Steve Lipper I’d like begin by asking each of you for your perspective as you look out to 2022.

Chuck Royce I think in general the opportunity set for small cap remains vast and strong in many ways. For example, valuations look very favorable compared to large caps, and the global economic rebound is still taking shape. So while I think overall returns are likely coming down for equities as a whole, I think active managers have a real shot of demonstrating their skill in the next few years, especially in the small-cap space.

Jay Kaplan Two issues that are very relevant for us all as investors and consumers are inflation and higher interest rates. For a while, the Fed held that inflation was transitory. But anyone who’s gone to the grocery store or the gas pump knows that this is not the case. Now that the Fed has acknowledged that inflation will be with us for a while, I think we're going to see more tapering and hear more hints dropped about higher interest rates. What that will do—and actually has already started to do, which you can see more in individual stocks than in the market averages—is hurt the valuations of longer duration assets. Companies that don't have earnings and are story stocks have seen their prices come down hard when they have an earnings miss. We’re also seeing earners, cyclicals, and companies with pricing power doing better, so I think there’s an opportunity for high-quality small-cap companies with earnings to do well in 2022.

Andrew Palen I’m focusing on companies with strong market positions, intimate customer relationships, pricing power, and market share gains, with particular attention on idiosyncratic, a-cyclical growth companies and businesses that can compound value through inflationary environments. I think these are the attributes that are likely to win out in this kind of environment.

SL Each of you touched on the idea that the gust of the tailwinds is going to diminish. To develop that metaphor a bit, it seems that the skill of the ships’ captains could make a big difference in 2022. In that context, how might inflation affect small caps?

CR One relevant observation that goes back roughly 90 years and has been important to me since I began investing in the early 1970s is that small caps are the only major asset class that has beaten inflation in every decade since '30s.

SL That is significant. You can’t say the same for cash, bonds, or large cap stocks. We often tell clients that the more concerned you are about inflation, the more you may want to be leaning into small cap and away from high-valuation stocks.

CR I’d also add that small caps can adapt better simply by virtue of their size, which I’ve always thought gives them an advantage. I think this is especially the case among high-quality quality small caps, where companies with high returns on invested capital, prudent capital allocation practices, and other attributes are best equipped to handle sudden changes, such as inflation.

SL Tight labor markets are creating wage increases, which is a key inflation input. But labor shortages can also create opportunities. Do you think this creates opportunities?

JK For the businesses that can pass through price increases, it’s a positive. There are also companies in certain industries that can benefit from tighter labor markets. I've invested in a lot of companies that specialize in the sourcing and provision of people—they provide human capital. Whether it's a company like Korn Ferry or Heidrick & Struggles that helps to recruit people, or Kforce, which places technology workers, or Robert Half or Resources Connection, which have divisions that provide consultants to get work done, those companies are providing people, so for them, tight labor is a benefit. But it’s important to note that the labor market is making life tough for most other companies.

CR I think Jay is exactly right and has done a marvelous job identifying companies that I think are very well positioned for the years ahead, and we own several of them in Penn. These are typically lower capital-intensive companies that provide high-demand services and have great returns. They should do well in an inflationary environment.

AP I think pricing power and scale are really important in an environment like this. Companies need to have funds available to invest in labor productivity and business effectiveness or performance. I’ve been looking at companies that build and/or furnish talent in a digital context, specifically where hybrid or remote work has emerged as a model for employers. One business I like in this space is Upwork. They’re the world’s largest global talent marketplace with almost half a million freelancers and three quarters of a million employers on its solutions platform. I think they can build on that already highly impressive base in the current labor-starved environment.

Companies that have experienced limitations on hiring and adjusted compensation also have renewed investment in back-office tools and technology under the broader umbrella of automation. I’m particularly interested in how this should benefit Repay, which is a payments business that benefits from inflation from the spending side of things with a business’s receivable and payables. Repay gets spreads on the volume, and they’re integrated tightly with software solutions that get more productivity out of anything from replacing paper processes to automating other functions. They’re benefiting by posting roughly 40% operating margins, which provides cash to reinvest in their business.

SL Let's turn to each of your highest conviction investment ideas for 2022. Let’s start with Chuck.

CR Focusing specifically on what we’re doing in Penn, with the help of almost everyone on Penn’s investment team, we’ve been adding property & casualty insurance stocks to the portfolio’s top 100 positions, including International General, RenaissanceRe, and Amerisafe. We see very favorable supply/demand dynamics and attractive pricing in this area, which has been underscored by our discussions with companies and customers. We see this as a potentially powerful secular shift that’s just beginning.

AP I'd highlight GCM Grosvenor, which is an alternative asset manager in the emerging quality zone in which I primarily operate. The stock is trading at a discount to the market but has accelerating fundamentals and, I think, a sizable rerating potential. We have a lot of history with alternative asset managers going back to Ares, KKR, and Oaktree. Grosvenor is trading for about 15x earnings with a 3% dividend yield compared to its peers, which trade at double that multiple. Competitors trade at this higher valuation higher because they’ve had higher growth in recent times, but that is converging. However, Grosvenor has made some significant investments and is accelerating from high-single to double-digit top-line growth as earnings improve from the mid-teens to more than 20%. This is a high- profitability business with more than 40% EBITDA margins. And its growth acceleration is arguably de-risked to a large degree. Grosvenor is active, with four of six flagship fund launches and contracted fees that are ramping up as prior funds continue to reach investment cycle. And they’re actually in harvest phase, which makes the incremental margins on this growth higher than at any time in the company’s history. Another way to look at this is that if you capitalize their private market business at their peer’s multiples, you're getting their 50-year-old $27 billion asset under management liquid markets business for free, so I think there’s attractive optionality on growing asset volatility as we look to next year.

JK As we made our way past the worst of Covid, a lot of companies benefited from substantial catch-up spending to the point where they may be viewed as having over-earned. Like a good contrarian, I’ve been trying to find companies that may be under-earning due to no fault of their own, and that has led me to businesses in the semiconductor supply chain. Many of us know that there were some serious issues in getting semiconductors. If anybody's had to buy a car, for example, like I just did, you’d hit that phenomenon headfirst—there aren’t many cars because there aren’t any chips.

And chips are everywhere. So the question for me became, how can we find companies that may not be seeing great earnings now because they’re suffering from the chip shortage? I expect that it should self-correct into the second half of 2022, and that has led me to some of the electronic contract manufacturing companies. When we buy an electronic product like a computer or a phone, it has a brand name on it, but the people who support that brand may not actually touch or manufacture anything. The manufacturing is all done under contract. The companies that do this are not only active in electronics, they also work now in 5G, cloud computing, electric vehicle components, medical instruments, industrial, and aerospace. So there’s a lot of growth even as the companies are hampered right now, initially by Covid-driven Asian facility closures and more recently because of the semiconductor supply problem. If I’m correct in thinking that supply and distribution are no longer problems by the second half of 2022, these companies should do very well, and earnings should improve by a lot. Sanmina and Jabil, both of which sell for about 10 times earnings, are two potential beneficiaries.

SL Let’s conclude with a look at Penn’s overall positioning. Although we have always been bottom-up investors, from an exposure standpoint it’s interesting that Penn has landed with its three biggest overweights in Industrials, Information Technology (IT), and Financials. And the Fund’s holdings in IT lean more to what we call tangible tech—we hold in more semiconductors & semiconductor capital equipment and electronic components than software. If the economy continues to recover and do well, companies across these and other cyclical areas we like are going to benefit. Penn also has no exposure to Utilities and is very light in Real Estate, which provides some insulation against inflation and rising interest rates.

Penn will celebrate its 50th anniversary under Chuck’s management next year, which is quite a milestone. The Fund has achieved an extraordinary return for clients over that period, and we hope to continue delivering attractive returns for our investors in 2022 and beyond.

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