How have you been positioning Royce International Premier Fund’s portfolio amid increased volatility in the non-U.S. small-cap markets in 2022’s challenging environment?

The barrage of negative geopolitical and economic news has sent share prices on the proverbial rollercoaster ride. However, even in the face of higher volatility and record-low returns for non-U.S. small-caps, we’re convinced that, in the long-term, companies that can create the most value, as measured by consistently high returns on invested capital, will see their share prices rise the most.

In fact, with so much attention on how the current market environment is hurting companies’ stocks prices, it’s easy to forget that bearish environments create longer-term opportunities for select companies. We’ve been working to take advantage of investment opportunities that we believe can ultimately benefit from current uncertainties, particularly through second order effects. Regardless of the market climate, we focus on trying to ensure that our portfolio consists of companies well positioned to deliver strong operational results.

What gives you confidence in the ability of your holdings to operate effectively?

Our confidence in their relative operational resilience is a byproduct of our disciplined investment approach: We focus on companies with significant pricing power, which allows them to pass through cost inflation. They have net cash balance sheets, which means they can benefit from rising rates as their interest income rises. Our companies also tend to be asset light, with almost a third carrying no inventory at all, and therefore less susceptible to supply chain disruptions. Additionally, our companies typically sell low-cost but mission-critical products and/or services into their customers' operating (as opposed to Capex) budgets, which means they generate more predictable revenue streams and are typically among the last to be targeted when their customers review expenses in a recessionary environment. Another factor that’s of particular importance in today’s market is that our holdings have virtually no direct exposure to consumer markets or Russia and Ukraine.

How have rising rates affected your holdings?

One of the consequences of rising interest rates is that capital becomes scarcer and more expensive. This climate creates acquisition opportunities for conservatively capitalized companies that self-finance their growth and can thereby gain market share, often at the expense of their more highly levered peers—which may lack access to capital—or private equity—which may find the increasing cost of debt financing prohibitive. This dynamic is a great example of the second order effects we referred to earlier. We are seeing this play out in our portfolio where many companies—those we call ‘aggregators’—are leaders in fragmented industries. They’ve been able to exploit their low-debt balance sheets to acquire complementary businesses at increasingly attractive valuations. These aggregators pursue disciplined and systematic acquisition strategies and are also attractive to us because they can successfully reinvest capital even when they otherwise have minimal operational capital requirements—and therefore really harness the power of compounding.

Can you provide some examples?

Based in the U.K., Marlowe is a leading provider of commercial services that include testing for fire safety and water quality, risk and compliance services that help customers properly manage their environmental footprint, and employee wellbeing. Marlowe is one of the few listed market leaders in this space yet has only a single-digit market share. It’s taken advantage of its leadership in its fragmented industry by using a disciplined M&A strategy to close 20 earnings-enhancing acquisitions in the last financial year alone—which has allowed it to grow sales by an average of more than 40% per year.

Enghouse Systems is a Canadian company providing call center and videoconferencing software that helps a range of customers interact with clients, as well as business and operations support software for the likes of telecom companies. Enghouse is led by Steve Sadler, one of the early pioneers of the aggregator model in the software space. It generates more than 25% free cash flow margins, which allows it to supplement its net cash/no debt balance sheet for additional M&A firepower. We like its proven M&A track record and superb valuation discipline. After a 12-month M&A hiatus that Sadler attributes to insufficiently attractive valuations, its M&A pipeline is now twice its usual size, and the company has doubled its M&A team in the last six months. Sadler has described the current rising rate environment as “Nirvana”: It provides Enghouse higher interest income just while its more leveraged competitors struggle, and economic pressure creates more opportunities to acquire smaller competitors at highly attractive valuations.

Finally, Norva24, which is not in a glamorous industry, but is in our view a highly attractive Swedish provider of outsourced maintenance services of underground sewer systems. Municipalities and other businesses such as property management firms and restaurants hire Norva24 to clean, repair, and maintain underground pipes. It’s the European market leader, but Norva24 holds less than a 10% market share. It has identified 1,900 acquisition targets in its addressable markets, and we believe it’s set to be the consolidator of choice due to its strong scale advantages. What we find particularly compelling is that Norva24 utilizes acquired companies to secure additional M&A opportunities, creating a sort of virtuous circle. During negotiations, someone who has previously sold their business to Norva24 provides positive feedback to the owners of the target companies. Similarly, acquirees often secure introductions to other potential targets.

As these examples show, there is no single recipe to being a successful aggregator. What our team looks for is a clear rationale for the approach, a proven track record in M&A, disciplined investment parameters, and a well-staffed team to execute. We have around a dozen such companies in the portfolio and have meaningfully increased our investments in the group so far in 2022.

What other opportunities is the current market environment creating?

Certain sectors or industries lie outside our stringent investment parameters. Two notable examples are Energy—where we have no direct exposure because we find that returns are not sufficiently consistent due to the sector’s inherent cyclicality—and banks or insurance companies, which typically do not pass our balance sheet screens. With Energy, we’ve tried to benefit by investing in companies that help customers improve energy efficiency, reduce consumption costs, and improve yields. Our companies can thus benefit from the increasing need to offset rising energy costs, as opposed to profiting directly from increased energy prices.

For example, Carel Industries is an Italian company that sells components and software that’s incorporated in cooling equipment like refrigerators and HVACs to make them up to 50% more energy efficient. The need for these solutions is acute as buildings are responsible for 40% of the world’s energy use, leading to ever increasing regulation on energy efficient practices. As the cost of energy rises, so does the financial incentive to adopt Carel’s products. Approximately 15% of the portfolio is invested in companies benefiting from this secular opportunity, and we have also increased our dollar investment in them this year.

Similarly, instead of investing directly in banks or insurance companies, we’ve sought to benefit from their increasing profitability by purchasing shares in companies that serve them. Many investors have a kind of knee-jerk negative reaction to higher interest rates yet some business models—specifically traditional banks and insurance companies—that were hurt by low rates can now be expected to see increased profitability in a more historically normal rate environment. Boa Vista is a company that we added in 2022’s third quarter. It’s the “Equifax of Brazil,” providing credit scoring, fraud prevention, and data analytics primarily to banks and other lenders. The company’s extensive database of 40 million corporations and 240 million consumers, coupled with its proprietary risk models, help customers accurately assess credit and make sounder financial decisions. Boa Vista is a premium price provider, and we believe that, as its customers become more profitable, we’ll see greater adoption and usage of its data and algorithms. Asseco Poland , the leading provider of proprietary IT services and software in Eastern Europe, is another example. It derives around a third of its revenue from the banking and finance sector, providing core banking systems to more than half of Poland’s banks. Asseco also holds a controlling stake in one of the globe’s leading providers of core platforms to the insurance industry.

Which areas have you been proactively trimming?

Year to date, six of our ten complete sales were based on valuation, a critical discipline for us. We also employ a systematic process to evaluate companies’ cap rates as they relate to the 10-year U.S. Treasury yield. With the arguably unprecedented surge in bond yields, the 10-year has moved from just over 50 basis points—its lowest rate since the Fund’s inception on 12/31/10—to around 400 basis points—its highest since the Fund’s inception—over a roughly two-year period. This rapid rise has compressed earnings multiples, which has disproportionately hurt many of our companies because they’re perceived as being longer duration or growthier investments. However, we have mitigated this multiple compression by proactively trimming our most relatively expensive holdings—that is, those with earnings yields that no longer offer a compelling enough premium to the risk-free rate.

We think this discipline will contribute positively to long-term performance; the Fund’s cap rate as of 09/30/2022 reached its highest level since early 2015. It’s worth noting that this favorable valuation should also be viewed in the context of the seemingly inexorable strengthening of the U.S. dollar, which we estimate has led to a roughly 25% additional ‘currency discount’ within the portfolio relative to purchasing power-implied exchange rates.

All of this is to say that we are convinced that the future opportunities for our portfolio have never looked better, despite or perhaps even partially due to recent performance challenges—creating what we think is a timely opportunity for long-term investors to take advantage of the growing spread between the portfolio's operational embedded value and its valuation.

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