What are some of the challenges and opportunities you’ve found in the current market, particularly in the recent rally?

First, the Russell 2000 fell 31.9% from its peak on 11/8/21 to its most recent low on 6/16/22, which is within the historical range of small-cap bear market declines. In fact, the average downturn since the 1979 inception of the Russell 2000 was also 31.9%. Given all the negative sentiment in the current market, the odds favored a rally. The catalyst for the 22% rebound through 8/15 included signs that inflation may be plateauing and quarterly earnings growth outlooks that were less dire than expected

Although the “risk-on” rebound within small-cap was broad, it was led by lower-quality companies and more speculative industries. This dynamic created a challenging near-term relative performance environment for quality that followed several quarters of small-cap companies with the highest returns on invested capital outperforming. As a result, valuations for companies with the kind of durable, high-return business models that we look for in our Small-Cap Premier Quality Strategy remain reasonable.

Can you discuss a high-confidence (or otherwise notable) holding that’s been successful so far in 2022?

Acrosa supplies materials and structures for critical infrastructure projects. Over the past four years, management has implemented a return on investment-driven, portfolio simplification and transformation plan so that its less cyclical, higher-return growth businesses now generate most of the profitability. Arcosa’s Construction Products segment, fortified with $1.4 billion worth of strategic acquisitions, primarily sells natural, recycled, and lightweight aggregates such as sand, gravel, and crushed stone, that are used in public works projects as well as non-residential and residential private construction. Aggregates businesses tend to be local monopolies because the low value/high weight nature of the product typically makes transport beyond a 50-mile radius cost prohibitive. Ownership of reserves and barriers to permits for new sites further limit competition. These factors keep pricing steady in cyclical downturns while yielding pricing power when volumes are healthy.

So far in 2022, its stock has been buoyed by healthy pricing and volume gains in its core growth businesses, as well as signs of demand troughs in more cyclical, commodity businesses that management has right sized. We believe Arcosa still has plenty of runway to create more shareholder value over the long term. In Construction Products, it has intentionally positioned its aggregates platform in states with healthy fiscal budgets, approved infrastructure spending plans, and/or net population growth such as Texas and Arizona. We think these forces should drive solid organic growth while the $1 trillion U.S. infrastructure bill should both broaden and bolster these multi-year tailwinds. The positive outlook for its Engineered Structures segment—which is a national, scale-advantaged producer of utility support structures and telecom towers—is reflected in order strength and healthy backlogs driven by utility grid hardening, the integration of renewable energy sources, coverage expansion, and next generation telecom network buildouts.

Arcosa’s free cash flow generation, combined with other divestitures of non-core businesses—for example, the expected close of the sale of its storage tank business in the second half of 2022—provide management with more resources to fund attractive internal growth investments and additional bolt-on acquisitions, particularly in the fragmented Construction Products business.

Arcosa (NYSE: ACA)
(12/31/21-8/31/22)

Can you also talk about a high-confidence (or otherwise notable) holding that hasn’t done well so far and why you think it can rebound?

Ziff Davis acquires and operates digital media and internet brands in high value verticals such as Technology, Gaming, Health Care, and Shopping. Its portfolio of owned sites includes PCMag.com, Spiceworks, IGN, What to Expect, MedPages, and RetailMeNot. The category focus and domain expertise of its brands, underpinned by the editorial content and tools Ziff Davis produces for the sites, attract consumers with a “high intent to purchase” products or services in each site’s specific categories. These capabilities enable the company to deliver a more targeted audience and improved returns on the digital ad dollars marketers spend on its sites. Advertising accounts for the majority of Ziff Davis’s revenue, which it has historically grown by expanding its share of spend with existing customers and adding new advertisers. Its remaining sales come from subscriptions.

Its businesses share several attractive qualities, such as the recurring nature of subscriptions, sticky advertising customers as reflected in a historical net revenue retention rate of greater than 100%, and high contribution margins associated with leveraging content across millions of visitors to drive ad sales. With no physical inventory and relatively low capital intensity, the company generates about 20% free cash flow from every dollar of sales. Management also has a long track record of compounding value by reinvesting excess cash flows into digital media acquisitions that enhance existing verticals or supply a foothold into new ones.

Ziff Davis’s stock has fallen roughly 20% so far in 2022. Digital ad spending is normalizing from pandemic peaks just as corporations are curtailing advertising budgets due to weaker consumer spending in the face of inflation and higher interest rates. While we can’t predict the depth and duration of the spending downturn, we are optimistic that favorable secular trends and Ziff Davis’s specific initiatives should allow the company to reach its mid-to-high single digit annual organic revenue growth long term. E-commerce’s penetration of total sales activity is forecast to remain on an upward trajectory as consumers continue to devote more time to digital media than traditional media. As a result, digital media continues to take share from traditional outlets, having already garnered 60% of ad spending. Recently enacted privacy laws and user tracking policies instituted by Apple and Google enhance the value of ads served based on first-party publisher data such as that which Ziff Davis collects from the sites it owns, as opposed to those using third-party data stitched together from sources with no direct relationship with the end customer.

Near-term operating challenges are also creating opportunities for long-term value creation. Digital media valuations (both public and private) have contracted to more reasonable levels that neither the industry nor Ziff Davis has seen as an active buyer over the past ten years. With a proven and systematic acquisition approach, prodigious free cash flow generation, and more than $1 billion of liquidity (including $650 million of cash on hand), we think the company is in an excellent position to go on offense at prices that could yield cash on cash returns above its 20% historical target.

Ziff Davis (Nasdaq: ZD)
(12/31/21-8/31/22)

What is your outlook for small-cap quality?

We think that the near-term volatility in the financial markets—mostly the result of macroeconomic uncertainty—should favor quality as small-cap investors seek shelter in companies with durable business models, strong balance sheets, and consistent free cash flow generation. While the small-cap quality companies we invest in are not immune to recessions, as we saw during the Global Financial Crisis and again during the pandemic pullback, the sustainable competitive advantages quality companies possess give them the financial wherewithal not only to survive a difficult economy but also to go on the offensive and take share from or acquire weaker competitors. They often emerge in an even stronger position when conditions improve. The ability to self-finance growth also gives quality companies the financial flexibility to invest through a downturn to best position themselves to capitalize on secular growth drivers affecting the industries they serve—including automation, digital transformation, higher infrastructure spending, and rising semiconductor capital intensity. The case for small-caps in general—and in particular the quality cohort within the asset class—would also appear to have valuation on its side. The portfolios within each of Royce’s premier quality strategies have superior profitability characteristics in aggregate yet generally trade at attractive valuation measures on an absolute basis and relative to the Russell 2000. We continue to believe that owning a portfolio of companies with resilient business models that sustainably generate returns on invested capital well in excess of their cost of capital and are led by management teams adept at capital allocation should produce above-average long-term returns for investors.

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