Interest rates are hardly in unprecedented territory.

Rising interest rates—and the rapid pace at which they have climbed—continue to alarm many investors. We therefore think that it’s especially important to remind investors that since 1954 the only sustained period that saw rates at or near zero was the combined post-Financial Crisis and Covid eras that spanned more than a decade from 2009 to 2021.

Fed Funds Effective Rate, 12/31/54-9/30/23

Source: FRED, Board of Governors of the Federal Reserve System (US)

We think the long-term, zoomed out view shown above tells us, emphatically, that Interest rates are merely normalizing—and are hardly in unprecedented territory. In fact, the decade-plus period following the 2008-09 Financial Crisis was the anomaly.

What does this mean for small-cap investors?

During this anomalous period of ultra-low costs of capital and ultra-low discount rates investment approaches which emphasized “growth at any cost” became financially viable and even attractive for investors. Consequently, capital flooded towards high-growth endeavors with the promise of profits far in the future. This had a disproportionately adverse impact on the small companies in our investment universe, which are subscale and have structural limits to the financial leverage they can absorb. They faced stiff competition for acquisitions—and were often outbid by private equity buyers and larger strategic buyers that had greater borrowing power. These subscale companies also had to compete for talent with their larger counterparts, which had a higher revenue base to spread their costs over, especially in industries that saw heightened demand during the pandemic.

As both interest rates and the cost of capital continue to normalize, we find ourselves in a world that is again profit- and returns-conscious. In this environment, we expect select companies in our investment universe to benefit from reduced competition for talent and more benign price competition for deals. We also expect to see more M&A (mergers and acquisitions) activity in the small-cap universe, with smaller companies able to make accretive acquisitions that help them gain scale, add technological capabilities, etc.

How is Royce’s Small-Cap Opportunistic Value Strategy positioned in the current environment?

The Strategy invests in companies that are undervalued for what we believe are temporary reasons. Included in the portfolio are businesses that are subscale but are in unique niches or possess unique capabilities or assets that can either find strategic buyers amid slowing economic growth or can be buyers themselves to build scale; companies with strong normalized earnings power that are underearning due to macroeconomic factors or past strategic missteps; or companies that have ample long-term growth potential that is not reflected in their current valuations due to their size, growing pains, or macroeconomic factors.

While M&A activity remains depressed compared to the flurry of deals seen during the pandemic years, we are seeing green shoots emerge. In general, well capitalized buyers have opportunistically started buying assets that are attractively valued—which is beginning to benefit both sellers and buyers of assets within Royce Small-Cap Opportunity Fund’s portfolio.

Certain portfolio companies have started selling assets to strategic buyers looking to acquire them as the buyers reach for increased scale or capabilities as well as to well capitalized financial buyers who have started loosening their purse strings for smaller deals that don’t require excessive leverage. Examples of recent buyouts of companies from our portfolio include strategic consolidation of oil & gas exploration & production companies, niche retailers (bought by financial buyers), and mergers among banks that are trying to build scale in part to get ahead of increasing regulatory burdens.

A few companies in our portfolio that have low leverage and/or strong market positions have also begun deploying capital opportunistically. Examples include companies in industrial niches such as air purification, hydraulics, and electronics that have been acquiring smaller undervalued businesses in an accretive manner.

While some portfolio companies face near-term softness in demand as consumers and businesses continue adjusting to persistent, though moderating, inflation and higher interest rates, we believe these factors are both temporary and, even more important, are already reflected in the valuation multiples in most cases. For example, as of 10/31/23, Royce Small-Cap Opportunity Fund’s P/S (price to sales) and P/B (price to book) ratios were 0.8x and 1.4x respectively—which were attractively low in our view and were close to the Russell 2000 Value’s respective P/S and P/B ratios of 0.9x and 1.1x. (The Fund’s P/S and P/B ratio calculations exclude cash.) In addition, the portfolio’s financial leverage levels are quite manageable with the aggregate indebtedness at only 1.5x times EBITDA (Earnings Before Interest Taxes Depreciation and Amortization—a proxy for cash earnings).

We remind investors that attractive capital allocation opportunities abound in any cyclical downturn—and we expect our companies to capitalize on such opportunities and emerge from this downturn as stronger, more competitive players in an environment that after a long break has returned to normalized rates.

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