This transcript has been edited for clarity.

Francis Gannon: Hello and welcome. This is Francis Gannon, Co-Chief Investment Officer of Royce Investment Partners. Thank you for joining us. Our conversation today is with Portfolio Manager Mark Fischer and Senior Analyst Evan Choi who, along with Assistant Portfolio Manager Mark Rayner and Senior Analyst Yutetsu Ametani, manage the Royce International Small-Cap Premier Quality Strategy, which we use in the Royce International Premier Fund. Mark, I thought we’d start with a bit of an update. The international small-cap market, and quality in particular, continues to be a very challenging area. How do you think about that in today’s environment?

Mark Fischer: You’re right, Frank—it has been challenging and to be perfectly honest, it’s also been quite frustrating. We’ve had over a protracted period now large-cap outperform small, we’ve seen the U.S. generally beat international, and quality has been overshadowed by investor preferences for cheap value stocks and also those benefiting from various themes. Think back to COVID, and you’ll remember the work-from-home stocks and the reopening plays. More recently, inflation hedges like banks, commodities, energy stocks—which by the way also tend to have lots of debt—and then most recently anything related to AI. Meanwhile, emerging markets where, as you know, we’re structurally underweight, have outperformed our core developed markets. Then to top it off, the U.S. dollar has blown almost every major foreign currency out of the water—so talk about the perfect storm of headwinds.

But we really want to focus on what we can control. When we look for investments for our clients, we’re looking for great companies that can sustainably compound shareholder value, independent of thematics or the economic environment, the assumption being that sooner or later other investors will recognize this value creation and then share prices will follow. Actually, I would argue that these types of businesses are really well positioned to weather and thrive in challenging or even volatile environments because of these quality attributes. Remember—we‘re looking for durability: businesses that you can buy for your retirement account and then sleep well at night knowing that when you do retire, these businesses will be bigger and better. Unfortunately, those aren’t the types of companies that have typically been bid up in recent years.

But if I may, Frank, I'd like to make two important points: one is that we haven’t changed, and that’s really important. We’re always learning. We’re refining around the edges, but consistency is critical to us. We want our clients to know exactly what we’re doing and want them to rest assured that we’re staying true to our discipline. The second point is that what gives us reassurance that what we do still fundamentally works is that our companies have become increasingly desirable to strategic and private equity investors of late. We’ve had seven consecutive quarters of takeout activity in the portfolio, with nine companies subject to takeover bids—this is on a portfolio of some 60 companies. So while the public markets haven’t yet appreciated the value of our companies, the private market certainly does.

FG: Those takeout moments are usually bittersweet.

MF: That’s right.

FG: I’m wondering, though, if you could spend a few more minutes on why you think this takeover activity is happening. Is there any country or sector where you’re seeing more of them happen?

MF: Unfortunately there’s no magic pattern that I can point out as it relates to country or sector. The companies that have been acquired span six different countries and they are very varied in their sectors and what they do—everything from software to healthcare to equipment manufacturing. But one of the advantages of our Strategy is that we’re looking where most public markets investors are not. That’s because most people, as you know, think of the world in terms of value or growth. They’re looking for cheap stocks, or they’re looking for growing stocks—and we do that, too. But our starting point is somewhat different because we require companies that create high returns on invested capital. Those aren’t always the cheapest. Those aren’t always the fastest growing. Lots of them are under appreciated and their prices don’t reflect the long-term value that they’ll create.

But this dislocation in recent years has only widened. When we look at valuations, we prefer to use a metric called the cap rate, which is EBIT [earnings before interest & taxes] over enterprise value. It’s effectively a pre-tax buyer’s yield—an earnings yield that you would get if you bought the entire company. Our Fund as of the end of the first quarter of 2024 is at a 7.2% cap rate versus 6.2% for the benchmark. Now that’s a six-year record spread. At the same time, though, our companies continue to generate lots of value. So strategic and private equity buyers, who are much, much longer-term oriented than today’s average public equities investors are taking advantage of this.

And of course, as you mentioned, Frank, it’s bittersweet. We generally don’t like these types of situations because somebody else is effectively stealing our future value creation, if you will. But what it does tell us is that we’re on the right track, and the good news, we think, is that we have a lot more of these high-quality but still highly undervalued businesses in the Fund today.

FG: Evan, let’s bring you here into the conversation. I’m excited to have you join us, could you perhaps give us an example?

Evan Choi: Sure Frank. Thanks for having me. I think JTC, which is a company listed in the U.K., is a great example of what we do. What JTC does is provide outsourced fund and trust administration services. For example, JTC will set up a closed-end fund for an investment manager or a trust for an ultra-high net worth individual, and it effectively becomes the in-house operations team for that client, handling everything from ongoing administration to accounting to regulatory reporting.

FG: How did you come across this company?

EC: We actually used to own one of JTC’s competitors, a company called Intertrust, a few years ago before—big surprise—it got acquired by private equity. We probably would have also owned JTC back then had it not been for valuation. So, we just kept it on our premier wish list. Fast forward to late 2023, and JTC gets flagged after seeing some share price volatility. We decided to take a look at it and were able to lean on the existing knowledge we had built from owning Intertrust. We were fairly quickly able to come to a decision and officially initiated a position in the fourth quarter. And the beauty of our investment process is that we have a highly defined set of investment criteria that looks for specific business characteristics. This allows us to focus most of our time on understanding business models rather than trying to understand every single stock that’s out there, and that type of knowledge is repeatable. It doesn’t expire and compounds over time. In the case of JTC, we were able to leverage it quite effectively.

As to why we like JTC in the first place, it serves a fragmented base of over 10,000 clients globally and its services are low cost but mission critical. Imagine if NAV calculations weren’t done properly for a fund, or if regulatory and tax filings were not submitted on time for a billionaire with business interests in multiple jurisdictions. The complexities, as well as the financial and reputational damages involved, can be quite significant. That’s why once clients sign up with JTC, they very rarely leave. The costs associated with switching service providers and risking disruption and regulatory breaches are simply too high to stomach. We also like the fact that JTC generates non-cyclical and long-lived revenues. Revenues are non-cyclical because JTC makes money mostly on a time and material basis rather than on client asset values. And while the majority of its services are tied to regulatory driven maintenance work like reporting or accounting, revenues are long lived because JTC will serve a client for the entire life cycle of their fund or trust from initial setup to end of life, which can be between 7 to 15 years, sometimes even longer.

All those factors combined have enabled the company to post an unbroken 35-year track record of revenue and profit growth, even during the 2008 Financial Crisis. We don’t expect that record to end anytime soon. Growth prospects for not only JTC, but for the entire industry are quite attractive. Tightening regulations, rising operational complexities, the growing number of millionaires and billionaires all drive a greater need for specialist administration providers. Industry consolidation is also underway. Despite being one of the globally leading players, JTC holds just 2% market share in a highly fragmented market made up of a long tail of mom and pops and small businesses spun off from larger accounting or law firms.

To give you an idea of the consolidation potential, if you look at the global accounting market, the “Big Four” hold close to 70% market share. In the fund and trust services market, the top four players don’t even hold 20%, and it's our view that JTC is one of the natural and leading consolidators of the market, having successfully completed 30 acquisitions already to date. We initiated a position in JTC late last year after taking advantage of what we saw as unjustified share price volatility. The shares had fallen 7% since reporting H1 [first half] results in September that saw the business post 21% organic revenue growth, which is quite startling in my view and speaks to how dysfunctional the U.K. market has become, which by the way is a topic that probably needs its own podcast episode.

We were able to acquire shares at a very attractive multiple of 12.0x forward EV/EBITDA [enterprise value over earnings before interest, taxes, depreciation & amortization], which represented a significant discount to takeout multiples in the sector—and takeouts have been abundant in this sector. Private equity and strategic buyers at this point have acquired every single publicly listed competitor of JTC’s over the past few years, including Intertrust, which I mentioned we used to own, as well as another U.K. listed company called Sanne, which got acquired at over 20.0x EV/EBITDA—or a 30% premium to where JTC is trading at today. So JTC is effectively the last man standing, and while our investment process is not reliant on takeouts to drive successful outcomes, nor do we buy companies with the express objective to see them get acquired, I personally would not be surprised if JTC also got taken out at some point in the future.

FG: I think it’s a great example. Is there another one that you could share with us?

MF: I thought that JTC example that Evan provided was great. Thirty-five years of consecutive profit growth—that’s really what we want to achieve for our clients. Maybe I’ll provide another U.K. example in the Fund of a company called Marlowe. It's a classic RIP stock. We’ve held it for over 5 years. We first came across it when it was only in its third year as a listed business. They go around to thousands of U.K. companies and test, inspect, and certify that those companies are complying with regulations around things like fire safety, water hygiene, air quality. They’ll show up a couple of times a year and provide what is a low-cost solution, but one that is mission critical because it’s required by law. Marlowe operates under three-to-five-year average contracts, which gives them high levels of visibility. But its average customer relationship actually spans more than a decade, because when contracts come up for renewal, customers generally don't switch. Why would you risk a compliance nightmare or a faulty sprinkler when fire breaks out just to save a couple of pennies on the dollar?

And as you can imagine, this business is all about route loop density, meaning, if you have the densest service network, you can reach your customers faster and more reliably, and you can also provide those services at a lower cost. The scale advantage that Marlowe has as a market leader we think is quite durable. But what makes Marlowe really exciting to us is it’s long term growth opportunity. It’s a market leader. But despite that, the market is extremely fragmented. We estimate, for example, that it still has a less than 10% overall market share and it’s been successfully rolling up the industry—much like JTC has, by the way—by buying up small, often family-owned businesses, which it can find at very attractive multiples. And we think there’s still plenty of runway for them to do that.

Marlowe also used to own another business in which it sold software and services to ensure compliance in the related area of human resources. Think consultancy to improve staff well-being, or tools that employers can use to make sure that they’re compliant with employment law. That division accounted for some 40% of profits, but Marlowe was able to recently sell it to a private equity buyer for the equivalent of over 120% of its entire market cap. Again, this is a prime example of where a private buyer sees value where the public market does not. The remaining testing inspection and certification business that we’re left with as investors in Marlowe now trades at an implied valuation of just six times EBITDA, while these global peers trade at nearly twice those levels—and past transactions in the space have been made at even higher multiples than that. We have a high quality, now net cash, structurally growing asset with additional optionality should it be acquired.

FG: What’s interesting is that both the examples that both you and Evan have highlighted today are from the United Kingdom. Is there anything notable that makes the U.K. particularly attractive today?

MF: As Evan mentioned, this topic really does deserve its own podcast. We are, of course, completely bottom up. We’re not looking to invest in the U.K. because we’re we have the view that the U.K. somehow is poised for a macro rebound. We're business analysts, we're not economists. But the U.K. has been incredibly fertile for us as investors, and that also explains why we’re significantly overweight this market. Most important is simply that there are plenty of outstanding globally leading businesses in the U.K. and many of which, like JTC for example, generate most of their revenues from outside the U.K. so they’re exporters of their products or services.

But being a U.K.-listed business for many companies has been incredibly painful in recent years. We have U.K. equity valuations which are near all-time lows—some 40% discounts to global equities. You’ve also had a challenging macro post-Brexit, which explains part of that, and a market environment in which generally speaking there have been more sellers than buyers. For example, we’ve read that equity fund managers have had over 30 months—that’s three-zero—of consecutive net outflows. Pension fund allocations to U.K. equities have fallen from over 40% in the late ‘90s to some 4% now. So it’s a tenth of the level that it used to be.

The result is that the market cap of the entire U.K. equities market is similar to the market cap of Apple, which is absolutely incredible if you think about it. When companies are often penalized indiscriminately for their listing, we have the opportunity to pick out companies at great valuations that are great businesses.

FG: Thank you, Mark and Evan, for a timely update on international small-cap investing and the Royce Small-Cap Premier Quality Strategy. We appreciate your time today.

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