Miles Lewis: We believe that M&A is poised for a rebound in 2023, particularly in the second half of the year when markets will have had more time to digest the current macroeconomic environment. Moreover, we think that small-caps, including holdings in Small-Cap Total Return’s portfolio, could be beneficiaries. M&A activity has been well below 2021 levels in 2022. Through the end of this year’s third quarter, it had fallen to levels last seen in 2013 according to Bloomberg. So, while low interest rates fueled an M&A boom for more than a decade—culminating in a record year in 2021—M&A activity cooled in 2022 for myriad reasons, including increased market volatility and rapidly rising interest rates.

We see three reasons for a rebound in M&A activity in 2023. First, private market values tend to lag public market values by a few quarters. As private businesses adjust their valuation expectations, the bid/ask spread between buyers and sellers should narrow, allowing more deals to materialize. Second, credit markets have not been conducive to financing new deals in 2022, particularly in the second half. However, we believe the credit markets will also adjust to the higher rate environment, providing a key source of financing that will enable a pickup in M&A. Third, we believe there is significant dry powder for the acquirers, including both private equity and strategic buyers. The former group has raised meaningful capital in recent years, with a significant amount so far undeployed. Many strategic buyers also appear well positioned to increase purchases. Moreover—and this could be key for many of our holdings—companies with strong balance sheets and/orthose that locked in low rates with longer maturities are uniquely well positioned to capitalize. We also think many companies will see significantly higher levels of free cash flow in 2023—which might be a 2023 surprise itself. Companies will begin to work down elevated inventory levels, brought on by the unusual dynamics of the pandemic (e.g., snarled supply chains). Similarly, working capital requirements should also abate as many input costs, such as raw materials, begin to roll over. These sources of cash trapped on balance sheets will be released, resulting in elevated levels of free cash flow that can be deployed towards M&A.

We think that small-cap investors stand to disproportionately benefit from a potential M&A recovery, with our Small-Cap Quality Value Strategy very well positioned. By virtue of their size, small-cap companies are by definition more easily digested in a market that may not be receptive to mega deals. And in our portfolio, we own high quality assets with strong balance sheets trading at attractive valuations—precisely the attributes buyers typically seek.

Lauren Romeo: Channeling my inner Yogi Berra, I’d venture to say that what will surprise investors in 2023 will be something that wasn’t expected. Looking back, it’s usually “out of left field” events rather than deviations from expectations about the major macroeconomic and geopolitical uncertainties currently dominating investor debate—such as inflation, recession, or rising interest rates—that drive the biggest shifts in investor sentiment in a given year. Fortunately, being a “peerless prognosticator” about the stock market or economy is not a requirement for the Royce Small-Cap Premier Quality strategies on which I work. Instead, a core tenet of the business buyer’s approach we employ is to identify and own companies with durable business models that can compound value well into the future, over a myriad of business and market environments. This necessarily focuses our research, thought, and team debate on assessing the sustainability of a company’s competitive advantages and the structure, secular trends, and potential disruptions that face the company’s industry. These are the key determinants of a company’s ability create shareholder value—i.e., to generate returns on capital and reinvest free cash flow at rates that exceed its cost of capital. We believe buying and holding a portfolio of proven value creators should continue to produce attractive risk-adjusted returns over time.

While the Premier Quality strategy doesn’t require much focus on predicting near-term macro surprises, we do welcome them. The volatility that often accompanies surprises can sometimes cause stock prices to change much more dramatically than the economics and value of the underlying businesses. So, whatever 2023 brings, we will be poised to take advantage of such short-term price dislocations in existing holdings or candidates to maintain what we believe is an attractive risk/reward profile for the strategy.

Jim Stoeffel: I believe one of the big surprises in 2023 will be that inflation cools much more quickly than anticipated, which should create attendant implications for Fed policy. In the early stages of the inflation spike, I generally shared the Fed’s view that it would prove temporary. It’s true that there have been certain underlying secular changes, such as shortening supply chains and workforce participation rates, that provided inherent tailwinds to inflation. Likewise, the horrific events unfolding in Ukraine have added an unexpected wild card into pricing oil and natural gas, as well as certain commodities such as wheat.

That said, I continue to believe that the primary impetus for the spike in inflation was related more to extreme monetary and fiscal stimulus in demand-based economies that were juxtaposed against the collapse in supply chains in production-based economies. A recent analysis from Raymond James shows that U.S. savings rates spiked to a record 30% during the Covid lockdowns. As Western economies opened while China and other supply-based economies remained shut down, the excess savings turned into excess demand—which could not be supported by the dwindling supply of products in many areas. Both the demand and supply side are now being corrected, and we are already seeing significant declines in pricing in many areas, including commodities, housing, and freights costs, to name a few. And this is all taking place before the Fed’s rates hikes have had sufficient time to bite.

In our Small-Cap Opportunistic Value Strategy, we have been looking at stocks on a company-specific basis as the potential for lower inflation is just one aspect of a complex macro environment. However, we find higher-end apparel retailers to be one example of an interesting play on our inflation thesis. This area was badly hurt by higher freight costs and commodity input costs—which are now falling—and we are hopeful that high-end consumers will remain resilient in the face of a slower economy.

Chuck Royce: I think the biggest surprise will be a robust bull market beginning in 2023. In my experience, when market observers are nearly all convinced that a long-running bear market will continue to linger, the market shifts into high gear, seemingly unexpectedly. I believe that we’ll most likely see the turnaround driven by a positive catalyst, though whether it comes in the form of better-than-expected economic news, falling inflation, or an end to the Ukraine War, I can’t say. And while it’s less likely than a positive surprise, the catalyst may also be simply the absence of any more bad news in the context of our current situation. In other words, once investors have more fully acclimated to the recent larger-than-usual amount of uncertainty, they’ll look more closely at fundamentals and recognize that valuations for many companies, especially within small-cap, are reasonable to inexpensive.

In any event, I expect that 2023 will see at least the beginning of a bullish cycle for equities. Based on the research we’ve done and the data we’ve examined, I’m more confident in the prospects for small-cap stocks than for large-caps. The winners in the previous decade’s environment that saw zero interest rates, low inflation, and low nominal growth—specifically mega-cap stocks and small-cap growth—will no longer lead. One important source of confidence about future returns comes from the recent state of long-term small-cap performance. For the periods ended 9/30/22, the three- and five-year annualized returns for the Russell 2000 were 4.3% and 3.6%, respectively. These long-term returns were significantly lower than their three- and five-year monthly rolling averages since the inception of the Russell 2000 (12/31/78), which were 10.8% and 10.5%, respectively. We haven’t seen trailing three- and five-year returns this low since March 2020 and June 2009. And the respective returns for the three- and five-year periods ended 10/ 31/22 (+7.1% and +5.6%, respectively) and 11/ 30/22 (+6.4% and +5.5%, respectively), while higher for the Russell 2000 than at the end of September, were still well below their respective long-term averages. So I’m bullish on small-caps for 2023.

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