This transcript has been edited for clarity.

Francis Gannon: Hello and welcome back to the Royce Exchange.

This is Francis Gannon Co-CIO of Royce Investment Partners.

Our focus today is on the micro-cap asset class, which represents a unique segment of the public equity markets, characterized by small, often underfollowed companies with significant long-term growth potential. I've always been fond of saying that the small-cap asset class are the forgotten asset class, but I would argue that micro-caps are even more forgotten if possible. That was, at least until last year, when micro-caps outperformed for 2025 as a whole, outperforming the Russell 2000, the Russell 1000 and even the top 50 names in the Russell as well by a significant amount.

Joining me to break down some of the opportunities in the micro-cap asset class are portfolio managers James Stoeffel and Andrew Palen, each of which has significant experience in this area. Let's just start off by defining micro-caps. How do you guys think about the asset class, Jim?

Jim Stoeffel: Technically, the way we think about it is, we look at the largest stock within the Russell Microcap Index, which right now I believe is about $1.3 billion dollars. Candidly, and to your point, Frank, about looking for companies that we think can grow and become bigger companies, we tend to think about stocks maybe smaller than that because we want them to grow out of being a micro-cap. Our average micro-cap stock right now is about $700 million dollars. So, we're about 50% below where our maximum could be because we want stocks to move up. And then we have a fair amount of stocks that are really super small, you know, under $100 million, $50 million, $60 million. And those are interesting equities because if they're successful, they become really, really big stocks and they become really, really big contributors to performance. The risk obviously being that when you're that small, you lack scope and scale and if you make one bad decision, it tends to be pretty ugly. So, we tend to think about, from an investment perspective, running pretty diversified portfolios that we can go after some of the really small things that can be, you know, 5 or 10 baggers or whatever the number is. But generally, and Andrew, you can correct me, I would think sort of $500 million to $700 million is sort of our sweet spot of companies that have gained scope and scale but still provide a significant amount of opportunity.

Frank: Andrew, could you spend a second talking about some of the inefficiencies in the asset class and therefore some of the opportunities?

Andrew Palen: As you alluded to, things start from a point of even just less institutional sponsorship, whether that's on our side of the table with investors who are following the companies speaking to management and really having a dialogue about company strategy, I think you'll find lots of companies are going about their way without the same kind of oversight from investors that larger companies have, even down to brokers and research and just general dissemination of information about what the company is doing and what they're planning on doing. I would also note that the companies are making investments. On that last point, I'd say the companies are making investments with longer term horizons, and it's not showing up in numbers.

And so, that's an opportunity for us to add value as we’re actually going through and focusing on these companies.

Frank: And then narrowing it into the way you view the world within micro-caps, what differentiates your approach? How do you look at the asset class and therefore how do you invest in it?

Jim: I'll take that one because Andrew hit on really the key issue in terms of these companies making investments. If you're a micro-cap company, more or less each investment you make into the business, growing the business is a relatively meaningful shot on goal. They don't necessarily have a lot of capital, you have to get most of the investments right more or less. The key from our perspective is, we're looking for companies that we think can be much bigger over time. We spend a lot of time thinking about where they're investing their capital and 1. whether we think that's a good use of their capital and 2. whether we think the management team is capable of executing against the strategies that they've articulated. So, we spend a lot of time talking to management teams saying, ”Well, OK, what is it you're trying to accomplish?” Andrew and I have both been investing for a long time, and after a while you sort of get some feel for what's realistic in terms of what they're trying to accomplish. So, the keys, in my opinion, to successful investing in micro-cap are, 1. Are they allocating their capital with a realistic risk return profile? and 2. Do we think the management team is capable of executing against the investment case that they've articulated to us? I think those are the two keys.

Andrew: And maybe just drawing out a point Jim made about successful investments and having, at the company level, it being a meaningful shot on goal. And if it pays off, that can be meaningful to returns. I think that's a great framing for what we're hopefully doing more often than not, which is investing with the with kind of a medium term horizon. In those cases where things do work out, we’re happy to cost average our position up, at least as attractive kind of risk reward. So, that boils down to really underwriting an ability for compounding value . As things unfold, these qualitative dynamics show up in quantitative places. I think that's where we add a lot of value, is speaking to the companies, having some frameworks around how things can go right. With our experience with companies of this size, things never go as planned and that's especially so in micro-cap.

Frank: Spend a second on that if you will, in terms of how do you mitigate risks? You've already talked a little bit about the number of names you might own within the Strategy. But, how about from a individual company standpoint? How do you mitigate risk?

Jim: A couple of areas. 1. you start with the premise that micro-cap companies, because of their scope and scale, there's typically a fair amount of operating leverage in the business. If revenues start expanding, there's a tremendous amount of operating leverage and so, in a general sense, we do have stocks that have leverage, but we we're very thoughtful about micro-cap companies that have a lot of financial leverage because we're already taking a lot of risk. So, we're trying to mitigate that particular aspect of it. I still think that the key to these companies is to talk to management, understand what their strategy is, have them articulate it, set up milestones, and then monitor whether they're executing against that strategy, recognizing that sometimes it's not a, probably oftentimes, it's not a straight line up. Andrew hit on a key aspect of that, that sometimes we're willing to buy the stocks after they’ve started working because it's been de-risked in a way. You have a management team that's articulated in an investment thesis. We buy the investment thesis and then they execute against what they said they're going to do, which provides enterprise conviction, for lack of a better term. And then it makes it easier for us to buy the stocks even if they're up. So, a lot of it just comes down to having done this for a long time, knowing what may work, what may not work. And then really just monitoring the management teams against what they said they they're going to do and being hardnosed about that.

Andrew: Adding on to what Jim's saying, I think another important factor is the ability to admit we've been wrong. You can control for sizing pretty easily. You're dealing with riskier situations in micro-caps. I think it's important to know, iteratively following these companies and sort of knowing when things are going in the wrong direction. I'd say this this sort of general dynamic, even up through small-caps, where I think the risk reward in the returns you see going from average businesses that are headed towards good businesses, can be a much more attractive risk reward or trying to invest in businesses that are trying to remain great because you have more attractive going in valuations and often there are misunderstood things about the business that play out over sufficiently longer time horizons where you can see consistent reinvestment opportunities or other things that that make it a better long term investment.

Frank: This idea of emerging quality, if you will.

Andrew: Yes, and we've covered this a little bit, but maybe to expand a bit further on emerging quality, which I'd put alongside, you know, depressed earnings, out of favor value, and more growth at a reasonable price type situations within our Strategy. Emerging quality starts from this insight that a lot of businesses that will turn out to be better businesses if things are going to show up in qualitative ways—things like customer-centricity or switching costs that are underappreciated about the business and its relationship with customers, or other value chain dynamics that we reveal through conversations with either the company or competitors. After we get through that filter, it's really understanding where the business might be cyclically or from its life cycle and what their reinvestment opportunities are for the business, so if there's an upcoming product cycle or a thematic driver in the business that hasn't been reflected in numbers.

Frank: So, I guess taking all of that into account, does your process lead you to certain sectors of the market and away from certain sectors of the market, Jim?

Jim: The thing that makes small-caps and then in particular micro-caps work is earnings growth. And you need relative earnings growth relative to Mag 7 or whatever else it's going to be to have decent performance. So, you want the tailwind of earnings growth. We do tend to be pro-cyclical because we want that tailwind of cyclical growth to help us. If it works, it's great. If the investment case doesn't work, you've got some tailwind that'll protect you as opposed to constantly going after stocks where you have some sort of major headwinds without cyclical growth. We definitely have a pro-cyclical bias. We're overweight industrials, we're overweight tech. We tend to be underweight biotechs, because there tends to be not a lot of underlying earnings support to the business. And if you get it right in terms of their particular product, that's great, but it tends to be a little binary. Over the course of five years, that's OK. Over the course of a year or two, that might not be great. And we tend to be a little bit underweight, banks. Again, banks are relatively efficiently priced asset, and so they never get overly cheap unless you have a financial crisis. So, you should think about what we do as being generally pro-cyclical. We're not trying to invest in companies that aren't making money, and sometimes we get those wrong. We're looking for companies that are going to be bigger. We want to sell companies because they become $4-, $5-, $6-, $7-, $8-, $9-, $10-billion-dollar companies because we got them right. And that's really the underlying gist of what we're trying to do is to find companies that we think have a strategy that will allow them to become small and smid-cap stocks, and we're happy to sell those to other people to when we get them right.

Frank: It's really interesting. I think the micro-cap asset class here at Royce is part of our research DNA, right? I think we follow companies through certain life cycles and understanding them while they're micro-cap companies has been, kind of, one of the keys to our long-term success. How often do you see small micro-cap companies grow up if you will, to become small-cap companies?

Jim: That's where we're trying to add value is through identifying these stocks that are going to become small-cap stocks and that's how we approach the portfolio. So, we have these stocks that we get right, they run up and they become not micro-cap and then we start harvesting that capital to reinvest at the bottom of the portfolio where, you know, they're still smaller, the investment case hasn't been proven, and where we think the risk reward is significant and maybe 10% upside, 90% downside or with 10 times upside or whatever 90% downside. So, if you look at what we have done relative to how we manage the portfolio, we have a very significant number of stocks at the top of the portfolio that are not micro-cap, or that we've earned that through fundamental research and understanding how micro-caps work.

Frank: You both mentioned the importance of meeting with management teams on a regular basis and the consistency of what you're hearing from them and what are you asking them? What are you looking for? Is there some commonality in most of those discussions?

Andrew: One thing I'd highlight that we haven't discussed has been that, you know, there's a lot of discussion these days thematically. And a lot of what we're seeing in the sort of cyclical businesses that are tied to the economy and to the broad industrial capacity buildout that we've been seeing, you know, with thematic drivers like onshoring deregulation, electrification, kind of next generation manufacturing infrastructure. That very much applies to our companies as well. A lot of the discussion is about the big tech giants or the big industrial giants and what they're seeing. but when we're speaking to our companies, they're very much seeing these types of drivers and are the underlying component suppliers that builds up to these larger themes. I think a lot of the conversations we're having are about, I mean at this point, investments made 2, 3,4 years ago are coming online and driving the business and becoming meaningful business drivers and value drivers for the companies as we go forward.

Frank: Jim?

Jim: Andrew's got it right. The way to think about a lot of our companies is, we're selling the picks and shovels into the broader universe. And if you look at the supply chain around AI, it's one of the broadest supply chains I've ever seen in my life. We're trying to figure out where we can find opportunities in a theme that we think is 100% true and make money. The big topics of the day are obviously AI, that's a that's a multi-pronged sort of issue. The first is, is AI spending in a bubble? And we don't think so yet, but it could get there for sure. And then the next one is how are companies going to harness AI to generate, you know, returns for their businesses? And that's obviously one of the first questions you ask every management team is, how are you harnessing AI to make your business a better business? The tariff issue is obviously, well, it has been front and center. It feels like it's dying down a little bit. But from the micro-cap and small-cap perspective, that was a problem because these companies had to make investment decisions, based on a very uncertain environment and I feel like we're through that. The geopolitical situation has become challenging, and that adds an element of Black Swan type risk that we're thinking a lot about. Then the regulatory environment, Frank, which you which you touched on, which I think has gotten shoved to the side a little bit with everything that's going on, but the regulatory environment has clearly gotten better, which is good for our companies. With the exception of the geopolitical stuff, everything seems to be either good on the regulatory front or a little bit less bad, say on the tariff front. The economy remains pretty strong. You have a lot of stimulus in the pipeline right now, whether it's the great Big, Beautiful bill or even the Biden administration's Jobs Act money is just starting to flow. You had something called the BEAD Act, which was targeted towards telecom, and there's also a lot of money in the system. So, I think the environment's pretty good for the economy. Things feel pretty good right now candidly, but knock on wood, I don't like to jinx myself.

Frank: There are so many myths about small-caps and micro-caps, right?

One of them, I think is around capital allocation; is capital allocation for companies that are micro-cap different than small-cap?

Andrew: I'd say that the capital allocation process is more capital starved with more frequency. When businesses are sub scaled there'll be periods where the business has more capital available, and there are periods where capital is more scarce, and so it breeds different business cultures, different executive behaviors.

Capital allocation is, you know, I'd say as important as it could be with businesses that have de-risked their balance sheet or diversified the business.

You know, this gets back to the point that incremental investments that the companies are making are more meaningful to the enterprise value of the business.

So, yeah, I would say capital allocation is important and that's something that we can investigate first hand. Speaking to these companies that are less covered or have perception gaps, and that's a source of differentiated returns for the Strategy.

Frank: Perhaps an unfair question to ask, but how do you think investors should position micro-caps in their thought process or in their portfolios?

Andrew: I think a lot of the discussion that we've had so far has been about cyclical drivers, thematic drivers and broader takeaways, lack of institutional sponsorship, or you know, a perceived underweight allocations with investors. I think I'd also highlight just the overlooked things. There are plenty of businesses that operate in fragmented markets and still have the growth runway or business quality that you might find in larger-caps, but we're getting them at more attractive valuations with the bigger opportunity for the re-rating evaluation and potentially attractive runways for those business returns. And so, I'd highlight that as a way to get differentiated exposure in investor allocation.

Frank: Yeah, I agree. I think having the right approach to help mitigate risk for the best risk adjusted returns going forward, I think, particularly in this asset class is really helpful. Jim, anything to add there?

Jim: Well, the only thing I'd go back to—and we get this question all the time—is again, why? Why micro-cap versus the Mag 7 and I don't have any problem with them, and we have lots of companies that sell into those companies, which is great. We want them to be successful, but their earnings growth is just starting to slow because of the law of large numbers. For micro-caps or small-caps to work, you need relative earnings outperformance, which you actually had last year, which is why micro-caps have started to work because they're growing their earnings much faster than the Mag 7. It looks like that'll continue into this year. Then you have a really pretty significant valuation disparity. Valuation won't make stocks go up, but, if the fundamentals get better, and you have a valuation disparity, that's where you start to get really big relative incremental returns. I think it's a diversification strategy to own some micro-caps, and there should be some allocation to micro-caps because they're not necessarily correlated because there are a lot of individual company specific things going on, and the setup is just pretty good with the improving fundamentals, very attractive, in my opinion, valuations and that's a nice setup. We've had 10 years of challenged small-cap value investing. It doesn't take a lot of incremental capital to really drive small-caps. You know, NVIDIA has more market cap than the entire Russell 2000. I'm not sure that matters, except that it doesn't take a lot of incremental capital to come out of Nvidia, Apple, and Amazon to really drive decent performance in small and particularly micro-cap. The setup is good. I think everyone should have some exposure to small- and micro-cap just as a as a diversification effort with an asset class I think is really attractive from a valuation standpoint.

Frank: We get a lot of questions about private equity. How is private equity affecting microcaps?

Jim: I don't want to disparage people, but the tricky thing is, if you're private equity, your whole schtick is sort of, well, you know, there's not a lot of good micro-cap investments to be had. And I know that's untrue because we’ve found a lot of them.

Andrew: One of the fastest growing areas within private equity has been private equity secondaries. And I think I'd also highlight that dynamic, which has been ongoing, which is, really given the developed nature of the asset class with increasing frequency, these transactions are between sponsors, and so it doesn't involve public companies. I think that also drovea lot of the conversation the last couple of years with the valuations which these transactions are happening in the markets.

Frank: Sure, the public markets wouldn't pay those valuations is the big difference which is fascinating. But anyway I appreciate both of your time today and thank you for enlightening us all about micro-cap asset class.

Jim: Thank you.

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