How did Royce Small-Cap Special Equity Fund perform in 3Q22 and over longer-term periods?

The Fund declined 3.6% for the quarter, outperforming its primary benchmark, the Russell 2000 Value Index, which was down 4.6% for the same period. Small-Cap Special Equity was down 16.0% for the year-to-date period ended 9/30/22, outpacing both its primary benchmark—which fell 21.1%—and its secondary benchmark, the Russell 2000 Index, which declined 25.1% for the same period. The Fund also beat the small-cap value index for the 1-, 3-, 5-, 15-year, and since inception (5/1/98) periods ended 9/30/22 and outperformed the Russell 2000 for each of these periods except the five-year period. This is consistent with the Fund’s history of strong down-market results.

How was performance at the sector and industry level in 3Q22?

Seven of the Fund’s eight sectors made a negative impact on quarterly performance, with the biggest detractors coming from Consumer Discretionary, Materials, and Real Estate while the only positive impact came from Industrials. Financials and Communication Services made the smallest detractions in 3Q22. At the industry level, three areas in Consumer Discretionary detracted most for the quarter: auto components; leisure products; and textiles, apparel & luxury goods while diversified consumer services (Consumer Discretionary), food products (Consumer Staples), and electrical equipment (Industrials) were our largest contributors.

Which positions had the biggest impact on 3Q22 performance?

The portfolio’s top detractor at the position level for the quarter was Standard Motor Products, which manufactures replacement parts and related items for the automotive industry, including ignition and electrical parts, emission and engine controls, and sensors, among others. The top contributor was H&R Block, which specializes in income tax return preparation and do-it-yourself tax return preparation services and products.

At the sector level, how did the Fund perform versus the Russell 2000 Value in 3Q22?

Our advantage over the benchmark was entirely attributable to stock selection in the quarter. Stock picking was a significant advantage in Industrials, as was our low weighting in Real Estate and stock selection in Communication Services. The portfolio’s cash position also contributed positively to relative performance. Conversely, stock picking detracted in Consumer Discretionary versus the benchmark while our lack of exposure to Health Care and Energy also hurt relative results.

How did the Fund perform at the sector and industry level for the year-to-date period ended 9/30/22?

Seven of eight sectors had a negative impact on year-to-date performance. The sectors making the largest detractions were Consumer Discretionary, Information Technology, and Materials. Communication Services made the only positive impact while Financials and Consumer Staples detracted least. At the industry level, auto components (Consumer Discretionary), semiconductors & semiconductor equipment (Information Technology), and leisure products (Consumer Discretionary) detracted most for the year-to-date period, while diversified consumer services (Consumer Discretionary), media (Communication Services), and commercial services & supplies (Industrials) contributed most.

Which holdings had the biggest impact on year-to-date performance?

Interestingly, the same two positions had the biggest impacts on 3Q22 and year-to-date performance—our top detractor was Standard Motor Products while our top contributor was H&R Block.

How did the Fund fare versus the Russell 2000 Value for the year-to-date period ended 9/30/22?

The portfolio’s advantage over its benchmark was again solely due to stock selection in the year-to-date period. Stock picking in Industrials, Communication Services, and Consumer Discretionary made the biggest positive relative impact. As was the case in 3Q22, our cash position again contributed positively to relative performance. Conversely, our lack of exposure to Energy and Utilities detracted most from relative year-to-date period results, followed by our substantially lower weighting in Financials.

What is your outlook for the economic and market environment?

We are still seeing too much so-called good news on strong data to expect to achieve a soft landing. Much more economic slack needs to be created. To reach the Fed’s self-imposed bar of needing to see “clear and convincing data” of a strong enough slowdown, we need much weaker employment, wage increases, and Personal Consumption Expenditure (“PCE”) inflation readings. The bottom line—in the Fed’s own words (and we will see if this translates to deeds)—is that it will take a hard landing to stomp out inflation. This is all happening when nominal growth is exclusively inflation driven. The resulting damage will lower revenues and earnings. The nastiest impact will be on those companies that have depended on price hikes to offset higher costs. Smart, successful companies that will do relatively better in the environment we foresee are cutting costs significantly now. In addition, domestic small-caps remain at a significant discount to large-caps as measured by trailing twelve-month P/E’s. In fact, small-caps are relatively cheaper than they have been since before the Great Financial Crisis 15 years ago.

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