Fund Performance

Royce Small-Cap Special Equity Fund was down -1.4% for the year-to-date period ended 6/30/24, lagging its benchmark, Russell 2000 Value Index, which declined -0.8% for the same period. The portfolio outperformed its benchmark, however, for the 3-, 5-, 25-year, and since inception (5/1/98) periods ended 6/30/24 and trailed for the 1- and 10-year periods.

What Worked... and What Didn’t

Seven of the portfolio’s nine equity sectors made a negative impact on performance in the first half of 2024. The sectors making the largest detractions were Consumer Discretionary, Consumer Staples, and Real Estate while the only positive impacts came from Materials and Industrials. At the industry level, automobile components (Consumer Discretionary), consumer staples distribution & retail (Consumer Staples), and real estate management & development (Real Estate) detracted most for the year-to-date period, while construction materials (Materials), electrical equipment (Industrials), and machinery (Industrials) were the largest contributors.

Standard Motor Products, a manufacturer primarily of aftermarket auto repair parts, was the largest detractor for the year-to-date period ended 6/30/24. Its shares fell -15% on a single day in mid-February when the company reported earnings that missed expectations due to weaker demand from aftermarket customers, the impact of a former customer’s bankruptcy, and a mild winter. Milder weather continued throughout the spring and early summer, which will pressure air conditioning sales. Further, elevated interest rates have increased the cost of the company’s accounts receivable factoring programs. Ingles Markets is a regional grocer whose shares declined most of 2024’s first half but slipped most sharply following the company’s mid-February earnings report that included reversion to pre-covid margins. Marcus & Millichap is a real estate brokerage. As expectations for the pace of Fed rate cuts have moderated throughout the year, the persistence of higher for longer interest rates hurt its stock because, as a real estate broker, Marcus & Millichap is sensitive to transactional activity and therefore interest rates. Movado Group is a designer and manufacturer of watches through its own and licensed brands. Consumer health has been an overhang on the stock, as Movado has a dominant share in the ~$1,500 watch price point. In addition, larger customers have been managing their own inventory levels more tightly. ODP Corporation, which operates a chain of office product stores and a business-to-business distribution platform, was the fifth-largest detractor in the year-to-date period. Its shares dropped sharply following disappointing results reported in mid-May, with both sluggish consumer spending on retail items and weaker business spending hurting its business.

Encore Wire, which manufactures building electrical wire, was the largest contributor at the position level for the year-to-date period ended 6/30/24. The company has reported strong earnings recently, alongside elevated copper prices and investor interest in the electrical space. Encore also received an offer to be acquired for $290 a share back in April, an 11% premium to the prior day’s close following the announcement. The acquisition closed in early July. United States Lime & Minerals produces lime and limestone products used in various industrial applications. The company has some unique elements in that it has no analyst coverage, has a controlling shareholder, does not hold analyst calls, and doesn’t participate in conferences—making it likely to be screened out of certain investors’ universes. The stock has rallied throughout the year on strong earnings, supported by elevated lime pricing and volumes. Sylvamo Corporation is a low-cost manufacturer of uncoated papers globally. Quarterly results reported in mid-February included better than expected operational results, as well as a recent valuation of Brazilian forest lands that have appreciated by $600 million since 2021. Its shares improved by 24% on the day results were announced in February—and results reported in May also included guidance that were above expectations. Mueller Industries, which primarily produces copper tubes and fittings, has seen more resilient margins than what analysts had been expecting throughout the period. Additionally, the company’s acquisition into the adjacent electrical wire and cable market has been received positively. Gencor Industries, which manufactures asphalt plants, was the fifth largest contributor for the year-to-date period. The stock rallied following earnings results in mid-May, as Gencor has benefited from incremental demand from government stimulus and increased spending on U.S. infrastructure.

The portfolio’s disadvantage versus the Russell 2000 Value was attributable to stock selection in the year-to-date period ended 6/30/24—our sector allocation decisions were additive. Stock selection hurt most in Consumer Discretionary, while both stock selection and a substantially higher weight in Consumer Staples also detracted, as did stock selection and a much lower weight in Energy. Conversely, stock selection and higher weightings in both Materials and Industrials were strengths versus the benchmark, as was our significantly lower exposure to Financials in the first half of 2024.

Current Positioning and Outlook

Manic-depressive is a fitting description of the market these days, based on the latest economic input. As we have mentioned before, there appears to be a large cohort of investors who are trying to bring about a reduction in interest rates, despite whatever short- and long-term issues remain. Market participants, as they have done now for a year, keep believing that there will be more rate cuts than the Fed is signaling. The Fed, we believe rightly so, will not be swayed by a single good inflation report or indicators of a slower economy. They want/need a cluster of such numbers continuing before they feel they can reduce rates. Yet, the market continues to fight the Fed. This behavior was evident in 2023 and so far in 2024 and has so far proven wrong. Because of many secular issues previously mentioned (aging population, defense spending, interest on federal debt, etc.) inflation is likely to be higher than assumed and the Fed will need to remain in a higher for longer mindset until these headwinds disappear. The Fed’s rate reductions are most likely to be fewer than what was previously the norm.

At the end of June, small-cap stocks with market capitalizations below $2.1 billion were trading at a 13.0x P/E ratio and a price to sales of ratio of 1.2x, while those large-caps with market caps of more than $17.8 billion were trading at a 21.9x P/E and 3.3x price to sales—which shows hoe inexpensive small-caps are vis-?-vis large caps. There have been only two periods in the past that had similarly extreme divergence: during the dot-com bubble and the onset of Covid. In both instances, small-cap outperformance followed. In addition, the difference between the 10-year average annual total return of the Russell 1000 and Russell 2000 at 6/30/24 was at a two standard deviation level in favor of small caps. So, while large-cap outperformance can continue, we think it is reasonable to expect a mean reversion in favor of small-cap stocks.

Average Annual Total Returns Through 06/30/24 (%)

Annual Operating Expenses: 1.22

¹ Not annualized.

Important Performance, Expense and Disclosure Information