Over most of its long history, Royce Small-Cap Opportunity Fund, the mutual find we manage in Royce’s Small-Cap Opportunistic Value Strategy, has had significant exposure to the Information Technology sector and, within it, the semiconductors & semiconductor equipment industry. The portfolio’s weightings in both areas have also been higher when our conviction is strongest than those in both its primary benchmark, the Russell 2000 Value Index, and its secondary benchmark, the Russell 2000 Index.

These higher weightings are a distinctive feature of the portfolio among actively managed small-cap value funds because so many other managers avoid making significant investments in Information Technology. However, the criteria we use across all sectors in this Strategy is squarely focused on helping us find inexpensive small- and micro-cap companies that we believe have strong growth prospects.

We typically begin the process by screening for companies with low price-to-book and price-to-sales ratios. From there, we apply our extensive knowledge of sector and industry dynamics to begin culling what we believe are the best ideas among an often lengthy list of potential portfolio candidates. Much of the team’s time is spent staying educated and up-to-date on business, industry, and sector cycles because we are not just looking for cheap stocks but also for companies with catalysts for growth.

Within semiconductors, we gravitate toward component makers and companies that provide testing services. Most are domestic enterprises that sell to larger, global manufacturers. While there are comparably few small-cap semiconductor makers, we also know those companies well. The industry functions today as a highly efficient oligopoly in our view, from the larger manufactures such as Taiwan Semiconductor, Nvidia, and Applied Materials to the smaller though well established companies that we consider. The importance of semiconductors has increased steadily over the last three-plus decades, and shows no signs of slowing down. Semis are ubiquitous; they are found in nearly every device we use, as well as in countless industrial applications. Their importance in areas such as Artificial Intelligence, 5G, automotive, consumer electronics, and the Internet of Things has altered the industry’s dynamics, giving semiconductors less of a boom-and-bust cyclical profile. The industry’s strong and usually steady growth has also helped spur a wave of consolidation over the last several years.

The shares of most semiconductor companies, regardless of market capitalization, were hit hard by lingering Covid-driven supply chain disruptions, which in 2022 saw the industry’s post-Covid rebound considerably derailed. We watched and waited for valuations for both new and existing holdings to fall into ranges that we found attractively inexpensive. With the reduction in earnings we have seen across the industry over the past couple of quarters, we have been finding a number of interesting investment opportunities that fit our Interrupted Earnings theme. We believe that the semiconductor industry is experiencing a normal cyclical earnings correction and expect that many of these companies will be shifting toward positive longer-term growth outlooks. More specifically, we also believe that semiconductor testing will continue to grow faster than the overall semiconductor industry and hold two companies that specialize in testing whose long-term prospects we think are bright.

Cohu provides back-end semiconductor testing and handling equipment. We became involved in the stocks after Cohu acquired Xcerra in 2018, which we viewed as a sound and complementary strategic acquisition. Within the context of our investment themes, we originally viewed the company as a turnaround as there were significant execution risks around integrating Xcerra, as well as the challenge of managing the debt Cohu took on to finance the acquisition. The company has successfully executed our original investment thesis, including several hundred points of gross margin improvement and significant debt reduction. Its shares began to recover in 4Q22, and we continue to like the stock, as Cohu has a very diverse set of end markets including nascent growth opportunities, such as testing semiconductors for EVs, and a high level of recurring revenues.

FormFactor designs, develops, manufactures, and supports precision, high performance advanced semiconductor wafer probe cards that is a leading provider of essential test and measurement technologies along the full integration circuit life cycle, from characterization, modeling, reliability, and design de-bug to qualification and production tests. We like FormFactor’s strong position in a duopoly market where it provides consumable products that are designed into its customers’ chip manufacturing processes. In contrast to Cohu, its shares have only recently begun to recover, thanks in part to solid fourth-quarter results in which FormFactor’s management noted improved demand from its foundry and logic customers, and signs of a trough in the forecast for demand in the semiconductor memory industry. We also think that the secular trends of increased complexity in chip manufacturing and packaging will continue to stoke the need for more test intensity and, by extension, demand for FormFactor’s probe cards.

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