How did the International Small-Cap Premier Quality Strategy perform in 1Q22?

Mark Rayner The mutual fund Mark and I manage in the Strategy, Royce International Premier Fund, declined 14.0% for the quarter, lagging its benchmark, the MSCI ACWI ex USA Small Cap Index, which was down 6.5% for the same period. Relative results were better over longer-term periods—the portfolio outperformed its benchmark for the 5-, 10-year, and since inception (12/31/10) periods ended 3/31/22.

Mark Fischer The Fund’s quarterly performance was disappointing to us on both an absolute and relative basis. It was in fact our worst quarterly disadvantage versus the benchmark in a down market since inception. Underperformance in down quarters has also been historically rare as the Fund outperformed the MSCI ACWI ex-US Small Cap in 10 of the previous 15 down quarters. Our preference for companies with superior and defensible levels of profitably, along with well capitalized balance sheets and pricing power, generally leads us to cyclical areas while avoiding companies in the energy and other commodity areas. And while we look for companies with a-cyclical attributes in these areas, the market did not discriminate in 1Q22, which was particularly difficult given our overweights in chemicals and machinery.

Which sectors and industries hurt and helped most in 1Q22?

MR Seven of the portfolio's eight equity sectors made a negative impact on quarterly performance. The biggest detractions came from Industrials, Information Technology, and Materials while the only positive contributor was Consumer Discretionary. At the industry level, machinery (Industrials), chemicals (Materials), and software (Information Technology) detracted most for the quarter while specialty retail (Consumer Discretionary) was the only contributor.

Which holding made the biggest negative impact in 1Q22?

MF The portfolio’s top detractor at the position level in 1Q22 was the U.K.’s Victrex plc, which is the global leader in the production and sale of an ultra high-performance engineered plastic called PEEK—which can be considered the 'Rolls Royce' of plastics. It’s not cheap—but it is stronger, lighter, more durable, and more recyclable than other kinds of plastic. These qualities make it suitable for use in various mission-critical applications across the industrial and medical sectors: airplanes, cars, dental implants, containment domes at nuclear power plants, and smart phones, to name a few. Victrex enjoys a very sticky customer base because PEEK is specified into its customers’ products, so that switching requires a time-consuming re-qualification process, while Victrex also generates customer loyalty through its dedicated technical sales teams who work closely with the customer to ensure their needs are met. With a more than 50% global market share and a vertically integrated manufacturing process, Victrex benefits from strong economies of scale that allow it to produce its products more economically and with higher quality than its peers, resulting in industry-leading profit margins.

MR In the long term, we believe the trend towards greater energy efficiency and environmental awareness will provide a structural tailwind for Victrex as its products increasingly replaces other, less environmentally friendly materials. In the meantime, the company continues to enjoy a more than 25% return on net operating assets and an 83% equity ratio with net cash. In February 2022, Victrex released its interim management statement for the fiscal first quarter of 2022, in which the company reported year-over-year revenue growth of 9%, reiterated its previous full-year growth expectations, and pointed to price hikes demonstrating the company’s pricing power. However, market participants were wary that potential raw material and energy cost inflation, which are typically passed on to customers with a lag, as well as investments in growth, may create a challenging backdrop for the company to improve margins for the year.

Which position made the biggest positive contribution in 1Q22?

MR Our top contributor was Totvs, a leading Brazilian ERP (enterprise resource planning) software company that’s headquartered in Sao Paulo. Totvs provides mission critical software, which then becomes highly integrated into its clients’ work processes, thereby generating a high cost of change and recurring revenues of more than 70% of the total. This stickiness is being supported by an early transition to SaaS (software as a service) based revenues. Partly driven by a robust M&A strategy, the company is able to offer a broad range of systems to a highly fragmented customer base operating in a wide-range of sectors across Brazil, which enables it to dominate the still relatively under-penetrated SME (small- to medium-sized enterprise) segment with a market share approaching 50%. Given the fact that some 25% of Brazilian GDP is thought to be touched by the company’s software products, it is often claimed that in effect 'Totvs is Brazil.' This often means that Totvs’s stock is bought and sold thematically by shorter-term investors looking in turn to add or reduce their exposure to Brazil. This occurs despite the visibility offered by high margins (fiscal 2021’s adjusted EBITDA margins was 24.7%) and sticky revenues.

MF Given the stock’s exposure to thematic investing, we typically add or trim our position against the flow of sentiment. Therefore, while the stock fell 45% in U.S. dollar terms from August 2021 into early January 2022, we more than doubled our position. From early January to the end of 1Q22, the stock then rose more than 80% in U.S. dollar terms to new all-time highs.

What accounted for this steep gain?

MF In February, the company reported revenue growth of 24% and adjusted EBITDA growth of 33% for fiscal 2021. Perhaps more important, though, has been the appeal of Brazil from a top-down perspective. Due to its soaring commodity prices, its stock market has been one of the world’s best performers so far in 2022 in U.S. dollar terms.

What accounted for the Fund’s disadvantage versus its benchmark in 1Q22?

MR Our disadvantage versus the benchmark was primarily attributable to stock selection in the quarter, though sector allocation also detracted. At the sector level, stock selection hurt most in Industrials, Materials, and Financials vis-à-vis the benchmark. Conversely, our very low weight and savvy stock selection helped relative performance in Consumer Discretionary while stock picking in Health Care also contributed to our relative quarterly results. In addition, there were two key factors that help put our underperformance into context. Within the benchmark, lower-ROIC companies outperformed those with higher ROIC while higher-leverage companies outpaced those with lower leverage. Each of those affected our relative results in 1Q22.

What is your view of the volatile international markets?

MR When we reviewed 2021, we noted a three-way tug of war between competing themes: ‘growth at any price’, ‘cheap -reopening plays’ and ‘inflation hedges.’ The first two waxed and waned during the year with the latest data on the pandemic. The last has been fueled by the debate as to how much commodity price inflation will seep into the wider economy. The terrible events unfolding in Ukraine have unexpectedly propelled ‘geopolitical risks’ to the forefront of investors’ minds. This has in turn added fuel to the fire of the commodity price inflation theme, as well as heightening previous concerns regarding interest rate rises, supply chain issues, and the emergence of cost-of-living increases for consumers. Given this overdose of uncertainty, we feel that the market has had a somewhat knee-jerk reaction—investors bought a lot of lower P/E stocks in 1Q22 whilst moving away from those with higher P/Es. This shift has been quite indiscriminate, and irrespective of a company’s pricing power, ROIC (returns on invested capital), capital structure, or enterprise value. In our view, the market has in effect moved paradoxically towards just those companies that look least able to withstand the economic impact of the issues currently stalking the market. We, meanwhile, have not changed portfolio positioning much at all and therefore did not participate in the rally driving more cyclical businesses such as banks, energy stocks, and metals & mining companies.

What is your outlook for the Strategy?

MF In spite of the difficult quarter, we’re confident about the Strategy’s long-term prospects. Throughout the first quarter, we continued to look for companies with superior and defensible levels of profitably, with well capitalized balance sheets and pricing power. As a happy byproduct of our long-term investment style, we also believe that—perhaps contrary to the market’s current thinking—our holdings are very well positioned to side-step the worst of the challenges currently driving the market: inflation through holding companies with pricing power; interest rate increases through owning cash generative businesses with low debt; supply chain issues by our preference for asset light models; and, finally, the increasingly pressured consumer by our structural preference for B2B businesses with visibly repeat revenues.

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