The initial rebound for small-caps from this year’s low on 4/8/25 through the middle of the fourth quarter has so far been led by low quality factors such as stocks with low or no returns on invested capital (ROIC) and higher debt levels. Stocks with quality attributes such as high and/or steady ROIC, profitability, and reasonable or low valuations have mostly been underperforming. However, previous small-cap leadership phases have started in much the same way as the current rally, with the lion’s share of the early gains going to lower quality and / or high growth stocks. As these prior upswings matured, however, higher-quality companies took over leadership, which became primarily driven by companies with positive earnings.

High-Quality and Low-Quality Small-Cap Stocks Have Historically Had Different Performance Profiles—Low-Quality Has Led Early While High-Quality Has Led in the Second Year of Small-Cap Rebounds
Average Russell 2000 ROE Quintile Performance Over the Last 25 Years as of 9/30/25

Past performance is no guarantee of future results. Source: FactSet.

Here are 4 holdings that we think are positioned to thrive in a high-quality leadership phase:

Arcosa supplies key materials and engineered structures for U.S. infrastructure. Over the past four years, management has implemented a return on investment-driven simplification plan focused on Arcosa’s less cyclical, higher return, growth businesses that now generate the bulk of its profits. In its Construction Products segment, Arcosa sells aggregates such as crushed rock, sand, and gravel, along with specialty minerals that are the core ingredients in concrete and asphalt, which are essential for construction and infrastructure projects. Aggregates businesses tend to be local monopolies because the low value/high weight nature of the product typically makes transport beyond a 50-mile radius cost prohibitive. Ownership of reserves and barriers to obtaining permits for new sites further limit competition. These factors keep pricing on a healthy upward annual trajectory. Solid long-term organic volume growth reflects Arcosa’s use of acquisitions and internal investment to intentionally position and expand its aggregates platform in states with healthy fiscal budgets, approved infrastructure spending plans, and/or net population growth such as Texas and Arizona.

Arcosa’s other growth business is Engineered Structures, where the company is a national, scale-advantaged producer of utility support structures and telecom towers. This business continues to see order strength and healthy backlogs driven by utility grid hardening and transmission expansion in the face of rising load growth, and next generation telecom network densification. To keep pace with demand, Arcosa is adding structures capacity in a capital-efficient manner by converting an underutilized wind tower facility.

Finally, management’s continued right-sizing of its remaining cyclical businesses—producing wind towers and barges—has positioned these units to realize solid operating leverage as volumes benefit from a more favorable investment backdrop. Overall, we continue to believe the positive, long-term secular trends and continued shift of Arcosa’s portfolio to higher ROIC businesses bodes well for long-term growth in earnings and cash flow. With strong free cash flow that enables it to deleverage quickly after large deals and ample high return reinvestment opportunities, particularly in the still-fragmented aggregates business, Arcosa appears to have a long runway to continue compounding value.

Exponent is a leading multidisciplinary science and engineering consulting firm that applies scientific rigor and technical expertise to analyze complex problems across industries. Founded in 1967 as Failure Analysis Associates by a group of Stanford professors and engineers, the company pioneered the practice of uncovering the root causes of accidents, product failures, and process breakdowns. Exponent’s premium positioning stems from its combination of specialized expertise, diverse end markets, and a highly resilient business model. The company operates within a large and fragmented $800 billion engineering and scientific consulting market and has cultivated a reputation as the go-to advisor for highly complex, high-stakes matters, such as product recalls, regulatory inquiries, and litigation support.

Roughly half of Exponent’s business is reactive and countercyclical—driven by legal disputes or accident investigations—while the remainder addresses proactive R&D, safety, and risk management initiatives. This balance provides stability through market cycles. The firm’s expertise is quite deep, with 70% of staff holding PhDs, creating high switching costs once embedded with clients. With more than 10,000 annual engagements across 2,000 clients and 85% repeat business, Exponent’s relationships are broad and sticky.

We see Exponent as being well positioned for continued share gains as technological innovation and environmental and safety concerns become increasingly complex. Emerging technologies such as artificial intelligence, autonomous systems, advanced materials, and “forever chemicals” have all expanded the scope of problems requiring Exponent’s expertise. While the broader consulting industry faces margin pressure amid AI efficiency-driven automation that has been leading to fewer billable hours, we think that Exponent stands to actually benefit from AI proliferation, as its core work often involves sparse datasets and unprecedented problems that resist automation, resulting in diverse use cases where AI will drive higher demand for core failure analysis such as autonomous vehicles, AI-enabled medical devices, and risk modeling for data centers. Most recently, headcount, utilization, and growth have inflected positively after the company refocused its labor model. Equally important, Exponent remains poised to show solid growth and margin expansion via operational scale and utilization gains.

Exponent’s business model is asset-light (CapEx accounts for roughly 2.5% of sales). The company carries a negligible amount of debt and consistently generates 20%+ ROICs. Exponent has also grown solely organically, with no acquisitions in over two decades, preferring instead to emphasize intellectual capital development and disciplined reinvestment. The company is currently exhibiting a positive rate of change in its fundamentals. As such, we believe Exponent represents a premier platform for long-term compound growth in an era where technology, regulation, and risk are becoming increasingly intertwined.

Onto Innovation provides inspection, metrology and lithography equipment that is critical for quality and process control in semiconductor chip manufacturing. Its broad portfolio of solutions and technologies are a key differentiator as Onto has solutions that are applicable across the chip-making process, from front-end wafer fabrication to middle and back end of the line applications, including advanced packaging. It holds the #1 or #2 position in most of the process control niches in which it currently offers tools with high barriers to entry given the long process of getting a tool validated and the high cost to customers of switching tool suppliers, particularly when ramping up to high volume manufacturing. The growth of Onto’s existing portfolio is fueled by secular trends such as increasing complexity of advanced node integrated circuit architectures (e.g., the shift to Gate All Around transistor design) and increasing use of advanced packaging approaches (e.g., chiplets and die stacking), both of which are vital to enabling faster, smaller, more capable and more energy efficient chips. These technology transitions mean that there are more points at which wafers and dies must be inspected for defects, along with other critical dimensions that must be measured given the higher cost of failure of a device once it’s been packaged. As a result, the amount spent on the types of process control tools Onto provides is growing as a percent of total semiconductor equipment CapEx.

Onto also has a proven track record of driving growth by expanding its addressable markets via new product development (its current pipeline would expand its sales opportunities by another $1 billion) or acquisitions (e.g., ONTO recently announced the purchase of Semilab’s materials analysis business, which further broadens its technology offerings and is margin accretive). Finally, about 15-20% of Onto’s sales come from software, parts, and services sales to its installed base, which provides a less cyclical, annuity-like revenue stream.

We have owned Onto’s stock in other Royce-managed portfolios in the past and continued to follow its progress given its quality attributes, so our antennae rose when the stock fell significantly after the company announced 1Q25 earnings. Our subsequent due diligence led us to believe that the key investor concern—a missed incremental inspection business at a key customer—was not a permanent loss but rather an opportunity that could be regained later this year. (In its 2Q25 earnings report, management gave an encouraging update on its progress and improved the prospects for a reacceleration of sales and earnings growth in 2026.) We have also been encouraged by the addition of two high level executives and several engineers from rival industry leader KLA corporation over the past 12 months. Onto appears to have multiple paths to achieve its targeted longer-term model, which could yield double-digit earnings growth and earnings power of over $8 share. We therefore felt that the stock’s risk/reward profile after its sell-off in May 2025 presented an attractive point to take an initial position.

UFP Industries is the largest pressure-treated lumber processor in North America and a scaled converter of softwood, serving three more-or-less equal end markets—Retail, Construction and Packaging—via a national network of more than 200 facilities. The company’s model blends massive “buy-side” leverage—north of 7% of North American softwood output sourced across approximately 90 mills, often under managed vendor/consigned programs—with an asset-light footprint (like Exponent, CapEx account for around 2.5% of sales) and a dense, near-customer plant network that lowers freight, raises turns, and enables “optimal fiber utilization.” On the “sell side,” UFP translates raw-material scale into leadership positions across retail building products (pressure-treated lumber), residential engineered components (roof trusses, floor systems, and factory-built housing solutions), and industrial packaging (machine-built pallets and protective packaging). Culture and incentives reinforce returns—each plant is a profit center, and managers are measured on ROIC. The company has recorded over 65 consecutive years of profitability and a recent reorganization from geographic to market orientation has sharpened pricing, sourcing, and customer focus.

As UFP shares its scaled economics with customers, we see a durable mix-shift toward higher value-add as the core retail position compounds into attractive adjacencies. For example, in its Retail end market, UFP’s embedded share with the home-center channel (the largest supplier of pressure-treated lumber along with meaningful single-vendor category shares at both Home Depot and Lowe’s) creates a logistics and service moat that competitors struggle to match. This customer footprint in commodity-oriented products affords the company the advantage to attack the composite decking and railing categories with its patented mineral-based composite platform, Deckorators. We view Deckorators as a meaningful multi-year profit opportunity: it offers unique product attributes and protected IP to go with UFP’s ability to route product through its existing big-box distribution versus the harder-to-replicate two-step distributor model used by incumbents Trek and Azek. This should lower delivered cost, improve availability, and accelerate placement at the point of sale. We would anticipate that competitors will forfeit share over time in this very attractive category as UFP leverages proximity, service levels, and breadth of offerings to win the aisle and the professional contractor. The same network economics support Construction and Packaging: shared plants manufacture engineered wood components and custom packaging near customers, extending lumber buying power into higher-margin, mission-critical parts of customers’ bills of materials.

Beyond the structural under-supply of U.S. housing, UFP is emerging from a cyclically low lumber environment that structurally reset higher gross margins versus past cycles, helped by a mix upgrade and operating discipline. The company’s balance sheet is conservative. With more than $1 billion in cash and more than $2 billion of liquidity, ROIC has structurally increased cycle to cycle and stands at 15%+ at a depressed moment in industry dynamics. We believe UFP Industries has differentiated, durable business model attributes. Management is laser focused on cost take out while facing a depressed industry backdrop at a time when they continue to gain share at home centers and exhibit steady expansion in engineered components and industrial packaging. In addition, the scaling of Deckorators can support multi-year margin and cash-flow compounding from here.

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