This podcast was recorded on 11/29/22. It has been slightly edited for clarity.

Francis Gannon: Welcome, everyone. This is Francis Gannon, Co-Chief Investment Officer at Royce Investment Partners. Thank you for joining us. I’m thrilled to have a conversation with Charlie Dreifus, portfolio manager of the Royce Small-cap Special Equity Fund. We're going to look back at performance in this volatile period and look forward to seeing what opportunities that volatility is creating for the Small-cap Special Equity Fund.

I should note that Special Equity is outperforming its benchmark. The Russell 2000 value index for the 1-, 3-, 5-, 15-year, and since inception periods going back to May 1st, 1998, through the end of the third quarter of this year. The Fund has a strong history of down-market results, and this year has been no different. Charlie let’s begin with your current thoughts on this environment, especially around this idea of cooling inflation, which has been getting a lot of run in the headlines of late.

Charlie Dreifus: My pleasure, Frank, and thank you for the opportunity to speak with everyone. There’s increasing evidence that we’ve had we’ve hit peak inflation. What we have not, in my opinion, hit, is peak interest rates. And there’s a lot of optimism and enthusiasm about, you know, lower inflation numbers and so forth. Indeed, the Fed will likely increase by smaller increments and perhaps even pause. To me, a pivot—a true pivot—means reducing rates, not merely lowering the rate of increase or pausing.

Investors should be mindful of the destination, meaning what the terminal rate that the Fed is trying to accomplish or thinks it needs to accomplish rather than the journey. The journey can change over time, but it’s clear to me at this point that the Fed sees their obligation to continue to be on the aggressive side regarding taming inflation.

FG: Let’s spend a second on that on your comment there, Charlie, about the journey. Many people are expecting earnings to continue to decline, especially going into the first half of next year as we enter a recession—either mild or deep is to be determined. But many people believe that the market has not yet seen its bottom. What are your thoughts on that?

CD: I too, don’t believe we’ve seen the bottom. The usual characteristics of a bottom—really widening junk bond spreads, higher VIX numbers, and earnings estimates dramatically coming down. None of that has really appeared to any significant degree. And so, it’s interesting—preliminary data for the third quarter shows how margins are being compressed. Sales were up nearly three times what earnings were. Earnings declines will likely be dramatic, and with the fourth quarter results, or the preannouncements to them, we’re likely to see a substantial reduction in the earnings estimates for 2023.

We also usually at a market bottom have some calamity. And some might argue that we’ve seen that in crypto. I don’t see it being widespread enough in terms of the traditional counterparty risks and bringing other entities down with them so I don’t think we’ve seen a bottom, but the further correction can be one of two kinds. I’ve seen corrections over time, which means that earnings take a while to catch up to valuations. And that can last and has lasted in the past for a decade. Thus, the term lost decade. It can also be much more forceful and quicker with a 20-30% washout. The desperation, the capitulation, people are just disgusted, don’t want to own equities, dumping them irrespective of valuation, yield, whatever.

FG: Charlie, much is being made of the fact that the multiple compression we’ve seen this year has really come from price, and the next shoe to drop is earning. What are your current thoughts on valuation?

CD: Well, small-caps benefit by virtue of them being less, foreign sourced, or saying it the opposite way, more U.S.-centric in terms of their revenues and earnings, which, relative to some parts of the world means better business conditions, but also less of a hurt from currency. We don’t know how long and how high inflation will continue, but I think that's an interesting observation. And finally, I’ve seen data that shows that on the next 12-month earnings basis small-caps are selling one standard deviation below their traditional valuation to large caps. So, there are a lot of arguments to favor small-caps currently.

FG: Can you talk about two specific holdings in the Fund?

CD: Sure. And here again, I have been known to be a contrarian. I do prowl the new low list. We do screen for severe characteristics. So, we ask the companies that we populate the portfolio with to meet a very stringent and difficult set of metrics. Consistent with sort of the contrarian approach, two names that I want to discuss are the in the discretionary area and people’s first reaction would be, “We’re going into recession, and you know we have this high inflation. Why would you want to be in, you know, consumer discretionary?” And the answer is valuation. So, this is a time to look at retailers, manufacturers of consumer items that they sell through others.

And in that light, there are two names I’d like to highlight. One is Macy’s, obviously a traditional department store but well beyond that, they have a thriving e-commerce business. And they’ve done an incredibly good job because of expenditures, which we’re monitoring, in the IT, in their software, and in their data manipulation of consumer trends. They have not gotten stuck with the high inventories that other retailers have faced. They’ve navigated this with some skill, and they will be the first to concede that a lot of that comes from this intelligence they’re getting from these proprietary screens that they’re using.

The company also has a real estate component. They own a lot of their real estate, albeit less valuable than it would have been a couple of years ago, but it still has value. And they have, which is not often found, an overfunded pension plan in the retail space. And most importantly, and again consistent with being greedy when others are fearful, it’s selling at an incredibly low valuation.

The other one would be in a sort of a similar component—in fact, they sell to Macy's. It’s Movado. It’s perceived as a watch company, although they are also in costume jewelry. They’re known for their brands Movado and EBEL. But they also do a lot of private label under names like Hugo Boss, Lacoste, Coach, and so forth. They wholesale to other retailers as well as selling in their own stores and online.

They have been making strides and and expanding at a fairly rapid pace their costume jewelry offerings, which have been well received, and, importantly, incredibly inexpensive. And they have a very conscious, conservative management. In fact, on the most recent earnings call, they highlighted—and it’s something we’re watching; there’s no truly perfect stock—and here they’re facing and seeing North American weakness. Sales outside of the U.S. are doing quite well. It’s within North America that sales are a bit lackluster or actually down.

So, despite that, the company gave forward guidance with a very good earnings number, making the stock very attractive. This company, after the year ends, after their inventories and receivables turn to cash, has an incredible balance sheet, the likes of which would entice Warren Buffett's mentor Ben Graham because it would qualify as a net-net working capital candidate.

FG: One last question before we let you go: What’s your outlook on the market over the next 12 months?

CD: I don’t think we’ve seen the bottom. So, I think the market again could go sideways. I have trouble coming up with a scenario where the market, on a sustained basis rather than these rallies that we’ve seen, is done and is on its path higher on a consistent basis. One outcome could be that correction in time; the other outcome is a more dramatic, deeper correction. So, I think that’s ahead of us. Despite that—or maybe because of that—I feel quite good about Special Equity.

These are the times where historically we have done well and used cash that we’ve accumulated to make timely opportunistic purchases that have then performed in a manner that has helped our results. So, while I’m not terribly enthusiastic about the market, I find myself being enthusiastic for Special Equity.

FG: Great. Charlie, thank you for your time today and maybe you’re right that this is an opportune time to invest in Small-Cap Special Equity.

CD: Thank you, Frank.

FG: Thank you.

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