How did Royce Small-Cap Special Equity Fund perform in 1Q23 and over longer-term periods?

We were pleased that the Fund has performed well during a very challenging bear market for small cap stocks. The Fund advanced 3.4% for the quarter, outperforming its benchmark, the Russell 2000 Value Index, which was down -0.7% for the same period. The portfolio also beat its benchmark for the 1-, 5-, 15-year, and since inception (5/1/98) periods ended 3/31/23, as well as the Russell 2000 for each of these periods except the 15-year period.

This is consistent with the Fund’s history of strong down-market results. To emphasize the Fund’s strength in the recent bear market, Small-Cap Special Equity was down -3.6% from the most recent small-cap peak on 11/8/21 versus respective declines of -19.7% and -24.7% for the Russell 2000 Value and Russell 2000 Indexes.

How was performance at the sector level in 1Q23?

Five of the portfolio's nine sectors made a positive impact on quarterly performance, with Industrials, Information Technology and Consumer Staples making the largest positive contributions while the largest negative impacts came from Communication Services, Consumer Discretionary, and Real Estate.

How did the Fund perform at the industry level in the first quarter?

The top contributors at the industry level were two areas in Industrials—electrical equipment and machinery, which were followed by the semiconductors & semiconductor equipment group from Information Technology. Media, which is in Communication Services, detracted most, along with consumer staples distribution & retail (from Consumer Staples) and textiles, apparel & luxury goods from Consumer Discretionary.

What were the portfolio’s top contributor and detractor at the position level for the quarter?

Our top contributor was Encore Wire, which manufactures copper electrical building wire and cable. The company supplies residential wire for interior wiring in homes, apartments, and manufactured housing. Encore also manufactures wire for commercial and industrial buildings. Its customers are wholesale electrical distributors that serve both the residential and commercial wire markets. TEGNA, the top detractor in 1Q23, is a broadcasting, digital media, and marketing services company that owns and operates television stations which deliver news and informative content. TEGNA also provides marketing solutions and services to individuals and businesses of all sizes. Its stated purpose is to serve the greater good of its communities. Each was a top-10 holding at the end of March.

At the sector level, how did the Fund perform versus the Russell 2000 Value in 1Q23?

Our advantage over the benchmark was entirely attributable to sector allocation decisions in the quarter. At the sector level, our significantly lower exposure to Financials—and our lack of exposure to banks—helped most versus the Russell 2000 Value. Stock selection was highly additive in Industrials, where our higher weighting also helped. Our lack of exposure to Health Care also contributed to our quarterly advantage, as did our cash holdings. Conversely, our higher weighting in Consumer Discretionary and stock picks in Communication Services and Real Estate hurt relative results.

What is your outlook for the economic and market environment?

In navigating the macroeconomic seas, credit spreads are perhaps the most useful guide. They have widened, though not by as much as perhaps they should have. As more and more strains filter through the economy, however, they are likely to widen further. We are also watching for any widening in investment grade corporate bonds. When this occurs, and people become increasingly concerned about the duration and intensity of the looming recession, equities typically decline. Against this uncertain backdrop, small caps look very attractively priced relative to the market as a whole. In fact, they are as relatively inexpensive now as they were at the beginning of the pandemic. The headlines likely caused this, with fears about a looming recession, the availability of credit, and the inherent lower market liquidity in small caps. Yet there are high-quality small caps (we believe we own many) that have been marked down in the exit from the asset class. Remaining selective will be the key, and our discipline reinforces that. Once there are more attractively priced small caps on an absolute basis, we are ready to pounce, as we have during previous opportunities.

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