Podcast: Compelling Small-Cap Values in Today’s Market
article , video 09-12-2023

Podcast: Compelling Small-Cap Values in Today’s Market

Portfolio Managers Jim Harvey and Brendan Hartman discuss AI, two high-confidence holdings, and where they’ve been seeing compelling long-term opportunities with Co-CIO Francis Gannon.


This transcript has been edited slightly for clarity.

Francis Gannon: Hello and thank you for joining us. This is Francis Gannon Co-Chief Investment Officer at Royce Investment Partners. Today I'm joined by two members of the Royce Small-Cap Opportunistic Value Strategy, Portfolio Managers Brendan Hartman and Jim Harvey, who manage Strategy along with James Stoffel and Kavitha Venkatraman.

“We own semiconductor and semiconductor equipment companies—and we've been invested in that space for over a decade due to the secular growth nature of that market and the fact that the technology and industrial companies are converging into what we call industrial tech companies. AI has always played a role when you think of machine learning and automation. Factory automation has been going on for decades. As these companies get more efficient, they're able to not only capture the data, but analyze it and use it, and we've seen some beneficiaries in the semi cap space.”
—Brendan Hartman

We're excited to hear about their views of the market and where they're seeing opportunities in this very dynamic economic period. The small cap opportunistic value strategy has had a strong start to the year and through the end of August is outperforming its benchmark, the Russell 2000 Value Index, year-to-date, but, more importantly, has outperformed over the past 1-, 3-, 5-, 10-, and 15-year periods. It's also important to note that the Fund has outperformed from the low of the Russell 2000 Value Index at the end of September

Brendan, there seem to be so many cross currents around the economy today. I'm curious if you've heard anything interesting during the second quarter earnings reporting season that just completed from management teams.

Brendan Hartman: You know, Frank, that's a great way to describe it. There’re so many different cycles going on in different parts of the economy. For example, the lower-end consumer is under increasing pressure due to rising interest rates and the fact that they have borne the brunt of the inflationary pressures. Yet, at the same time, we're starting to see a recovery in housing and technology, particularly memory and logic, which went into a downturn three or four quarters ago. They're starting to show signs of coming out of that down cycle. Overall, I would say most of the management teams were pretty upbeat on their earnings calls. Most of the companies maintained their guidance for the full year. The economy remains pretty healthy, management teams are constructive. I think one of the themes that we saw throughout the earnings reporting period was that there're fewer private equity buyers out there competing for M&A transactions due to higher interest rates and the fact that they can't lever these companies up like they once could and pay higher multiples—and that benefits our companies and the so-called strategic buyer because they're not competing against private equity firms paying exorbitant rates and multiples on these transactions. So we've seen some uptick in M&A, which is a positive. That's always a good sign for our companies as they can execute their business plans. But overall it was a very solid second quarter earnings season with it with a fairly optimistic outlook for the rest of the year.

FG: That's part of the dynamic period we're in is that the economy seems to be much stronger than people had anticipated, especially going into the end of this year, when many people had been predicting the recession to hit. Jim, one of the things that we've been focusing on is this idea of cost of capital and how this has changed so dramatically for corporations over the past year as rates have moved higher. Is it affecting businesses in terms of their decision making and their planning?

Jim Harvey: Yes, it is, Frank, and you used the word ‘dynamic,’ and that is a word that that we heard throughout earnings season when companies were describing the operating environment. We've talked about the inflationary pressures that are out there and different challenges as it relates to the overall global environment. But the one thing that the companies are consistently talking about are interest rates how that affects their cost of capital, and how it affects their customers’ cost of capital, how it affects decision making in terms of deploying capital. One thing that companies don’t like is uncertainty, and I think it’s pretty fair to say today that one of the biggest uncertainties in the world is where are interest rates headed and where are they going to eventually settle at. When you're making capital investment decisions, this is clearly the most important thing that you have to get your hands around. We're hearing about this time and again, especially as it relates to companies talking about their customers’ decision making process and how they're pausing, sitting on their hands, waiting to see how this whole thing plays out. So, it’s had a decent impact I think across the board on our on our companies and their customers’ decision making.

BH: If I could add to that, we talk to our companies about that all the time. When the rates were rising rapidly, you saw that people froze their decision making. And now that things have started to settle, and it looks like the Fed’s probably done or very close to it, I think the market adjusts, companies adjust. You’re seeing it in the housing market, right? That same or similar phenomenon with mortgage rates increasing rapidly. Once they settle, people adjust to that and they start making decisions again, and that's what we're seeing today. As always, markets adjust and I think we're getting through that period of uncertainty. You're starting to see some more decision making and an uptick in M&A activity, which again I think is a positive for the market and a positive for our portfolio.

FG: I was curious how you were thinking about the effects of AI from a portfolio standpoint as you think about the Strategy?

BH: Jim, why don't you start and then I'll follow up.

JH: It's funny. You know, this term, AI, came on the scene less than a year ago. It was last November that the Chat GPT was released. But now you’re hearing all of our companies talking about it in some form. Probably one of the most interesting things about it is, depending on the industry or sector you're in, especially technology-related companies or any type of consulting, where people have been leveraging and using technologies as part of their business, each one of them has said to us and have said on their conference calls that, “Hey, we've been using this technology for years. This is the kind of thing we've been doing for a really long time. It became part of the public's vernacular since last November.”

If you think about higher tech businesses, this is exactly what they've been doing. They help their customers increase efficiencies on the semiconductor manufacturing side, there are constant advancements there. And this happens to be the latest one, but it runs across all industries. It was a theme that came up time and time again on conference calls. It's going to present post both threats and opportunities to small-cap companies, right?

In some cases, stock prices are way down because the market is saying that AI is going to destroy business models, we don't think that's the case, and I think it's presenting some interesting opportunities, but part of the conversations we're having is how it's going to increase efficiencies with the companies that we own and eventually increase margins. It is a very dynamic thing that's happening right now. But it is, I think, going to present some very interesting opportunities in the small-cap space.

BH: Jim, the thing I would add, that the obvious sector people think about is technology—they think about NVIDIA and the chip makers that are making all these AI chips, and the mega data centers that are being built to handle all that demand for broadband capacity and data analysis. But we own semiconductor and semiconductor equipment companies, and we've been invested in that space for over a decade due to the secular growth nature of that market and the fact that the technology and industrial companies are converging into what we call industrial tech companies. AI has always played a role when you think of machine learning and automation. Factory automation has been going on for decades. As these companies get more efficient, they're able to not only capture the data, but analyze it and use it, and we've seen some beneficiaries in the semi cap space.

But at the same time, there're areas that are benefiting from AI that you wouldn't necessarily think of. For example, we have some medical imaging and diagnostic companies, and they're using artificial intelligence and data analysis on all the data that they've collected over the years to get better at reading MRIs and CAT scans and being better at predicting cancers—how they're going to grow and treat them earlier, which is pretty amazing stuff that gets us pretty excited. That’ll give you some idea of how ubiquitous this whole artificial intelligence phenomena is. I would differentiate, though, between generative AI, which as Jim mentioned is Chat GPT, which is when the computers make things up and think like humans too, and AI / machine learning which, again, has been going on for decades and seems to be accelerating the pace of development, which is great for the economy, it's great for society as a whole. But there are going to be some problems with it along the way. There’ll be bumps in the road, and those are the types of things we'll be able to take advantage of in the Opportunity Fund.

JH: The other interesting thing I wanted to add that has come out in some of our conversations with companies is that, if you think about this whole concept of what if artificial intelligence is—all of that data, right? When companies are thinking about how they're going to put it to best to use for themselves, there's a big concern around sharing data and allowing data within an organization to get outside their walls. This, I think, is something that's going to create a lot of work for IT services companies and consultants and those kinds of companies. It reminds me a bit of the dot com era when all this work had to be done for companies that were trying to figure out their Internet strategies. And I think there are a lot of similarities here where it's going to create a lot of work for technologists and consultants and those types of companies.

FG: I think it's a great point that the economic benefits of AI are not just going to be found within the technology sector, but they're really going to be found across every sector in the economy. I think that's a great way to think about it. Turning specifically now to the portfolio, I’d love it if you could each talk about a specific company that you have long term confidence in.

BH: Frank, you've heard us talk about our investments in the aerospace sector for a number of years now. We initially had an earnings interruption event there when you had first the two crashes of the new Boeing 737 Max airplane, which resulted in that plane being grounded for well over a year as they fixed some of the software and the training problems with that aircraft. That really shut down the OE [original equipment] production lines at Boeing, and it reverberated back to the supply chain. Then we had the second Black Swan event, which was the Covid lockdowns, which further damaged supply chains. It's been a multi-year healing process as we come out of that.

I'll give you one of the many stocks we own in that group: a small electronics company called Astronics. You’ve probably never heard of it. They're based up in upstate New York, but they've been around since the end of World War Two. They make a lot of the in-seat power electronics software that you find in an airplane to charge your phone and plug in your USB cord, get your Internet access through the aircraft's antenna system, and they have some defense electronics business as well. These folks have been crushed by the supply chain problems because almost all of their products are electronic components, where they're buying individual parts, assembling them into the finished product, and shipping to the customer. And that's started clearing up, which is helping them to work through their backlog. They had some financing issues—they had to get through, a new a new bank deal which hurt the stock, but they're coming out of that and their backlog’s hitting record levels because demand for their products is very strong. They’ve been winning new business—a major new program for the Army helicopter that's going to replace the Black Hawk, which will go for another 25-30 years from now—a great long-term program. We’re finding some great opportunities there, and we think that can be a multi-year holding for us where the stock’s got the potential to double and even triple from here.

FG: Jim, how about a company that you have long term confidence in?

JH: First, just to answer the question on which themes we’ve been focusing on—it’s been more in the growthier types of themes. The Undervalued Growth category and our Interrupted Earnings category I think are presenting some of the most interesting opportunities as the market is depressed. And as we've touched on already, there are higher growth parts of the market and higher growth companies out there that have been brought down. We are spending a decent amount of time on looking at companies in those areas, so I think that's going to be a further interesting area as the year unfolds as we get into next year.

One company that we own that had been experiencing high growth is called DHI Group, and here we have a company that's actually being hit by some of the cross currents that we've been discussing today. The company uses artificial intelligence to create AI-powered software that provides talent acquisition services to companies that are looking to hire people with advanced technology skills. Here is another company that’s been talking about the fact that they’ve used automation and artificial intelligence to identify candidates. But these are technology candidates, and their market is big tech companies. You can hear them talking about this on their calls, and you can see it by what's happening in the economy. They put a big pause on hiring tech people. And we were talking about this—there’s always going to be a need to hire technologists. In fact, data scientists are in super high demand. We've heard stats where there's one candidate for 20 open positions.

DHI sits in the middle of that. They run a marketplace where they attract advanced tech talent and try to match those people with their clients who are looking for people who understand the technology. The stock has been hit hard, and the third thing that's hitting this company is that the market believes that industries like this—which source tech talent—are going to go away because of all these new technologies. But when you have conversations with the management team, they say it's just the opposite. They're going to rely on DHI’s services to go out and find all these people that are going to be needed, and I think it’s going to play out well into next year.

FG: Great. Let's leave it there. Brendan, Jim, thank you for a great discussion about where you're finding opportunities and how your constant and consistent application of your process is enabling you to capitalize on this volatile market. Thank you all for joining.

BH: Thanks Frank. Thanks everybody.

JH: Thank you, Frank.

Important Disclosure Information

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

NET               GROSS
Small-Cap Opportunity 6.78 20.42 23.76 8.91 10.14 11.91 11/19/96  1.23  1.23
Russell 2000 Value
3.18 6.01 15.43 3.54 7.29 8.65 N/A  N/A  N/A
Russell 2000
5.21 12.31 10.82 4.21 8.26 8.00 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. Harvey’s, Mr. Hartman’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 Opportunity

Astronics Corporation


DHI 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.

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.

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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. Smaller-cap stocks may involve considerably more risk than 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.



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