Why Small-Cap Growth Looks Promising
article 01-28-2025

Why Small-Cap Growth Looks Promising

PM Chip Skinner discusses his investment approach, two high-confidence holdings, and his optimistic outlook for Royce Smaller-Companies Growth Fund.

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After outperforming small-cap value in 2024, up 15.2% versus 8.1%, it might be said that small-cap growth is enjoying a moment. In fact, however, it’s been having a moment for much of the last decade. Over that span, the Russell 2000 Growth Index outperformed the Russell 2000 Value Index in seven of 10 calendar years, including better performance in two down years, 2015 and 2018—which has not been a common occurrence since each style index’s inception on 12/31/78.

We have offered a growth-oriented approach for more than 25 years: Royce Smaller-Companies Growth Fund. Managed by Chip Skinner since 2007 (who co-managed the Fund from 2003-2007), the Fund is enjoying its own moment, having beaten both the Russell 2000 Growth and Russell 2000 for the 1-, 5-, 10-year, and since inception (6/14/01) periods ended 12/31/24. The Fund gained 21.8% in 2024, outpacing both the Russell 2000 Growth, its primary benchmark, which was up 15.2%, and the Russell 2000, which was up 11.5% in 2024.

“I want to find companies that look poised for multi-year periods of robust growth driven by sustainable competitive advantages and/or that appear to be benefiting from secular growth themes that create favorable conditions for the business. I also like companies that I think have multi-year runways for growth as part of a powerful industry or innovation shift.”
—Chip Skinner

A Great Year for Small-Cap Growth—and Royce Smaller-Companies Growth Fund
2024 Returns

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges

Past performance is no guarantee of future results.

We spoke to Chip about his investment approach, two high-confidence holdings, and his outlook for both his portfolio and the small-cap growth category.

How would you describe the approach you use in Royce Smaller-Companies Growth Fund?

CS: Basically, I use a growth at a reasonable price approach in the Fund. Like all of Royce’s portfolio managers, I’m price sensitive and conscious of valuation. So, while I’m looking for high growth, I never want to over-pay for it. That can be a tricky balance, and like any manager, I don’t always get it right, but my goal is to create market-beating long-term returns with a reasonable amount of risk.

What kind of companies do you typically focus on?

CS: I usually invest in smaller companies with superior revenue and/or earnings growth that are selling at prices that don’t appear to fully reflect the company’s prospects. I want to find companies that look poised for multi-year periods of robust growth driven by sustainable competitive advantages and/or that appear to be benefiting from secular growth themes that create favorable conditions for the business. I also like companies that I think have multi-year runways for growth as part of a powerful industry or innovation shift.

Can you give us a couple of examples of high-confidence holdings?

ACV Auctions is a wholesale used-car auction company that primarily targets auto dealerships with an all-digital online method for dealer-to-dealer transactions. The company earns approximately $500 per vehicle on every unit transacted, which allows the dealership to convert used car trade-ins and excess inventory into cash. With its “digital first” beginnings, it has developed technology that collects used car data and other features, providing the most precise appraisals for its customers. Around 85% of the wholesale market is still in physical auctions; vehicles need to be transported to a physical site where buyers and sellers must travel to inspect vehicles and participate in the auction. ACV has been taking share from physical auctions through its “better mousetrap,” which will save time and money—and likely drive the online share of industry transactions from 15% today to more than 50% in the not-too-distant future. (And it’s worth noting that ACV has 10% of that 15% market share). With half of dealership ‘rooftops’ (6,000 out of 17,000 in the U.S.) as customers, the biggest drivers of transaction volumes for ACV have been signing new customers and penetrating existing customers further—and thus shifting share from physical sites to ACV’s digital solution. Management has several other growth initiatives underway to increase customer ‘wallet-share,’ including transportation services for customers, floor plan financing for buyers, enabling dealerships to use technology to compete with their more digital peers (Carmax, Carvana, etc.) , and expanding into new auction segments such as commercial fleet owners, bank repossessions, rental car fleets, and “red light” —that is, very old or low value—vehicles. While the company has invested heavily in these initiatives, it has recently achieved break-even, and the margin expansion that may be just around the corner will highlight the attractiveness of ACV’s business model.

ACV Auctions (Nasdaq: ACVA)
12/31/23-12/31/24

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges

Past performance is no guarantee of future results.

Another would be a company I discussed recently on our website in a piece that looked at Three Small-Cap Growth Stories in Payments Processing: Cantaloupe, which used to be known as USA Technologies. The company started out as a vending machine hardware provider that enabled those machines to accept credit card payments over wireless networks. Today, it offers a comprehensive suite of solutions including micro-payment processing, self-checkout kiosks, mobile ordering, connected point of sale systems, and enterprise cloud software. Cantaloupe sells this wide-ranging set of products and services to restaurants, hospitality and hotel pantries, office coffee service and pantries, stadiums and concert halls, outdoor festivals, and amusement parks and arcades. In addition, the company makes cashless card readers for laundromats and cashless vehicle services, such as parking, vacuum machines, and self-serve car washes. Among other uses, its software allows a vending chain operator to more effectively manage all of their units while also offering a host of self-checkout collateral, including kiosks, coolers, and cabinetry.

Cantaloupe’s current CEO, who took the helm in 2022, joined the company after a challenging period involving some accounting issues and getting the business back on track so that its ample growth potential could be realized. Today, the company handles more than a billion transactions annually for more than 30,000 customer endpoints across the globe, providing end-to-end technology solutions for the unattended retail market—a growing niche. The company has made some recent acquisitions, moving into new areas since the market for vending food and beverage has been growing more slowly. We think one very appealing feature of its business was its decision to bundle parts and services with the recurring subscription offering. Under this arrangement, Cantaloupe is basically renting its hardware at a premium while receiving recurring revenues from its SaaS segment. The company has also been expanding by targeting new verticals in micro markets—small, self-service retail spaces, usually found in office buildings or other workplaces, where people can buy food and drinks without a cashier.

Cantaloupe (Nasdaq: CTLP)
12/31/23-12/31/24

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges

Past performance is no guarantee of future results.

What is your outlook for small-cap growth investing?

A single year does not make a trend, but I think the strength of small-cap growth stocks in 2024 represents an overdue broadening of the U.S. equity market after several years of strength in a small handful of mega-cap Tech stocks. Other reasons to be optimistic include the more favorable interest rate backdrop, solid underlying GDP and employment figures with inflation growth holding at more acceptable levels. I also believe that the pendulum swings in the small-cap segment can extend beyond a single year. In support of the latter point, one only has to look at the 3- and 5-year average annualized returns for the Russell 2000 Growth and Russell 2000, which at 12/31/24 were appreciably lower than each index’s average monthly rolling returns for the 3- and 5-year periods since each index’s inception on 12/31/78. It also bears mentioning that short-term corrections within a small-cap bull market are not only common but are healthy for outperformance to continue.

There is also a very favorable earnings picture for small-cap growth over the next two years. Aggregate earnings per share for the Russell 2000 Growth is expected to increase by 144.2% during this period—tops among small- and large-cap stocks. Needless to say, that’s a very compelling argument for an earnings-focused growth strategy.

Average Expected Earnings Growth for 2025-2026
Index Aggregate Estimated Two-Year EPS Growth

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges

Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The EPS Growth Estimates are the pre-calculated mean two-year EPS growth rate estimates by brokerage analysts. Estimates are the average of those provided by analysts working for brokerage firms who provide research coverage on each individual security as reported by FactSet. All non-equity securities, investment companies, and companies without brokerage analyst coverage are excluded. Source: FactSet.

What can you tell us about recent portfolio positioning?

I didn’t make any major changes in 2024 beyond trimming and adding to positions based on fundamentals, outlook, and valuation. We reduced a few of our larger positions in aerospace & defense, an opportunity that has been predicated on Boeing’s inability to supply new commercial aircraft, which made companies that supply used and replacement parts more important in extending the lives of existing fleets. Boeing has a new CEO and has re-acquired some of its previous internal production capabilities, thereby at least steadying their ship. These actions can clearly impact the outsized growth that our holdings have been experiencing. Similarly, as highlighted in my recent interview on our website, positions related to the payment processing theme have been increased, largely because of strong underlying fundamentals and long runways of growth. Finally, three themes you may hear us speak more about in the future include Non-Bank Financials, Consumer Leisure Spending, and Nuclear Renaissance (Power/Nuclear Medicine).

Important Disclosure Information

Average Annual Total Returns as of 12/31/2024 (%)

  QTD1 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE ANNUAL
OPERATING EXPENSES
NET               GROSS
Smaller-Companies Growth 5.97 21.84 -1.22 9.17 8.09 10.43 06/14/01  1.49  1.57
Russell 2000 Growth
1.70 15.15 0.21 6.86 8.09 7.53 N/A  N/A  N/A
Russell 2000
0.33 11.54 1.24 7.40 7.82 8.04 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. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.royceinvest.com. 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 has contractually agreed, without right of termination, to waive fees and/or reimburse expenses to the extent necessary to maintain the Investment 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 1.24% through April 30, 2025.

All performance and risk information presented in this material prior to the commencement date of Investment Class shares on 3/15/07 reflects Service Class results. Shares of the Fund's Service Class bear an annual distribution expense not borne by the Investment Class.

Mr. Skinner’s thoughts and opinions concerning the stock market are solely his 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 outlined above will continue.

Percentage of Fund Holdings As of 12/31/24 (%)

  Smaller-Companies Growth

ACV Auctions Cl. A

2.7

Cantaloupe

2.5

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.

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 and mid-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 in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)

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. 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 Russell 2000 Value and Growth indices consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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