Podcast: AI Opportunities, Resilient Banks, and Industrial Shifts
article , video 09-06-2023

Podcast: AI Opportunities, Resilient Banks, and Industrial Shifts

Lead Portfolio Manager Miles Lewis and Assistant Portfolio Manager Joe Hintz discuss current opportunities in three key sectors in their Quality Value Strategy with Co-CIO Francis Gannon.


This transcript has been edited slightly for clarity.

Francis Gannon: Hello and welcome everyone. This is Francis Gannon Co-Chief Investment Officer here at Royce Investment Partners. Thank you for joining us today. Our conversation today is with two of the portfolio managers for Royce Small-Cap Total Return, Lead Portfolio Manager Miles Lewis and Assistant Portfolio Manager Joe Hintz. We're going to look back as well as forward on the outlook and the opportunities that we're seeing for this Strategy in today's market.

“The interesting thing is that the wild swings in the economy that the pandemic created were actually making those business models shifts hard to see. So much so that we think that the market has not fully realized the power and potential of the shifts. An interesting trend we're seeing now is that the slow normalization of the economy is finally allowing the improved fundamentals of these companies to shine through.”
—Joe Hintz

Small-Cap Total Return has had a strong start to the year and through the end of June is outperforming its benchmark, the Russell 2000 Value Index year to date, but more importantly has outperformed in the 1-, 5-, 10-, 15-year basis through the end of August, and from the low of the Russell 2000 Value Index at the end of September of last year.

Without question, it has been an interesting year—and what a difference a few months can make. Gone for the moment are the widespread predictions of looming recession risk, and now healthy disinflation talk is all the rage. Not all is rosy, however. With bond yields having backed up, the overall yield curve remains inverted.

Miles let’s start with you. Having just concluded second-quarter earnings season—reporting season, I should say—what are the most interesting or important developments you're hearing on your earnings calls and from management teams through the end of the second quarter?

Miles Lewis: Sure. Thanks Frank. And thanks everyone for having us on today. I would say a few observations. I'll start with the banks, which I think is still a very relevant topic despite the fact that it may seem like yesterday's news. And the thing that stood out to us during earnings season is that bank results were much more resilient than feared, at least relative to the stock price reactions you saw in the spring. And there's a few things that that really jumped out to us.

The first is that the business models are not broken. I think that was a common narrative back in March, April, and May. But small regional and community banks have a very important role to play in serving small and middle market companies throughout the United States, and that's a role that the big banks really can't fill very well. That was evident throughout the different discussions we had with management teams in the quarter.

The second observation would be that the bulk of funding cost pressures are really in the rearview mirror. They were most acute in that March, April, May timeframe, but banks told us that as things progressed through the quarter and into the third quarter, funding cost pressures began to abate. In fact, a few of our banks are talking about NIM [net interest margin] expansion in the second half of ’23. That was a very pronounced issue for a short period of time, but it does appear for now, assuming the interest rate environment and the outlook there continues to hold, that the worst is behind us.

The next observation is credit, which continues to hold up extremely well. That's pretty typical for this part of the cycle. When you're very late in the cycle, credit looks about as good as it can possibly get until it doesn't. So, it will deteriorate at some point, but it has been our view for quite some time that the biggest risks in the lending market have really migrated outside the regulated banking industry and into the shadow banking sector. We feel that when credit terms for the regulated banks, the banks that we own, it will be a minor income statement event and not some sort of existential crisis or balance sheet event. Within credit, commercial real estate, which was a big topic for a few months, also continues to hold up very well.

Then the last observation on the banks was loan demand, which has actually been fairly tepid, and that's consistent with the surveys that you see where banks are talking about tightening lending standards. You're seeing commercial real estate loans decelerate, you are seeing C & I loans, or commercial and industrial loans, almost flat, perhaps going negative on a year-over-year basis in some cases. But even that varies by region and where you are in the country.

FG: Joe, what are you hearing from companies around AI? We just had a really strong quarter from Nvidia. I'm curious what you're hearing from companies at least through the end of the second quarter around AI.

Joe Hintz: Absolutely. Thank you so much Frank. Obviously, everybody is talking about artificial intelligence, and I think coming out of the second quarter, it has become very clear that that generative AI demand is very, very real. The interesting part, though, is that the length of time that will be required until AI drives company fundamentals in a positive way will vary widely across the tech landscape.

Right now, everybody is focused on model training, which just means building out the underpinnings of things like Chat GPT. The computing power and all the supporting hardware components required to develop those models is mind-blowingly massive, and all of that spend is going into the data center. Any company with a tie-in to that type of activity is seeing a considerable shift in their medium-term outlook, and that shift is happening faster than any of these companies anticipated, which has not only positive implications, but also the negative side effect of potential supply chain challenges going forward.

On the negative side, within data centers, there's also a broader digestion period underway following massive acceleration of data center investments that was driven during the pandemic by the digitization of everything. This is creating kind of a somewhat confusing push-pull effect right now in terms of seeing big declines on one side that are perhaps only partially being offset in the near term by the rapid acceleration of AI-related spend.

One company that we own that is currently unfortunately being whipsawed by that effect is Coherent. Amongst a very broad list of varying technologies that they sell, Coherent is a dominant provider of optical networking equipment, which is essentially the rails that data travels on into and within a data center. They are seeing huge demand growth for very high-speed data rates to power that massive compute of AI, but they are also seeing significant near-term headwinds for the remaining data center spend. While this push-pull is unfortunate, we take a long—term view here and are excited by the future potential of their market position.

If I shift over to software companies, they are all touting their focus on driving new use cases from AI. But the actual economic benefits, if any, are incredibly hard to quantify or predict at this point for software companies, even though they're all talking about it. That being said, we do think that there are some opportunities where software and hardware overlap right now. I'm specifically thinking about a company we own called Teradata. They provide the best software for optimizing data and analytics within what is called a data warehouse. And that can benefit from the need to use software to optimize the hardware performance for things like generative AI. So, we would view a company like that as having secondary benefits from what we just discussed around data center spend patterns.

FG: Joe, moving on to Industrials, can you tell me what you're hearing there?

JH: We own several companies that have gone through significant shifts in their business models over the past several years. The interesting thing is that the wild swings in the economy that the pandemic created were actually making those business model shifts hard to see. So much so that we think that the market has not fully realized the power and potential of the shifts. An interesting trend we're seeing now is that the slow normalization of the economy is finally allowing the improved fundamentals of these companies to shine through.

I'll give you just a couple of examples. UFPI [UFP Industries], which makes various wood products for construction and other areas, demonstrated this quarter that margins at the low point of the cycle will be at significantly higher levels than they have been in the past. This is due to a complete shift in mix away from commodities toward value-added products. In other words, creating value for the client is bringing a whole new level of pricing power, which is hugely beneficial in difficult times. However, the stock valuation continues to imply that UFPI is either still a commodity-oriented business or that it is massively over earning. We do not think that either of those statements is true.

For AIT [Applied Industrial Technologies], an industrial distributor, the shift toward bringing new products and services to market, like automation and engineered solutions, is driving a similar margin uplift story. Not only are their new offerings higher margin themselves, but increased wallet share with clients increases throughput at the existing service center infrastructure, and those higher volumes similarly drive margins higher. This is a win-win, as customers get higher value -added service, and AIT gets economies of scale. While the market has been quicker to realize this shift than at UFPI, we still think there is a huge runway of opportunity for the company to continue this strategic playbook.

FG: Thanks Joe. It seems like it's been a pretty dynamic period of time, especially from an earnings and an outlook standpoint for many industries and sectors. Miles, the portfolio has a large exposure to Financials on both an absolute and relative basis. Can you talk about how you see the sector?

ML: Frank, I'm glad you asked that question. It's one that comes up pretty frequently with clients and prospective clients, and so I just want to step back for a second and kind of provide a little bit of a refresher for those that might be a little less familiar with the strategy. We do have a big exposure to Financials, but Financials exposure does not equal banks. Our Financials exposure is very diverse, and that is very intentional. A little less than 40% of our Financials exposure is in banks. However, we are underweight the group and fortunately we were underweight the group heading into the banking issues that occurred beginning in early and mid-March of this year.

The second-largest exposure that we have within Financials, which is a little over a third of our Financials exposure, is insurance, and even our insurance holdings themselves are quite diversified. For example, we own quite a few property and casualty [“P&C”] insurance businesses. These would be specialty and commercial insurance companies or reinsurance companies. We also own title insurance companies, which have nothing to do with P&C and are very correlated with the U.S. housing market.

One of our larger positions is Assured Guaranty, which is actually a bond insurance company providing financial guarantee policies largely for municipal borrowers. It has very little correlation to any of the things that we've talked about. So even within insurance, we have a great deal of diversification. The remaining exposure within Financials is spread out pretty evenly amongst various types of businesses ranging from stock exchanges to FinTech to asset managers.

There is significant diversity by business model and the underlying drivers of the businesses by the amount of cyclicality that we have in terms of economic exposure, exposure to interest rates, and the risk that's created with that exposure. And so it is very intentionally and by design a diverse portfolio.

FG: Joe, given the volatility we've seen across the Financials sector this year, how have how have you guys been positioning yourselves? Have you been adding to any positions or finding new opportunities?

JH: Absolutely. We felt that the banking crisis earlier this year created meaningful opportunities in the in the banking space. We actually added four new banks in the second quarter. However, we kept the overall bank industry weight flat to be in line with our longer -term views of the space. In other words, we sold outperformers to fund these new opportunities.

We also saw a lot of really great opportunities and so therefore added aggressively to existing holdings where we saw similar disruption in the market. For example, Bank United, one of our holdings, was trading at approximately 50% of liquidation value. That type of valuation implies massive, massive distress. But on the contrary, Bank United was actually allowed to submit a bid on the Silicon Valley Bank acquisition. What that means is that the regulators actually had to bless Bank United in order to even submit a bid. When you take it in that context, the bank’s valuation actually made no sense to us and was completely distorted from reality because on the one hand the market was saying that they're overly distressed, and on the other hand you have the regulators, who actually can kind of see what's going on, blessing the health of the bank.

Finally, we continue to feel very strongly about our P&C insurance thesis, as Miles said. The pricing, the hard market, remains very robust and so fundamentals are strong, so we feel very, very confident about our positioning there.

FG: Thank you, Miles and Joe for a great discussion about where you're finding opportunities in the market and how your consistent application of your process is enabling you to capitalize on this volatile market. Thank you all for joining us.

Important Disclosure Information

Average Annual Total Returns as of 6/30/2023 (%)

NET               GROSS
Small-Cap Total Return 6.50 9.42 14.29 5.81 7.76 9.97 12/15/93  1.26  1.26
Russell 2000 Value
3.18 6.01 15.43 3.54 7.29 9.17 N/A  N/A  N/A
Russell 2000
5.21 12.31 10.82 4.21 8.26 8.54 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 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. Lewis’s, Mr. Hintz’s, and Mr. Gannon’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.

Percentage of Fund Holdings As of 6/30/23 (%)

  Small-Cap Total Return



Teradata Corporation


UFP Industries


Applied Industrial Technologies


Assured Guaranty




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.

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.

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.

As of 6/30/23, the Fund had a 36.5% weighting in Financials versus 23.3% for the Russell 2000 Value Index.

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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. 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.) 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.)

Low Volatility:The Fund was in the lowest volatility quintile compared with all funds in Morningstar’s Small Growth, Small Blend, and Small Value Categories with at least five years of history, a total of 514 funds as of 12/31/22. The universe consists of each fund’s oldest share class only. Volatility quintiles are based on the average five-year standard deviation for each of the last four calendar quarters. Higher volatility is usually associated with higher risk.

Return on Invested Capital: (“ROIC”) 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). The portfolio calculation is a simple weighted average that excludes cash, all non-equity securities, investment companies, and securities in the Financials sector with the exceptions of the asset management & custody banks and insurance brokers sub-industries. The portfolio calculation also eliminates outliers by applying the inter-quartile method of outlier removal. As of 12/31/22, the Fund’s weighted average ROIC was 19.6% versus 9.2% for the Russell 2000 Value Index.

Valuation: The Fund’s valuation versus the Russell 2000 Value Index is based on the harmonic average of two fiscal years’ price to earnings (P/E) ratios—which were 10.9x for the Fund and 11.2x for the index at 12/31/22. The P/E ratios were calculated by dividing a company’s current stock price by its earnings per share and exclude companies with zero or negative earnings (13% of portfolio holdings, and 28% of Index holdings as of 12/31/22). Harmonic Average is a weighted calculation that evaluates a portfolio or index as if it were a single stock and measures it overall. It compares the total market value of the portfolio (or index) to its share in the earnings or book value, as the case may be, of its underlying stock.



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