This transcript has been edited for clarity.

Francis Gannon: Hello everyone and welcome to another episode of the Royce Exchange. I'm happy to be joined by portfolio manager Chip Skinner and analyst Will Collopy from our very successful Smaller-Companies Growth strategy. And we want to spend some time talking about the growth opportunities within the small cap space. But Chip, perhaps we could start with what we've seen happening from a rotational standpoint in the market so far this year, after what was a very successful year last year for small cap growth in general, value has really started to show strength this year. We've seen a bit of a rolling AI correction, if you will, through technology and healthcare in different areas of the market and it's really affected the overall performance of the Small Cap Growth Index, which is only up 3.7% through the end of February on a year to date basis versus small cap value which is up close to 9%. What are your thoughts on what's happening in the rotational aspect of the market that you're seeing from a growth perspective?

Chip Skinner: Well, thanks Frank. I might start back in 2025, which as you mentioned, was a good year for small cap growth. However, if you dig beneath the covers, it was quite a roller coaster year in terms of quarterly performance. We were sort of unpleasantly surprised with the administration's tariff announcement the first half of the year that caused a serious correction in the small cap growth segment in particular, as people worried about, what that meant for GDP and inflation and, relations with other countries, etc., etc., and fortunately there was a pretty swift bounce back I think before that the first half was over, so it was a bit of a white knuckle, first half of the year, and I think that was because the recovery was due to the fact that there was a view that maybe the tariffs didn't have as many teeth as people had thought. The impact might not be as severe, and maybe it was just a way to get trading partners to the to the negotiating table. As people got comfortable with that outlook, the third quarter was a very speculative quarter in terms of performance, at least from my viewpoint. Many of the very early-stage areas that may relate to Bitcoin or early-stage biotech companies, there's a whole segment called quantum computing where a lot of early-stage companies have very large market capitalizations. There was a period where a number of those less established companies were outperforming and a lot of us you know meaningfully underperformed in the third quarter. Then it seemed like we got overdone there and, life kind of returned to more of a normal state when the more traditional small-cap growth institutional investor names began to outperform again in the fourth quarter. So, even though it looked like a great quarter, there was a lot of anxiety and ups and downs in 2025.

Frank: How much do you think in that third quarter speculative moment was driven by the Fed and easing by the Federal Reserve to help these companies that are probably carry a lot of debt?

Chip: Many of them don't have debt and actually have a lot of cash which makes an investor more comfortable, even though they may not have revenues or profitability.

I do think the rate environment and rate expectations had a lot to do with the third quarter. The economy in general has been pretty stable. It's been growing, employment has been pretty solid, inflation has been under control even with the tariff discussions, and so I think the backdrop economically has been very favorable to the extent people seem to be changing their view on whether we're in an up-rate environment or down rate environment every so often. My personal view is, we probably are in a stable to maybe declining interest rate environment. I think that's partly to do with the fact that there will be a new Federal Reserve Chair appointed. There will be a lot of pressure to keep rates low.

Frank: Fast forward to this year--you've seen kind of the typical engines of growth, and I mean growth by those that are identified within the growth you know tend to be more growthy, as opposed to value, have faltered a little bit, specifically healthcare and technology, as the ramifications of AI rips through different parts of the overall economy. What's changed and how is that affecting how you're viewing the world?

Chip: Good question. If you look at the index’s year to date, just the first two months of this year, as you pointed out, there's. close to a 500 basis point performance differential between small cap value and small cap growth in terms of the indices. If you dig a little deeper on that, you will see that there has been a large broadening of the market, which I think is a positive thing, into areas that were not technology related. The equity markets in the U.S. have been, as we all know, you know, very technology focused--that's where most of the performance outperformance has come from. I think there has been some cooling in terms of expectations and timing regarding AI adoption. Certainly, investors are taking a pause or a break from being overweight this area. A couple of the sectors that have driven the outperformance on the value side have been energy, basic materials, industrials—typical value type sectors. And if you look at the underperformance in small-cap growth year to date, it has been mainly in the technology and the healthcare sectors. It's not surprising, to me anyway, that many small-cap growth traditional investors, long only investors, tend to have higher weights in healthcare and technology. The broadening of the market is positive. There does seem to be a shift in leadership in terms of sectors and maybe companies. It's been a rotating market. I'm not concerned about that and I'm quite positive on this year. I exited 2025 with a favorable outlook and I continue to have a favorable outlook even given some of the more recent geopolitical issues.

Frank: Spend some time talking about AI. It seems to be, you know, everyday we're dealing with it. The ramifications of it the fear over the possibilities of it, et cetera.

How are you as a growth manager thinking about AI in your respective portfolio companies?

Chip: It's a good point because one of the reasons technology has underperformed this year has been the software sub sector of technology, enterprise software.

This area has come under significant pressure because of fears that artificial intelligence and the models that drive this new wave of innovation have the ability to code software without manual software developer involvement. As a team, we believe that artificial intelligence is a very serious new innovation. It's one of the reasons I like to invest in small-cap growth companies because this is a global world of innovation through technology and through healthcare that has resulted in some pretty exciting and interesting trends. AI has been likened to the rise of the Internet, and how different business models came out, how some were disintermediated, and I think the same thing is going to happen and is happening regarding artificial intelligence. Artificial intelligence reminds me a lot of Moore’s Law that was in existence for the past 50 years, suggesting that the processing power of semiconductor components doubles in power every 18 months to two years. Well, the same thing is happening with these models. They are coming out with revisions, version updates even more frequently every six months or so. The last one happened just last month in February and has been considered a serious leapfrog over some of the earlier generations. ChatGPT 5.3 Codex is one of the two and the CLAUDE OPUS 4.6 is the other, they actually came out on the same day, February 5th. They're described as really, seriously game changing. They're able to write thousands of lines of code or build out and test an app just by giving it a voice command. This is thought of as having virtually caught up with what a human tech engineer is capable of doing, just a lot faster and a lot cheaper. That has certainly caused a lot of concern on how the software industry, for example, might look in just a couple of years. It's hard to speculate on what's going to happen. Software has been an innovation, a technology that has been life changing and business changing over the years. I think that will continue, but how the companies grow and how they develop their software probably will change. The thing that I worry about, even though I believe the industry is sustainable, is that every enterprise now is going to be thinking that maybe they can develop any application or software in house, and so They might pause a buying decision which is not good if you're if you're a growing company. The other thing is, these software companies are in a race to develop their own internal AI capabilities and to embed AI in their products at a faster rate than what an enterprise customer could do. I worry about the pricing. If you're paying, you know $1,000,000 a year for some enterprise license for software that negotiation each year will probably be a tougher negotiation, and you'll probably see some falling prices.

Frank: I've heard you often talk about these long trend changes that you try to tap into, themes, if you will. What are you looking at today that you would consider to be some of those long trends?

Chip: Well, we've been relatively consistent. We have about 10 themes that we can point to that we typically build a portfolio around. The ones that have been driving some of our performance of late and that we're still excited about include the aerospace Industry. There has been a lot of well-known discussion around Boeing and some of the safety and manufacturing issues that they've had. The FAA halted production of a couple of their platforms. And so there are a lot of smaller companies around the industry that have benefited from either retrofitting and refurbishing engines to make those engines last longer since the OEMs have not been able to actually produce new ones. Servicing parts, supplying parts. There have been a number of companies that have been very successful during this period and it's not an overnight fix. I think Boeing is under a new management making some progress. It's slow and steady. I think they're still well behind the rate of production that they used to be and they'd like to be, but they're gradually expanding. But you know now the global fleet of aircraft is aging and there's a bigger backlog to catch up with. Aerospace has been one category. One area that I'm intrigued by is the whole space side of aerospace. The satellite network has been in place for some time. More recently, the last few years, there have been companies that have built an end-to-end solution of launching satellites for communication and military purposes. Some of the cellular networks now are using satellite as a backup in case you're out of range of the cellular tower. That is a big growth area and it's just a handful of companies that are benefiting from that and that does have a crossover with the next theme, which is defense spending. You could argue that the U.S. has been constrained on the spend regarding the fiscal budget. I think that's changing. We've certainly been involved in more international military action than we have in some time. There's an innovation going on in defense which we were able to fortunately spot a little early regarding these unmanned aircraft. Before, it was boots on the ground. You would need a large army, you need to transport them. You need to control the battlefield and all of that is expensive. The Air Force fleet, those platforms are very expensive. When you lose one, it’s a problem. There has been a lot of innovation regarding small unmanned aerial vehicles, which have done everything from surveillance, identifying where the enemy is if you're on the ground. To carrying munitions, and actually, you know, making a run without the risk of loss of human life. This is a lot cheaper approach than the big fighter jets. That's an area that we're involved in. Drug discovery has been a theme of ours for a number of years. Every industry is seeing technological innovation. I think we've got a favorable FDA administration today that is in favor of looking at and pushing new drugs and treatments, you know, through the approval process. There are some interesting areas that we're taking advantage of. These are industries or sub industries that are benefiting from a durable, multi-year trend, and my view has always been, let's look in the areas or sectors or industries where there is above average growth, then we'll find the companies that are participating there.

Frank: Will, is there a particular theme that you're interested in as well?

Will Collopy: Another theme that we're interested in is the energy and power generation theme. Their load growth has been flat since the early 2000s, and we're really starting to see an inflection point in 2025-2026 and, estimates are that power load growth can be 10 to 15% CAGR and up through 2035 and potentially more than that and we're seeing a lot of companies in our small-cap space that are really the ‘picks and shovels’ that are going right into that theme and it could be the EPC companies, Engineering Procurement and Construction. They're moving the dirt so that we can build nuclear power plants. There are industrial names that are providing the nuts and bolts for those power plants as well. Ultimately, it's to drive that long. theme-power generation. We've seen a lot of great names in that space that similarly have better mousetraps. They have the experience of doing it for 20 years now that they start to fit right into this theme of accelerating, inflecting growth in power generation.

Frank: Yeah, I've always been a believer that innovation is not the sole province of the large cap space everybody talks about how wonderful, innovative, all these great businesses are, but obviously you've identified a lot of different areas that innovation is changing how things are being done. I'm curious, how does a growth manager approach the small-cap asset class?

Chip: It's a broad question. I would say that there are a number of ways to do that. We tend to have a longer term horizon for our investments in the portfolio, we're looking for companies that ideally we can own for a long time and some of our better performer names have been multi-year outperformers, and in some cases really unique companies that are creating a new industry and are dominating that industry. We refer to these types of companies as Amazons. They do what Amazon has done successfully, they've taken an innovation, which is online, retail purchasing and, built an entire huge business around it. There are lots of buckets of small-cap stocks out there, as you know, there are thousands of companies in the universe, but it's our job to narrow down that list and not focus on the ones that might be in the very early stage, startup stage. We want to not focus on the ones that have hit maturity and that are not, you know, growing, maybe even slowing down, and focus on the ones that are either slightly early in their multiyear growth cycle that are experiencing an inflection in their growth rate because of maybe some new products or something has changed in the business, or longer term holdings that we refer to as GARP--growth at a reasonable price. And so the combination of those categories is really what our sweet spot is.

Frank: Will?

Will: I feel like there's been a ton of companies in the small-cap space that have grown from being very small companies to being much larger companies, and it really fits into our investment philosophy of, you know, companies moving from developing into the GARP cycle into, you know, potentially an Amazon over the long run. Just attacking a huge, huge market.

Frank: Great. Let’s leave it there. Thank you, I appreciate your time.

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