International Small-Cap Premier Quality Strategy 3Q23 Update & Outlook
article 10-24-2023

International Small-Cap Premier Quality Strategy 3Q23 Update & Outlook

Portfolio Manager Mark Fischer and Assistant Portfolio Manager Mark Rayner on the long-term prospects for quality non-U.S. small caps.


How did Royce’s International Small-Cap Premier Quality Strategy perform in 3Q23 and over longer-term periods?

Mark Fischer: The mutual fund that we manage in the Strategy, Royce International Premier Fund, declined -7.6% for the quarter, lagging its benchmark, MSCI ACWI ex USA Small Cap Index, which was down -1.7% for the same period. The portfolio also lagged the MSCI ACWI ex USA Small Cap for the year-to-date period ended 9/30/23, down -3.5% versus a 5.0% gain for the benchmark. The portfolio outperformed the benchmark, however, for the 10-year and since inception (12/31/10) periods ended 9/30/23.

“We are taking the opportunity to improve the positioning of the portfolio by incrementally adding to current holdings and initiating new positions in companies where we have identified widening dislocations between a company’s value creation and its valuation.”
—Mark Fischer

How was performance at the sector level in 3Q23?

Mark Rayner: Seven of the portfolio’s eight equity sectors made a negative impact on quarterly performance, with the largest detractions coming from Industrials, Information Technology and Health Care. Real Estate was the only positive contributor, while two of our lower sector weightings—Financials and Consumer Discretionary—were the smallest detractors.

What about at the industry level?

MR: Professional services and machinery, which are both in Industrials, and software from Information Technology detracted most in the third quarter. Our top contributors were life sciences tools & services from Health Care, electronic equipment, instruments & components from Information Technology, and capital markets, which is in Financials.

Which countries had the biggest effect on third-quarter performance?

MF: The United Kingdom, Japan, and Sweden—the first two our largest country weightings at the end of September—detracted most at the country level for the quarter. Switzerland and Singapore were the only contributors while Finland detracted least.

What was the top detractor in the third quarter?

MF: Our top detractor was Learning Technologies Group (“LTG”), a UK-based company that helps companies recruit, train, manage, and retain their employees. The company provides its services through custom-made training programs and a comprehensive suite of software applications that HR managers can use to manage employee performance, administer and track learning, and handle organizational issues such as succession, compensation, or compliance. LTG’s solutions not only allow customers to save money by digitizing their HR processes, but also position them to navigate an increasingly complex work environment where compliance requirements are rising and employees are demanding employers engage with them and take an interest in their career development. LTG currently serves more than 6,000 customers that pay a reliable stream of revenues, more than 70% of which relates to recurring subscription fees or multi-year contracts, and because LTG’s solutions are critical to customers’ operational success yet often cost less than $15 per employee per year, customers rarely switch with retention rates exceeding 90% annually. LTG’s share price came under pressure recently as it revised its previous growth expectations and forecasted flat profits for the year. This hiatus in growth was primarily the result of a macro-induced slowdown in the 30% of the company's business that is more transactional in nature, as well as a delay in integrating two of its businesses (since resolved). Notably, the company continues to be cash generative and value creative, has a robust balance sheet, and is seeing strong customer renewal rates. In September, the company published its results for the first half of 2023 in which it reiterated conviction in hitting its revised profit targets for the year. In the meantime, the company’s valuation multiple is at an all-time low and sits at an approximately 70% discount to its historical average. LTG was also the Fund’s top detractor relative to the benchmark in 3Q23.

What was the portfolio’s top contributor at the position level for 3Q23?

MR: Based in Switzerland, VZ Holding is a leading private wealth manager for high-net-worth individuals close to retirement. These individuals often have complicated financial and estate planning needs that VZ Holding fulfills through a comprehensive set of services ranging from portfolio management, banking, mortgages to insurance coverage. We were initially attracted to VZ Holding as it sells its services to a diversified base of 65,000 clients via a technical sales relationship where its consultants create tailor-made financial plans and build long-standing relationships that usually end only when the client passes away. This results in minimal client churn and high levels of repeat revenue generated from ongoing management fees which today account for over 60% of the business. In mid-August 2023, VZ Holding reported strong, above-consensus results, with revenue of more than 9% and EBITDA above 12% year over year. The company also made operational progress on various fronts: its AUM rose 13%, net new money was broadly stable and exceeded expectations, and the company increased its client base by 4,000, demonstrating the its resilience during difficult economic environments. VZ Holding also benefited from higher interest rates on deposits held for its clients. Lastly, management also published an optimistic outlook for the second half of 2023, expecting higher growth than in the year’s first half.

At the sector level, how did the Fund perform versus the MSCI ACWI ex USA Small Cap in the third quarter?

MR: The Fund’s disadvantage was mostly attributable to stock selection in the third quarter. Stock selection hampered relative performance most in Industrials and, to a lesser extent, in Information Technology; our lack of exposure to Energy, which performed well within the benchmark, also hurt results vis-à-vis the MSCI ACWI ex USA Small Cap. On the other hand, the Fund’s low exposure to Real Estate and Consumer Discretionary, as well as its lack of exposure to Utilities, were additive versus the benchmark.

How did the Fund perform on a sector basis for the year-to-date period ended 9/30/23?

MF: Six of the portfolio’s eight sectors made a negative impact on year-to-date period performance, with Industrials, Health Care and Communication Services making the largest detractions. Information Technology and Financials were the only positive contributors while Real Estate detracted marginally.

What about at the industry level?

MR: At the industry level, professional services and commercial services & supplies, which are both in Industrials, along with interactive media & services from Communication Services, detracted most for the year-to-date period. Software and electronic equipment, instruments & components—both from Information Technology—and capital markets from Financials were the largest contributors.

Which countries had the biggest effect on year-to-date performance?

MR: The United Kingdom, Sweden, and South Korea detracted most at the country level while Switzerland, Brazil, and Denmark were the top contributors.

Which position detracted most for the year-to-date period?

MF: Learning Technologies Group was also the biggest detractor year-to-date through the end of September.

Which position contributed most for the year-to-date period?

MR: Our top contributor was Odontoprev, which is the largest provider of corporate dental care plans in Brazil. Corporate customers pay Odontoprev a small monthly membership fee, and in return their employees gain access to Odontoprev’s partner network of 30,000 dentists who they can book for regular cleanings or other dental procedures. We like its high-margin yet asset-light business model, which enables Odontoprev to generate strong cash flows and returns on invested capital (“ROIC”), as well as the structural growth prospects that Brazil’s expanding middle class supports. Compared to almost 80% in the U.S., we estimate that only 13% of Brazilians have private dental coverage today. Although the stock gave back some gains in August—a pullback we attributed to second-quarter numbers that disappointed the market—its shares had performed strongly through the end of July.

How did the Strategy perform versus the MSCI ACWI ex USA Small Cap for the year-to-date period?

MR: Our disadvantage versus the benchmark came mostly from stock selection. At the sector level, stock selection hurt most in Industrials, followed by stock picking in Communication Services and Health Care. Conversely, our much lower exposure to Real Estate, stock selection in Financials, and lack of exposure to Consumer Staples were each additive versus the benchmark for the year-to-date period.

What is your outlook for the Strategy?

MF: We believe firmly–and history has shown–that over longer periods of time, share prices are driven by company value creation as measured by high and consistent ROIC. Our value proposition therefore is to invest in companies with sustainably high ROIC, strong balance sheets, and attractive long-term growth prospects which trade at valuations (cap rates) that are equal to or better than that of the broader market. We believe that these companies are best positioned to harness the power of compounding returns over time. And while the Strategy’s ROIC and the balance sheets of its holdings have remained robust this year, a confluence of headwinds, including the market’s preference for businesses with lower returns and weaker balance sheets in international markets, as well as rapidly rising bond yields, have resulted in meaningful share price and earnings multiple contraction within our holdings. The last time we saw such a dislocation between ROIC and share price performance was during the run-up to the 2007-2008 financial crisis, following which the economic downturn was accompanied by a quick reversion to high-quality stocks that enjoyed two standard deviations of outperformance in the years following the crisis.

Given that the Strategy invests in companies with pricing power, strong balance sheets, and recession-resilient business models, we believe it is well-positioned to outperform in a more recessionary environment. We are taking the opportunity to improve the positioning of the portfolio by incrementally adding to current holdings and initiating new positions in companies where we have identified widening dislocations between a company’s value creation and its valuation. These dislocations can be particularly pronounced when growth momentum slows. Provided that growth and business quality do not appear to have been permanently impaired, and that companies remain value creative, such situations often allow us to take advantage of our long-term investment horizon by building positions at attractive cost bases, in turn setting ourselves up for strong future outcomes.

Important Disclosure Information

Average Annual Total Returns as of 9/30/2023 (%)

NET               GROSS
International Premier -7.57 9.33 -5.56 0.21 4.51 4.75 12/31/10  1.44  1.59
-1.70 19.01 4.01 2.58 4.35 4.21 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 2% 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 Gross operating expenses reflect the Fund's total gross annual operating expenses for the Investment Class and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund's most current prospectus. Royce & Associates has contractually agreed, without right of termination, to waive fees and/or reimburse expenses to the extent necessary to maintain the Service Class's net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) at or below 1.44% through April 30, 2024.

Mr. Fischer’s and Mr. Rayner’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 9/30/23 (%)

  International Premier

Learning Technologies Group


VZ Holding




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.

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed, or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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 may invest a significant portion of its assets in foreign companies which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see ”Investing in Foreign Securities” in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see “Primary Risks for Fund Investors” in the prospectus.) 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.)



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