How did Royce’s Small-Cap Opportunistic Strategy perform in 4Q22?

Jim Stoeffel: Royce Small-Cap Opportunity Fund, which is the mutual fund we manage in the Strategy, advanced 12.3% in the quarter, outperforming its benchmark, Russell 2000 Value Index, which was up 8.4%, and the Russell 2000 Index, which gained 6.2%, for the same period.

How was performance in 2022 and over longer time periods?

Jim Harvey: The portfolio lagged the Russell 2000 Value in 2022, -17.1% versus -14.5%, but lost less than the Russell 2000, which declined -20.4% for the calendar year. More important, the Fund also outperformed both indexes for the 3-, 5-, 10-, 15-, 20-, 25-year, and since inception (11/19/96) periods ended 12/31/22.

Which portfolio sectors made the biggest impact on 4Q22’s performance?

Brendan Hartman: Nine of our 10 equity sectors made a positive impact on performance. Industrials, Information Technology, and Consumer Discretionary—our three biggest sector weightings—made the biggest positive contributions. The only negative impact came from Health Care, while Financials and Consumer Staples made the smallest contributions.

What happened at the industry level in 4Q22?

Kavitha Venkatraman: The three largest positive contributors were machinery in the Industrials sector; oil, gas & consumable fuels from Energy; and aerospace & defense, which is also in Industrials. Health care equipment & supplies in Health Care, electrical equipment in Industrials, and chemicals in Materials detracted most in the fourth quarter.

What factors made the biggest impact relative to the benchmark at the sector level in 4Q22?

JH: Our advantage over the Russell 2000 Value came almost equally from sector allocation and stock selection in 4Q22, and nine equity sectors were positive versus the index. Our much higher weighting, along with a smaller impact from stock selection, helped most in Industrials while our lower exposure to Health Care and stock selection in Information Technology also made significant positive impacts versus the benchmark. On the other hand, having no exposure to Utilities and stock picks in Consumer Discretionary detracted from relative quarterly performance. Our cash holdings also hurt relative results, as you might expect in a strong quarter.

Turning to the calendar year, what were the most significant sector impacts in 2022?

BH: Eight of the portfolio’s 10 equity sectors had a negative impact on performance in 2022, with Consumer Discretionary, Information Technology, and Industrials making the biggest detractions. Energy and Materials made positive impacts, while Consumer Staples made the smallest detraction.

What about at the industry level?

JH: Specialty retail from Consumer Discretionary and two groups in Information Technology—semiconductors & semiconductor equipment and software—were the largest detractors, while oil, gas & consumable fuels in Energy, metals & mining from Materials, and energy equipment & services in Energy contributed most in the calendar year.

What sectors affected performance most versus the Russell 2000 Value in 2022?

BH: Our disadvantage versus the benchmark was attributable to sector allocation in 2022. Stock selection was additive, though not quite strong enough to give us outperformance for the year. Both our higher weighting and, to a lesser extent, stock picking detracted in Consumer Discretionary. Our substantial underweight and stock selection also hurt relative results in Financials. In Information Technology, the positive effects of our stock selection could not overcome the negative effect of our significantly higher weight vis-à-vis the benchmark. Conversely, stock election was additive in Materials, as were our lower exposures to both Real Estate and Health Care during 2022.

What is your long-term outlook for the Strategy?

KV: The continued decrease in money supply and easing supply chain constraints—helped in part by a general slowdown in demand—have combined to make a material dent in inflation, which we anticipate will continue through 2023. The Fed has nevertheless said it’s going to continue raising rates, with its eyes focused squarely on a labor market that’s so far held up during this period of rapid rate increases. We expect that managing increased labor costs and availability will likely remain challenges for our companies in 2023. Throughout 2022, we sought to take advantage of the wide dispersion in valuations to position the portfolio to benefit from a revival in business and consumer sentiment when the Fed reverses course, and when the business cycle improves. In the meantime, supply chain improvements should help small caps that have been facing higher costs or have been on allocation for inventory and have had to forego revenues.

JS: Picking up on Kavitha’s points, we think the past two years saw the beginning of the end of globalization. Re-shoring, near-shoring, and onshoring are real trends from which many of our companies should benefit. In addition, the Omnibus Spending Bill outlines a 10% increase in defense spending from which certain holdings are poised to benefit. Taking a longer-term perspective, the normalization of interest rates away from the 0% paradigm of the last decade will put an end to free money and growth at any cost. In our minds, this is undoubtedly a positive outcome for small caps in general, more so for those management teams that are superior capital allocators, as well as for disciplined value investors such as ourselves.

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