How Select Small-Caps May Benefit from Normalizing Rates
article 11-28-2023

How Select Small-Caps May Benefit from Normalizing Rates

Assistant Portfolio Manager Kavitha Venkatraman explains how a normalized rate environment can benefit our Small-Cap Opportunistic Value Strategy.


Interest rates are hardly in unprecedented territory.

Rising interest rates—and the rapid pace at which they have climbed—continue to alarm many investors. We therefore think that it’s especially important to remind investors that since 1954 the only sustained period that saw rates at or near zero was the combined post-Financial Crisis and Covid eras that spanned more than a decade from 2009 to 2021.

“Now that the cost of capital is increasing to more historically typical levels, we suspect that profits and cash generation will continue to attract investors’ attention, as will companies run by skilled allocators of capital.”
—Kavitha Venkatraman

Fed Funds Effective Rate, 12/31/54-9/30/23

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)

Source: FRED, Board of Governors of the Federal Reserve System (US)

We think the long-term, zoomed out view shown above tells us, emphatically, that Interest rates are merely normalizing—and are hardly in unprecedented territory. In fact, the decade-plus period following the 2008-09 Financial Crisis was the anomaly.

What does this mean for small-cap investors?

During this anomalous period of ultra-low costs of capital and ultra-low discount rates investment approaches which emphasized “growth at any cost” became financially viable and even attractive for investors. Consequently, capital flooded towards high-growth endeavors with the promise of profits far in the future. This had a disproportionately adverse impact on the small companies in our investment universe, which are subscale and have structural limits to the financial leverage they can absorb. They faced stiff competition for acquisitions—and were often outbid by private equity buyers and larger strategic buyers that had greater borrowing power. These subscale companies also had to compete for talent with their larger counterparts, which had a higher revenue base to spread their costs over, especially in industries that saw heightened demand during the pandemic.

As both interest rates and the cost of capital continue to normalize, we find ourselves in a world that is again profit- and returns-conscious. In this environment, we expect select companies in our investment universe to benefit from reduced competition for talent and more benign price competition for deals. We also expect to see more M&A (mergers and acquisitions) activity in the small-cap universe, with smaller companies able to make accretive acquisitions that help them gain scale, add technological capabilities, etc.

How is Royce’s Small-Cap Opportunistic Value Strategy positioned in the current environment?

The Strategy invests in companies that are undervalued for what we believe are temporary reasons. Included in the portfolio are businesses that are subscale but are in unique niches or possess unique capabilities or assets that can either find strategic buyers amid slowing economic growth or can be buyers themselves to build scale; companies with strong normalized earnings power that are underearning due to macroeconomic factors or past strategic missteps; or companies that have ample long-term growth potential that is not reflected in their current valuations due to their size, growing pains, or macroeconomic factors.

While M&A activity remains depressed compared to the flurry of deals seen during the pandemic years, we are seeing green shoots emerge. In general, well capitalized buyers have opportunistically started buying assets that are attractively valued—which is beginning to benefit both sellers and buyers of assets within Royce Small-Cap Opportunity Fund’s portfolio.

Certain portfolio companies have started selling assets to strategic buyers looking to acquire them as the buyers reach for increased scale or capabilities as well as to well capitalized financial buyers who have started loosening their purse strings for smaller deals that don’t require excessive leverage. Examples of recent buyouts of companies from our portfolio include strategic consolidation of oil & gas exploration & production companies, niche retailers (bought by financial buyers), and mergers among banks that are trying to build scale in part to get ahead of increasing regulatory burdens.

A few companies in our portfolio that have low leverage and/or strong market positions have also begun deploying capital opportunistically. Examples include companies in industrial niches such as air purification, hydraulics, and electronics that have been acquiring smaller undervalued businesses in an accretive manner.

While some portfolio companies face near-term softness in demand as consumers and businesses continue adjusting to persistent, though moderating, inflation and higher interest rates, we believe these factors are both temporary and, even more important, are already reflected in the valuation multiples in most cases. For example, as of 10/31/23, Royce Small-Cap Opportunity Fund’s P/S (price to sales) and P/B (price to book) ratios were 0.8x and 1.4x respectively—which were attractively low in our view and were close to the Russell 2000 Value’s respective P/S and P/B ratios of 0.9x and 1.1x. (The Fund’s P/S and P/B ratio calculations exclude cash.) In addition, the portfolio’s financial leverage levels are quite manageable with the aggregate indebtedness at only 1.5x times EBITDA (Earnings Before Interest Taxes Depreciation and Amortization—a proxy for cash earnings).

We remind investors that attractive capital allocation opportunities abound in any cyclical downturn—and we expect our companies to capitalize on such opportunities and emerge from this downturn as stronger, more competitive players in an environment that after a long break has returned to normalized rates.

Important Disclosure Information

Average Annual Total Returns as of 09/30/2023 (%)

NET               GROSS
Small-Cap Opportunity -4.95 20.85 17.48 7.53 8.61 11.58 11/19/96  1.23  1.23
Russell 2000 Value
-2.96 7.84 13.32 2.59 6.19 8.45 N/A  N/A  N/A
Russell 2000
-5.13 8.93 7.16 2.40 6.65 7.71 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. Venkatraman’s thoughts and opinions concerning the stock market are solely her 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.

All Portfolio and Index Characteristics calculations exclude Cash (3.7% of ROF as of 9/30/23), all non-equity securities, and investment companies. The Price-to-Book Ratio (P/B) is calculated by dividing a company’s share price by its book value per share (7% of Portfolio and 11% of Index holdings were excluded as of 9/30/23). The Price to Sales Ratio (P/S) is calculated by dividing the company’s market cap by the revenue in the most recent year (13% of Portfolio and 13% of Index holdings were excluded as of 9/30/23). P/B and P/S are calculated using a harmonic average. Harmonic Average is a weighted calculation evaluates a portfolio as if it were a single stock and measures it overall. It compares the total market value of the portfolio to the portfolio’s share in the earnings or book value, as the case may be, of its underlying stocks.

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 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. 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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