Royce Small-Cap Total Return Fund Manager Commentary
article 02-15-2024

Royce Small-Cap Total Return Fund Manager Commentary

The Fund gained 24.1% in 2023, outpacing its primary benchmark, the Russell 2000 Value Index, and its secondary benchmark, the Russell 2000 Index, which were up 14.6% and 16.9%, respectively, for the same period.


Fund Performance

Royce Small-Cap Total Return Fund gained 24.1% in 2023, outpacing its primary benchmark, the Russell 2000 Value Index, and its secondary benchmark, the Russell 2000 Index, which were up 14.6% and 16.9%, respectively, for the same period. The Fund also beat both benchmarks for the 3-, 5-, 10-, 20-, 25-, 30-year, and since inception (12/15/93) periods ended 12/31/23.

What Worked… and What Didn’t

Six of the Fund’s nine equity sectors finished 2023 in the black, led by Information Technology, Financials, and Industrials (the portfolio’s three largest sector weights) while small detractions came from Real Estate, Energy, and Health Care.

FTAI Aviation is an aircraft engine lessor that spun off several related aerospace businesses in 2022. It was 2023’s top-contributing position. After researching the company before the spin-off, we concluded that the market was drastically undervaluing both its non-leasing assets and their growth potential. In January of 2023, FTAI entered the portfolio as a top-5, high conviction holding. Its strong fundamentals helped to shine a light on the franchise value of its non-leasing assets during 2023. We began adding shares of First Citizens BancShares late in 2022 when they were trading at roughly 5x earnings per share. In March of 2023, First Citizens made its FDIC-assisted acquisition of Silicon Valley Bank. The market eventually re-rated its shares, first as it became clear that the acquisition was accretive and again when no systemic banking crisis materialized. Vontier Corporation is an industrial technology company that offers environmental sensors, fueling equipment, field payment hardware, vehicle tracking, and other related software solutions. It began 2023 as our largest position after finishing 2022 as one of our biggest detractors. However, our research gave us confidence in the business and its management, which allowed us to accumulate shares at what we thought were highly attractive valuations. Its shares rose in 2023 as strong secular tailwinds, healthy end market demand, improving supply chain conditions, and ongoing pricing realization all more than offset a slowdown in Europay, Mastercard, and Visa (“EMV”)-related sales.

BOK Financial is a bank that operates in attractive geographies across the Midwest and Southwest U.S. Despite what we saw as a strong deposit franchise, demand deposits/total deposits declined in 2023, and deposit beta—which measures deposit-rate sensitivity to Fed fund rate changes—was higher than anticipated, pressuring net interest margins (“NIM”). Fears of a commercial real estate (“CRE”) recession also likely kept the stock under pressure, even as CRE comprised only 21.4% of total loans as of 2Q23, with offices only representing 4.3%. Dril-Quip makes offshore drilling and production equipment for oil companies. Though solid fundamentally and benefiting from increased offshore drilling activity, its stock was hurt as energy services companies spent much of 2023 out of investors’ favor. Independent Bank Group also suffered NIM pressure, which crimped earnings.

The Fund’s advantage over the Russell 2000 Value in 2023 came from both stock selection and sector allocation, with the former making the larger impact—and coming from some of our highest conviction ideas. Stock selection fueled outperformance most in Information Technology, Financials, and Industrials, with the Fund’s larger weightings in the first and third sectors also contributing. Conversely, stock selection hurt relative results in Energy, Real Estate, and Materials.

Top Contributors to Performance 20231 (%)

FTAI Aviation2.87
First Citizens BancShares Cl. A1.92
Vontier Corporation1.78
International General Insurance Holdings1.70
Kyndryl Holdings1.68

1 Includes dividends

Top Detractors from Performance 20232 (%)

BOK Financial-0.43
Independent Bank Group-0.42
Healthcare Services Group-0.39
UMB Financial-0.35

2 Net of dividends

Current Positioning and Outlook

We were very pleased that the Fund delivered strong performance while maintaining lower volatility than our peers and strong downside protection from the November 2021 small-cap peak. These results were rooted in both our robust process and its implementation. The process is designed to cultivate conviction, which manifests itself in a couple of ways. First, we are able to add weight to names in which we have high conviction, such as FTAI Aviation. A second, related way our research builds conviction is by buying shares in the face of weakness. Of 2023’s top 20 contributors, six were meaningful detractors in 2022. As we look forward, our optimism for small-caps, value stocks, and our high-quality portfolio remains—albeit with relatively less opportunities than were provided in 2022. The strong performance of some of our best stocks, coupled with the small-cap rally that began in late October, created more symmetry from a risk/reward perspective. Nevertheless, we continue to find compelling new ideas, a benefit of having thousands of stocks in our universe. From an industry and sector perspective, we are warming up to both banks and consumer stocks. We found the banking industry’s leadership in 4Q23 noteworthy as, in our opinion, the group did not lead coming out of the Covid or the Great Financial Crisis bottoms. Fortunately, we have extensive expertise in banks and expect to find more opportunities in 2024. The U.S. consumer has arguably been in a recession for nearly two years. Thus, we think expectations are fairly low for many of the businesses we own and/or are considering, while fundamentals could positively surprise if the U.S. avoids a serious recession.

Average Annual Total Returns Through 12/31/23 (%)

Small-Cap Total Return 13.4024.0724.0710.6211.657.4110.968.259.0410.27

Annual Operating Expenses: 1.26

1 Not annualized.

Important Performance and Disclosure Information

Important Performance and Expense Information

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. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds and other investment companies.

Current month-end performance may be obtained at our Prices and Performance page.

Notes to Performance and Other Important Information

The thoughts expressed in this report concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2023, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds’ portfolios and Royce’s investment intentions with respect to those securities reflect Royce’s opinions as of December 31, 2023 and are subject to change at any time without notice. There can be no assurance that securities mentioned in this report will be included in any Royce-managed portfolio in the future.

As of 12/31/23, the percentage of Fund assets was as follows: FTAI Aviation was 1.9%, First Citizens BancShares Cl. A was 0.0%, Vontier Corporation was 2.0%, International General Insurance Holdings was 3.4%, Kyndryl Holdings was 2.6%, BOK Financial was 0.0%, Dril-Quip was 1.2%, Independent Bank Group was 1.8%, Healthcare Services Group was 1.8%, UMB Financial was 0.0%.

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.

All indexes referred to are unmanaged and capitalization weighted. Each index’s returns include net reinvested dividends and/or interest income. 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. The Russell 2000 Index is an 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 Russell 2000 Value and Growth Indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell Microcap Index includes 1,000 of the smallest securities in the Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The Russell 2500 is an unmanaged, capitalization-weighted index of the 2,500 smallest publicly traded U.S. companies in the Russell 3000 index. The returns for the Russell 2500-Financial Sector represent those of the financial services companies within the Russell 2500 index. 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 MSCI ACWI Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks.The MSCI ACWI ex USA Small Cap Index is an index of global small-cap stocks, excluding the United States.The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Returns for the market indexes used in this report were based on information supplied to Royce by Russell Investments. Royce has not independently verified the above described information.

This material contains forward-looking statements within the meaning of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve risks and uncertainties, including, among others, statements as to:

-the Funds’ future operating results,

-the prospects of the Funds’ portfolio companies,

-the impact of investments that the Funds have made or may make, the dependence of the Funds’ future success on the general economy and its impact on the companies and industries in which the Funds invest, and

-the ability of the Funds’ portfolio companies to achieve their objectives.

This discussion uses words such as “anticipates,” “believes,” “expects,” “future,” “intends,” and similar expressions to identify forward-looking statements. Actual results may differ materially from those projected in the forward-looking statements for any reason.

The Royce Funds have based the forward-looking statements included in this commentary on information available to us on the date of the commentary, and we assume no obligation to update any such forward-looking statements. Although The Royce Funds undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events, or otherwise, you are advised to consult any additional disclosures that we may make through future shareholder communications or reports.

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. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see ""Primary Risks for Fund Investors"" in the prospectus.)



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