Will Electrification and Electric Vehicles Galvanize Performance?
article 08-29-2023

Will Electrification and Electric Vehicles Galvanize Performance?

Portfolio Manager Chip Skinner discusses the critical investment themes of electrification and electric vehicles in Royce Smaller-Companies Growth Fund.

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In Royce Smaller-Companies Growth Fund, we look for companies with the potential to grow at an above-average rate over the long term. This search routinely leads us to industries (or sub-industries) undergoing a period of accelerated growth due to an innovation, the adoption of new best practices by industry participants, legislative or regulatory changes, or a paradigm shift that proves critical to business success.

“Electrification is a highly visible investment area and a powerful economic driver that is still arguably in its early stages. At the intersection of EV adoption and the transition to renewable energy, we can see how these innovations are beginning to displace both internal combustion engines and coal/natural gas fired power plants over the next decade.”

When electricity consumption first became pervasive, electrical utilities built large, efficient coal-burning power plants that were centralized by geography, with transmission lines distributing power to the local surroundings. Just as technological advancements led mainframe computers to be replaced, first by mid-frames, then by microcomputers, a similar dynamic is currently changing the electric power industry.

Power is increasingly being generated from sources closer to consumers, in part due to the shift to renewable energy sources (solar, hydro, wind, geothermal, etc.) that are themselves being driven by regulatory and environmental mandates. A home can be powered by rooftop solar panels in tandem with a stationary battery. (The latter is necessary for renewable energy given the interruptible nature of certain green power sources.)

For several years, companies all along the supply chain have been benefiting from this massive shift. This is particularly true in California. The Golden State has mandated that all new residential construction include solar panels. In a way, this is a generational re-tooling of an entire, quite massive industry. There has been a small share loss each year from natural gas and coal powered utilities, which is catalyzing rapid growth for those companies participating in the current market share sliver of renewable power. This sliver, however, has been expanding dramatically over the last few years—with expectations of growth for many years to come.

A plethora of industries are benefiting from this shift. The pure play companies are growing fastest, with some further along their maturity curve. In addition to renewable energy adoption, the most developed examples of electrification are hybrid electric vehicles (“HEV”) and battery electric vehicles (“BEV”). Other industries that are directly benefiting from each of these adoptions include solar panel manufacturers, installers, and component makers, as well as reserve/battery manufacturers (both residential and commercial grade), lithium and other battery material miners, renewable power project developers, engineering companies, semiconductor companies, semiconductor equipment manufacturers, automobile manufacturers, automobile component manufacturers—the list goes on and on, particularly as more devices and vehicles switch to electric power and renewable power sources move closer to the users and their homes.

With its leading market share in EVs, Tesla has become a key player in an industry that has otherwise seen only modest innovation in the internal combustion engine over the past 100+ years, while fostering a significant industrial ecosystem. And although EVs accounted for only 10% of the new auto production for 2022, and only about 6% in the U.S., some forecasts suggest these vehicles will represent 30-50% of automotive production, depending on geography, by 2030.1

An important example of vertical integration at Tesla is that the engine of their vehicles—the battery—represents 10-20% of each car’s production cost. Tesla constructed what the company calls a Gigafactory in Nevada (Tesla has since built others) that’s believed to manufacture 140 Gigawatts per hour worth of batteries each year, enough to supply approximately two million vehicles. According to Benchmark Minerals, a single Gigafactory requires the equivalent of 18% of the world’s current lithium production, along with the 24% of nickel, 14% of its manganese, and 9% of its cobalt production. Simple math suggests that if global EV passenger automobile production does in fact reach 30% by 2030, it would represent the need for 18 additional Gigafactories over the next seven years, necessitating significant investment in developing and processing the above listed materials. There is also a national need for more charging stations, electric power semiconductors, converters, electrical engine components, etc. As one industry veteran put it, “if it rolls, floats or flies…it will need battery packs in the future.” It is safe to say that lithium ion batteries are not limited to the consumer electronics and electric bicycle industries any longer.

Three portfolio positions further illustrate our interest in the related areas of electrification and EVs.

Aehr Test Systems (Nasdaq: AEHR) makes semiconductor manufacturing test equipment for the manufacture of Silicon Carbide (“SiC”) and other microchips. Known as a compound semiconductor, SiC combines elements of the traditional silicon wafer technology and a layer of ultra-pure carbon powder, which together has superior qualities, such as faster charging, longer range, etc., to traditional silicon chips for the EV battery systems. Failure rates are generally higher in SiC, which is why Aehr’s wafer-level burn-in test systems are an important step in the EV battery manufacturing process, increasing yields for manufacturers.

AMG Critical Minerals (AMG-Netherlands) is a vertically integrated miner, refiner, and processor of battery-grade lithium. Headquartered in the U.S. but listed in the Netherlands, AMG is a mini-conglomerate and something of a special situation-type of investment. In its long-life mine in Brazil, AMG will soon be able to mine hard rock lithium (spodumene), process it into concentrate on site, convert it into lithium carbonate, and convert that into lithium hydroxide to help meet high demand for battery-grade lithium in Western Europe. Over the next couple of years, management expects to add vertical production capacity (and thus capture more margin) once these processing steps are in place, expanding its already high margins. In addition to lithium, its second largest business is recycling vanadium, which will be used in stationary “flow redox” batteries in industrial applications.

Shoals Technologies Group (Nasdaq: SHLS) manufactures engineered electrical components, cable assemblies and systems for the utility-scale photovoltaic/solar farm industry. With roughly 50% market share, Shoals is the leading provider of Electrical Balance of Systems (“EBOS”) solutions, designing easier-to-install wiring systems that generally do not require high-cost labor or licensed electricians to install. Solar is cheaper than other renewable energy sources, has a faster time to production, and is more reliable. Shoals also has EV charging station and stationary storage products that should also contribute to future revenues.

Electrification is a highly visible investment area and a powerful economic driver that is still arguably in its early stages. At the intersection of EV adoption and the transition to renewable energy, we can see how these innovations are beginning to displace both internal combustion engines and coal/natural gas fired power plants over the next decade. Not only can we confidently envision significantly higher penetration rates than we have today in the U.S. but we are already seeing much higher renewable energy usage in Europe and greater EV penetration rates in China. Finally, federal governments—especially in the U.S. via the Inflation Reduction Act of 2022—continue to subsidize these powerful shifts through project funding and tax subsidies.

Important Disclosure Information

Average Annual Total Returns as of 6/30/2023 (%)

  QTD1 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE ANNUAL
OPERATING EXPENSES
NET               GROSS
Smaller-Companies Growth 5.33 22.28 7.10 4.76 8.00 10.11 06/14/01  1.49  1.55
Russell 2000 Growth
7.05 18.53 6.10 4.22 8.83 7.16 N/A  N/A  N/A
Russell 2000
5.21 12.31 10.82 4.21 8.26 7.69 N/A  N/A  N/A
1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.royceinvest.com. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Mr. Skinner’s thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Percentage of Fund Holdings As of 6/30/23 (%)

  Smaller-Companies Growth

Aehr Test Systems

2.9

AMG Critical Materials

2.5

Shoals Technologies Group Cl. A

1.6

Tesla

0.0

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 25% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.

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