What have been the biggest challenges and opportunities investing in 2022’s highly volatile small-cap market?

Kavitha Venkatraman First, I would remind readers that the Small-Cap Opportunistic Value Strategy we use in Royce Opportunity Fund is designed to take advantage of volatility and market dislocations. In that context, we have been sifting through stocks that we know well which have suffered huge price falls to identify those that appear unwarrantedly cheap. The sheer volume of stocks that fit this description has made the endeavor very exciting, making us feel like the clichéd kid in a candy store. For example, there are relatively stable industries where the long-term structural growth drivers remain intact, such as healthcare services, where many stocks have become very attractively inexpensive. Another example would be stocks in industries where the competitive landscape has undergone fundamental changes that have rewarded certain companies with higher pricing power and better growth prospects compared to history, but the market may not be recognizing these factors fully, such as in the semiconductor value chain.

Jim Harvey I’m struck by the large number of challenges and opportunities that we currently face. In fact, we may be experiencing the largest number of concurrent challenges that most investors have ever seen: inflation, supply chain disruptions, the Fed pivot to tightening, interest rate hikes, and the war in Ukraine. However, amid all of this uncertainty, we’re also seeing several positive opportunities. For our Strategy, the most relevant is the way that persistent market volatility has been allowing us to buy companies we like at low average prices. We’ve also seen many companies excessively punished despite their favorable long-term outlooks—which has provided another set of buying opportunities. In addition, we’re seeing certain secular themes in industries that are likely to not be too dramatically affected by the slowing economy, including companies involved in communications services, the shift to sustainable energy, and reshoring.

How have you been investing around companies involved in energy—which has been the strongest sector in small-cap so far in 2022?

JH Each of our E&P (“exploration & production”) names has performed well in this market. We’re mostly exposed to natural gas (as opposed to oil) and own companies that exhibit capital discipline. We’ve also had success by ranging into other industries that have benefited from the rise in oil prices, such as liquid natural gas shippers, steel and specialty alloy companies that serve the energy industry, equipment distributors, and MRO (“maintenance, repair, and operations”) companies.

KV The energy industry is in a fascinating spot in its history. While we believe that the world needs to, and will, transition to a low-carbon economy, the transition has so far been anything but smooth, and the lack of an orderly transition strategy is now widely recognized. The underinvestment in fossil fuels since the financial crisis of 2008-09 has never been more consequential than in our current oil & gas shortages, as we scramble to meet a resurgence in demand post COVID, exacerbated by the Russia-Ukraine conflict. The fossil fuel shortage is likely to remain an issue for a host of reasons: a) the Biden administration’s infrastructure spending has not even begun yet; b) the U.S. electrical grid requires capacity expansion to support the transition to electric vehicles and renewables; and c) the localization of supply chains has the effect of duplicating energy demand. While we are underweight in energy in the portfolio, we have increased our exposure to natural gas—as Jim mentioned—which we think is a credible transition fuel that has adequate scale. We also have our sight set on the long term and have exposure to the renewables value chain.

Are there any of the Strategy’s four themes or other areas that have been hard hit but where you’re seeing attractive long-term potential?

KV New opportunities are surfacing in growing businesses whose stocks have been beaten down primarily because of rising interest rates. We are systematically going through these to identify those which we think have sound business models that give them a competitive advantage, intact long-term growth prospects, and attractive economies of scale. Executing their business plans alone should support higher valuations for these companies, regardless of the macro environment.

Though not every stock that fits this description has fallen far enough to fit our valuation criteria, we are also seeing opportunities in stocks that offer higher growth, that could fall into our “Undervalued Growth” and “Interrupted Earnings” themes. One example would be software applications that advance the digitization of supply chains, back-office functions, etc. The market might take a myopic, short-term view, but digitization is an ongoing trend that will progress regardless of interest rates. Our long-term perspective serves us well in these areas as we navigate the challenges and opportunities that accompany market volatility.

Can you discuss a holding in which you have high confidence going forward?

KV A recent addition to the portfolio, IAA (NYSE, IAA), previously called Insurance Auto Auctions and spun out of KAR Global in 2018, is one of two players in a duopoly that offers salvage auctions for totaled cars consigned by auto insurers. Salvage auctions involve towing a large volume of cars from the insurers’ lots to the salvage lots, processing them, auctioning them, and finally transporting them to the buyers. We like this business because the salvage auction industry has several structural growth drivers. The most important of which is the increasing proportion of cars that are determined to be total losses, driven by the high cost of repairs due to their age, higher complexity and / or high labor costs. Increasing demand for salvage vehicles from buyers in emerging economies, who typically reuse parts and hence pay more for these vehicles than domestic buyers do, should also support future growth.

We added IAA to the portfolio when its shares fell in response to some market share losses and investors’ concerns around elevated used car prices. We think its valuation does not fully reflect the structural growth drivers I described or its attractive unit economics that should shine through as volumes return to pre-COVID levels. Management’s cost rationalization actions that have been underway since 2020 are also not obvious in IAA’s reported financials, given the dislocation in its pricing and margins caused by the unusually strong used car price environment. I think IAA is a classic example of a good business available for a great price because it is out of favor on concerns that should prove temporary.

IAA (NYSE, IAA) 12/31/21-6/24/22

Past performance is no guarantee of future results

JH I would highlight Daseke (Nasdaq, DSKE), which is the largest flatbed and specialized transportation and logistics company in North America. This is a turnaround candidate where new management joined two-and-half years ago, introducing transformation initiatives and better capital discipline while cutting costs and ushering in new technology. The new team also developed a more disciplined M&A strategy, which is important in its highly fragmented industry. Demand for Daseke’s services is tied exclusively to industrial activity—whereas traditional trucking companies have more exposure to consumer goods. We also like the fact that roughly 20% of its revenues are countercyclical (the Department of Defense is a customer) and see its industrial concentration as helping its business to benefit from the Infrastructure Bill. Yet its stock price has been brought down with the rest of the trucking sector, despite its markedly different profile and its ability to continue raising rates for its services. Finally, we see advantages in its below average driver turnover—which is especially relevant in the tight labor market—and strong balance sheet.

Daseke (Nasdaq, DSKE) 12/31/21-6/24/22

Past performance is no guarantee of future results.

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