This transcript has been edited for clarity.

Francis Gannon: Welcome to another episode of The Royce Exchange.

I'm happy to be here today with two of our portfolio managers, Chip Skinner, who's been with the firm for 22 years, has over 40 years of industry experience, and is our portfolio manager for our Smaller-Companies Growth Strategy, and Joe Hintz, who joined us a little over 4 years ago now, has over 10 years of experience in the industry, and works as a portfolio manager on our Small-Cap Quality Value Strategy.

I thought it'd be fun to talk about the year. It's been a really interesting year. Small-caps have faced numerous challenges from the start of this year, from uncertainty over tariffs and the resumption of Fed cuts to a continued push out recovery. In terms of the earning story, which I think is starting to change a little bit and that earnings recession has kind of been there for a period of time as well. But I'd love to get your thoughts on some of the aspects of the market that we've seen this year around small-caps, Chip perhaps let's start with you. What are your thoughts on some of the volatility that we've seen this year?

Chip Skinner: Thanks for having us. I've described this year as a small-cap growth manager feeling a little bit like a pinball in a pinball machine. There has been a lot of volatility. If I roll back the camera a little bit, The first quarter was a negative quarter, The Russell 2000 was down about 10%, and that was precipitated by the big new tariff regime that was announced. Small-cap stocks declined about 25%, believe it or not, from their recent peak.

So, there was a big correction in there. Interestingly, there was a big bounce back in the second quarter. We almost recaptured the entire 10%. Third quarter, another scenario where we had a lot of the speculative sort of categories or sectors of the small-cap universe really outperform things like crypto, quantum computing stocks, and a number of other areas where there's not a lot of revenues, not a lot of earnings, or any earnings.

For a traditional small-cap, long term investor, which was a difficult quarter to keep up with frankly. But then more recently in this current quarter, there has been somewhat of a return to more normal performance of some of the high quality long term growth companies that we invest in, so it has been a somewhat of a milkshake this year it seems like.

Francis: Joe, I’d love to pull you in here a little bit and talk about what you saw in the year that is almost complete. But one of the things that I think particularly affected quality managers or managers that focus on especially the type of businesses that you and the team invest in has been this outperformance of non-earners really from the low of the market in April this year, specifically biotech.

Biotech has been on fire this year post the tariff tantrum, if you will, on April 8th, but would love to get your thoughts on some of the volatility you saw in the market this year.

Joe Hintz: Thanks for having me on the program today. Appreciate the time to chat. Similar to what Chip said, interesting start to the year. We actually had a good Q1 in a down market and then the rip off the bottom after the tariff announcement has been extremely challenging for quality value managers.

No matter how you look at it, whether it's factors or the types of companies that have been outperforming, it's just been a very, very difficult market for quality managers. You've seen it in biotech, Chip mentioned crypto, you've got the Bitcoin miners. There's even a company in the index that's not supposed to have revenues, I think, until 2027 or 2028 that was one of the top contributors in the index this year. So, when you have that type of an environment where you have not even non earners but non-revenue companies in a small-cap value index leading the market, that's just a significant challenge.

I think a few things that are kind of interesting to think about: it reminds us a lot of the meme stock rally in late 2020, early 2021, when you had a lot of stimulus check investments in the market driving specific companies, thinking back to, I think, the Reddit online chat group of the Wall Street bets, and that was driving a lot of activity in a very small group of companies, I think this is very similar, but it feels much broader. I feel like we're seeing just such a bifurcated both economy and market in terms of anything AI related or Bitcoin or crypto related and then everything else. That's been driving a lot of this. I've been reading quite a bit in the last few weeks about how, compared to about 10 years ago, retail investors are driving just multitudes higher percentages of the market. So maybe you're continuing to see some of that meme stock element. It's just maybe broadened out a bit. The retail trade and then the bifurcated, “anything AI is going to rip,” and anything else is just kind of being left for dead, whether or not that is following the actual fundamentals and the trajectory of the company.

Francis: Joe, history shows that you do see these lower quality kind of stocks rip off the bottom and then quality does come back. You see those better companies come back usually a year after. Where are you seeing opportunities along that line today? Do you think that's going to happen #1? and #2, how are you guys positioning yourselves going into 2026?

Joe: I think the research that we've done has shown even the first six months is the biggest pain point in a big rally off the bottom. And then it starts to turn from there. I think we are in the last maybe month or so starting to at least see—I don't know if it's a full reversal of what we saw earlier in the year—but at least a winding down of that massive low-quality leadership. We are hopeful that that kind of rotation continues to happen into quality.

As we head into 2026 I think there are lots of different places to look for opportunity. First, starting from a macro perspective, taking a step back and thinking about what I just talked about around the bifurcated market and bifurcated economy. We have seen areas of the market that have been in a quasi-recession for a long time. The low-end consumer has been in a recession arguably for several years now. The industrial patch has been quite weak. There are parts of the semiconductor chain that have been weak outside of AI.

We're starting to see potential green shoots in some of those non-AI parts of the economy, which would be very, very positive for breadth in the market to see non AI companies starting to accelerate off the bottom of a cycle. We're seeing some green shoots in parts of the semiconductor chain, we're seeing in some of the regional fed data around manufacturing that we're starting to see some potential green shoots there. Some of the results from our industrial distributors, for example, are starting to see some, at a minimum, stabilization at the bottom of a cycle, and potentially some nice green shoots moving to the other side to the upmarket part of the cycle.

In general, we are hopeful that we're going to see some broadening out of the market. It's been tough for quality value. The other area where we see a lot of opportunity is where companies have been thrown out as if they're going to be AI losers, for example, even though we see a lot of opportunity there. We have an IT services company, it's been a very difficult year for this stock, one of our worst performers this year, but that's basically all come from multiple contraction, meaning that the market has gone from pricing this from a viable business to a melting ice cube business, and we think that the market's doing that because they think that it's going to be an AI loser and that their business model is in jeopardy. We think the exact opposite. We think that there's a lot of opportunity for this company to expand in an AI driven world and we think that as we move away from the picks and shovels phase of the AI build out to more of the true adoption by enterprises phase, this particular company is going to really, really benefit in helping enterprises drive AI adoption. So that's just kind of a smattering of areas where we see opportunity heading into next year.

Francis: Chip, just kind of building a little bit on that. When you think small cap growth, you think tech spending and those companies that are going to be beneficiaries of tech spending around AI, etc. You talked about quantum computing earlier. How are you thinking about in positioning the strategy going into 2026?

Chip: As you might expect, we have a higher mix of technology as well as healthcare companies. It's interesting because every company is going through some kind of a digital upgrade and spending on technology, and some of that will depend on how strong the economy is. But there's some real, as Joe pointed out, AI type areas or initiatives that are going to require a lot of capital spending and investment because I do believe that eventually this is going to change the way a lot of us work and a lot of the products that companies sell; every product will probably have embedded in it some form of artificial intelligence. The way we're positioning and the way we have for some time been positioning is by trying to identify some very long term, durable themes that will generate some of these new, world beating companies and actually new areas of the economy.

A couple of themes that have actually helped us this year has been this entire drug discovery area, which includes some of the tool providers that help biotech and pharma develop new products. We've also had some of our biotech positions do very, very well, some that were under followed and came out of nowhere, so to speak. We've had three biotech companies get taken out this year, and I think that's just an indication that Big Pharma has got a lot of older products in their portfolio that are approaching the end of their patent life, and they need to come up with some new candidates, some new products to drive that next phase of growth. The biotech area in general, particularly in small-cap, has been a period, an area of significant outperformance over the last 10 years, and that's for a lot of reasons. While people haven't really focused on it, a lot of the products in their pipeline have moved through the FDA approval process and are now later stage. We're focused on some of the later stage companies, and then you've got gene therapy, gene editing—these new areas that are also I think in the very early stages.

So, there are a lot of exciting innovations going on out there. We have a number of themes like this one that are generating some meaningful outperformance opportunities.

Francis: Obviously, AI is kind of like the word everybody wants to talk about all the time. But, I'm of the belief that as the market broadens out over the next year or two or three, given the fact that small caps have underperformed for such a long period of time, part of that is going to be AI driven, and what I mean by that is, “AI is coming to a small cap company near you,” right? And the market is going to transition from the people who are actually building AI, if you will, and the ones that are going to be the beneficiaries of AI. Have you guys actually seen from both a growth perspective and perhaps a quality value perspective, concrete evidence that companies are one, using AI and that you've seen it from an earning standpoint in the bottom line of many companies.

Chip: Yes, I think the last couple of years have been a period where particularly large corporations have been experimenting. You know, they've been doing beta testing and generally, internally, as opposed to using it to sell a product to a new end customer because there's some risk, there's some uncertainty. And so, they’ve been in this, sort of, proving out phase. I think the next step is to probably roll out new products. I think every software product is going to have some element of artificial intelligence embedded in it. If you don't, you're in trouble, like you said.

There are not that many direct plays in artificial intelligence in small-cap. A lot of them are large cap tech companies that may own or operate data centers, but there are a bunch of areas peripherally that are benefiting from the spend. Another theme of ours this year has been the whole nuclear renaissance. Which, again, an industry that's been dead for decades—nuclear power plants. We're going to need a lot more power, and it takes a long time to bring a power plant onto the grid. And so, I think everyone is looking for ways to either extend the life of their power plant or start developing some new ones. And there's a lot of technology, below the surface, some of these smaller modular power. None of these are on the market yet, but within the next three or four years, I think we're going to be seeing more product innovation powered by nuclear and power demand in general. There are, I think, going to be traditional energy companies that are going to have to step up with natural gas as a source to power a plant. We even have a geothermal company in our portfolio. It’s listed as a utility, but their phones are ringing off the hook: Can you provide us with some new power sources?

Francis: Joe, any thoughts on it?

Joe: Going back to that one company that I mentioned in terms of helping AI broaden out beyond just the picks and shovels phase, let me kind of expand on that. When I talk about picks and shovels, it's more about building out the data centers, getting the energy sources, getting the capability to run the AI models at all. Building out that infrastructure, that's what I mean by the picks and shovels phase, and that's what we've definitely been in. Nvidia is obviously the big winner there. Everybody's rushing to just build out massive numbers and massive scale of data centers. I'm not saying that that is going to end, but you have to move from that kind of capital intensity phase into the actual adoption phase. And I think we're very, very early days there. Heading into 2025, a lot of people were talking about this being the year of agentic AI—that has not really come to fruition.

So, what does that mean, Agentic AI? We're just basically talking about going from chat bots where you interact with the model through the chat interface to building out automated workflows to automate business processes. I think we're very early days in that, and that's been delayed by a year just by the complexity of doing this. But I think it is definitely coming. And so that IT services company that I mentioned, they're going to help companies build out agentic workflows.

In terms of seeing AI coming to the small-cap near you, if you want to take the baseball analogy where we haven't even hit the first inning yet, we're in the warm up phase. I think some of the larger companies, to Chip's point, are a little further along. You've started to see some interesting examples. So, I know this year it's been pretty widely reported across the news that healthcare costs are going up, whether it's because of weight loss drugs, higher acuity services being used, etc.

But healthcare costs are very much on the rise. And one interesting thing that I heard from one of our companies that is not in the healthcare space specifically, but has some exposure there is that hospitals are now using AI to better code because I think in the past, maybe because the coding system for different procedures is so complex, maybe something is missed and so the hospital doesn't bill the correct amount, and so you're now seeing AI being used to expand the hospital billing code, not in an illegal way, but just to make sure that the hospitals are getting paid for the procedures that they're performing. That is a big contributor apparently to some of this rise in healthcare costs. You know, I think that's just one example of an industry using AI to extract the requisite value that they had been missing out on in past years. Those are the types of things that we will start to see expand out into the economy going forward. Hospital systems, a lot of these are very large systems. Maybe they can afford to invest in that kind of stuff, maybe they're a little bit ahead of the game, but I think that type of thing will be coming to all industries across the U.S. heading into the next year for sure. As of right now, we are not hearing any of our companies talking explicitly about how much AI is helping them either to grow the top line or save on the bottom line.

Francis: So, it's that time of year where people start talking about the year out. You know, as we look to 2026, what are your thoughts? What's your outlook for 2026? Joe, why don’t you start?

Joe: We're maybe in a stance of potentially cautious optimism. One thing that does concern us is that the second Trump administration has brought a lot of unprecedented change, whether it's the massive scale up in tariffs, the significant change in immigration policy, etc. And I think we're only beginning to really see the true impacts of or potentially we're only beginning to see the impacts of these policies.

Maybe tariffs will completely not impact inflation in any major way. We're not macro investors, so it's hard for me to tell you for sure, but, you know, I definitely think heading into 2026, there could be some inflationary impacts that were delayed in terms of us seeing them in actual data but that starts to come through, and then also labor being much tighter now because of much tighter immigration policies. I think that's really going to impact areas like construction, home building, agriculture, etc. Those are areas where tighter immigration policy will impact things, and to what extent those things are impacted is to be determined. But there is definitely a lot of uncertainty as the country goes through some significant changes. That's the caution piece of cautious optimism.

I think the optimism side is something I alluded to earlier where we are seeing some green shoots from an economic perspective. AI has been the main driver of the economy for several years now. We are very hopeful that we're starting to see that expand out into industrials, into the non-AI parts of the chip economy, etc. A further expansion of the economy where you're seeing us coming out of some slower periods for a lot of these other parts of the market would be very, very positive just for the health of the market, the breadth of the market. And then lastly, I would just say that we are hopeful. I mean here at Royce we've done the research. It is common to see low, low-quality lead off the bottom in a market rally, but that transition should happen 6 to 12 months out, and that's where we are heading into 2026. So, I would expect to see quality regain leadership in terms of the types of companies that are really leading the market.

Francis: Chip, how about you?

Chip: I would make two points: one is equity market related, and the other one is the economy related. I'm a big believer in reversion to the mean, and if you look at the 1-,3-, and 5-year annualized returns that small-cap, whether it's small cap growth or small cap value, has massively underperformed the large-cap index, if you use the S&P 500, for example. Small-cap stocks have generated about half the return in an absolute sense that the big caps have. So, I do think we're due for a swing in the pendulum. Typically, you get paid for taking on a little more risk in the small-cap world. You get higher returns, and that has absolutely been flipped in the last five years for a lot of reasons that we know about—the big cap tech stocks have outperformed etc.

The other thing I would say about the economy is that the current administration, with the exception of this tariff program that's been put forward, is pretty pro-business and pro-economy. In fact, in addition to the ‘big, beautiful budget bill,’ we've seen several cases where the government has made actual investments or loans to accelerate and encourage development of plants and things in the nuclear space or in the rare earth area to increase the production capacity domestically. I think those are all pretty good indications that the administration is behind revving up the economic growth engine in the U.S. I think we've seen that, as I just mentioned, in the fiscal spending area, but I think we might see some changes in the Federal Reserve, maybe a new chairman who probably is going to be more sympathetic to what the Trump administration's been saying, and that would be lower rates.

So, if we have that combination of fiscal spending and lower interest rates, that typically is a pretty good backdrop for businesses in general for anyone who's going to borrow money to spend or invest in a project, and particularly for small- cap performance. So, I'm pretty bullish about the potential for that backdrop. Now longer term, there are some consequences. There's probably higher inflation and certainly more federal government debt that will have to be addressed at some point, but I think next year, that's what I'm thinking.

Francis: Yeah, I agree with you. One of the more interesting things out of that tax bill that was signed earlier this year is the fact that you can have 100% depreciation on research and CapEx, so you could see a great CapEx cycle begin, which would be wonderful for small-caps that I don't think the market has really come to grips with yet at all.

Perhaps the last question for you both before we go is, what was something that you read within the past year that people should pick up and read because I think we spent a lot of our time reading stuff. But, we never think of, this is a great piece. What's something you would recommend people read?

Chip: Oh gosh, that's a tough one. Most of the reading I do is research related or company related, and frankly there have been some great investment bank pieces that have talked about some of these new areas. One area that I know is going to happen one day, but we're still in the very, very early days, is applying technology to drug discovery. And you've seen even the FDA, who tend to not move on a dime, so to speak, in changing the way they review drug candidates. Even the FDA is saying, “look, the early stage safety trials, the animal testing that we do or that we require maybe, that's something we could do on a computer and create an animal model on a chip and run some safety tests so that we don't have to test them on animals.” I think that could be applied from the human organism standpoint—a human model will someday be there where we can run, using AI and data centers, and this is happening already. We know of companies that are doing this instead of hundreds of candidates in a period of time, they're running tens of thousands. Hopefully, the speed at which a drug can be approved, and the drug candidate can be identified is going to speed up dramatically, and probably the cost of developing new candidates will also drop. So that's an area that I'm looking at and looking for ways to participate.

Francis: Joe, last word.

Joe: Similar to Chip, I think obviously most of my time is spent reading about the companies that we're invested in and the industries that we're invested in and looking at. For the reading that I do outside of work, I think one of the most interesting books I read a little over a year ago now was a book called Endurance by Alfred Lansing. It's about Ernest Shackleton's 1914 expedition down to Antarctica, where they got stuck in the ice for, I think it was about two years. It's a story of survival in an extreme expedition type environment, and it's just a fascinating book. The reason I mention it is that I think it's an interesting book just to think about leadership, which is always an interesting topic for anyone who's interested in business. And just his ability to rally his crew through just unbelievable circumstances and survive. It's just an ultimate tale of survival and heroism and ultimately leadership and getting people through just unbelievable circumstances. So, just a fascinating read period. But I thought it had some implications to business to a certain extent from a leadership perspective.

Francis: Great. Well, thank you both. Till next time. Thank you.

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