the benchmark. Conversely, our lack of exposure to Energy—which continued to perform well within the Russell 2000—hampered relative performance in 4Q22, as did the Fund’s cash holdings and stock picks in Real Estate.

Moving to the calendar year, which sectors made the greatest impacts of performance in 2022?

LR: Eight of the portfolio’s nine equity sectors had a negative impact on 2022’s performance. The sectors making the largest detractions were Information Technology, Consumer Discretionary and Industrials. The only positive impact came from Materials while Consumer Staples and Communication Services detracted least.

What about at the industry level?

SM: At the industry level, semiconductors & semiconductor equipment, electronic equipment, instruments & components—both in Information Technology—and capital markets in Financials were the largest detractors while construction & engineering in Industrials, metals & mining in Materials, and software in Information Technology contributed most for the calendar year period.

Which holding detracted most from performance in 2022?

LR: That would be Mesa Laboratories, a company that develops and manufactures electronic measurement instruments for industrial and hemodialysis customers, including pipeline flow meters and calibration instruments. Mesa saw its results temporarily depressed by higher labor costs in its Sterilization and Disinfection segment and lost sales in its Clinical Genomics business in China due to Covid lockdowns. While management quickly took actions to address its issues, the stock’s lofty valuation and our concerns that Mesa’s strategy of continuing to shift its portfolio exposure toward faster-growing health care markets such as clinical genomics, as well as protein-based and cell and gene therapies, will require additional expensive and dilutive acquisitions. We therefore opted to exit our position in order to realize a tax loss and reevaluate the name, particularly relative to other candidates and existing holdings where our conviction was higher.

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

SM: The portfolio’s top contributor was Valmont Industries, which manufactures fabricated metal products and produces metal and concrete pole and tower structures in its Engineered Support Structures & Utilities Support Structures businesses. Valmont also makes mechanized irrigation systems. It had healthy earnings throughout most of 2022, driven by continued investments in grid resiliency and infrastructure upgrades, steady demand for renewable power and clean energy solutions, and the 5G network transition. Its agriculture markets also remained strong thanks to elevated commodity prices resulting from tighter global grain supplies, the need for increased food production, and a heightened focus on food security concerns.

What were the sources of the Fund’s advantage over the Russell 2000 in 2022?

LR: The portfolio’s advantage over its benchmark came exclusively from stock selection in 2022—sector allocation was marginally negative. Among sectors, stock selection, as well as our higher weighting, helped in Industrials and Materials while we also benefited from our lower exposure and some savvy stock picks in Health Care. Conversely, our lack of exposure to both Energy and Utilities, along with a lower weighting in Consumer Staples, detracted most from relative results in 2022.

What’s your long-term outlook for the Strategy?

SM: Small-cap companies with the highest returns on invested capital (“ROIC”) outperformed in 4Q22, reasserting leadership following a pause in the 3Q22. As of the end of 2022, these high-ROIC small caps had outperformed in six of the last seven quarters. As rising rates and increasing recessionary fears drove further multiple compression, we continued to optimize the portfolio by adding to existing holdings while also initiating positions in new names where we had been awaiting attractive entry points. Our strategy of buying high-quality companies for the long term when they are out of favor due to what we see as near-term market fears, cyclical, or other temporary reasons has been a core tenet of our Premier strategy since its inception more than 30 years ago. These market dynamics allow us to buy what we think of as high-quality companies without paying premium valuations.

LR: The majority of the Fund’s holdings created economic value because they produced returns on invested capital (“ROIC”) well in excess of their cost of capital. The fact that most of this value has not yet been capitalized in these companies’ valuations should improve the portfolio’s long-term risk/reward profile. Investor sentiment is often focused on the near term, but over the long run the stock market has proven efficient at reflecting the economic value companies generate and compound in their market valuations. So, regardless of what 2023 may bring, experience has shown that our best course of action is to stick to our approach of trying to identify high-return, durable business models when they are trading at reasonable valuations and hold them for the long run (assuming, of course, that the underlying investment case remains intact or improves). Cyclical headwinds could pressure financial results in 2023, but we believe that the normalized earnings power and growth that our holdings can generate over time remain very attractive. This conviction is rooted in their unique competitive advantages (for example, switching costs, brand equity, and network effects), strong cash flows, and low-debt balance sheets, all of which should help them to not just weather a recession but also to go on offense and emerge from any downturn even stronger, poised to capitalize on secular long-term growth tailwinds such as automation, reshoring, infrastructure spending, sustainability, and electrification and digitization.

Important Disclosure Information

Average Annual Total Returns as of 12/31/2022 (%)

NET               GROSS
Premier 9.98 -15.46 3.13 5.68 8.64 10.90 12/31/91  1.17  1.17
Russell 2000
6.23 -20.44 3.10 4.13 9.01 8.92 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 12/31/22 (%)


Mesa Laboratories


Valmont Industries


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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