This transcript has been edited for clarity.

John Davis: Hello and welcome to the Royce Investment Partners podcast. I'm John Davis, director of communications and marketing here at Royce, and I'm joined today by portfolio managers Jim Stoeffel and Kavitha Venkatraman. Along with Brendan Hartman and Jim Harvey, Kavitha and Jim manage our Small-Cap Opportunistic Value Strategy which we use in the open-end Royce Small-Cap Opportunity Fund. And as Jim and Kavita will describe in more detail, this is a theme-based value approach to small-cap investing.

The Strategy has performed very well recently, outperforming both its primary benchmark, the Russell 2000 Value Index, and its secondary benchmark, the Russell 2000 for the 1-, 3-, 5-, 10-, 15-, 20-, 25-year, and since inception periods ended 12/31/23. And this strong performance run has continued into 2024, as the Strategy also beat the Russell 2000 Value for all of those same periods through the end of February. And I think recent performance is a great place to start. Jim, what are some of the factors or decisions that have helped drive the Strategy’s impressive results during an otherwise pretty challenging period for small-cap value?

Jim Stoeffel: One of the keys to that is having experienced professionals executing against the Strategy. We've never had a more experienced team executing against the Opportunity Fund. This is where it becomes critical because there are going to be a lot of companies that are going to slow down because of the economy, and it'll be our job to figure out how many of these companies are slowing down just because the economy is slowing down. Which of our companies is slowing because we had this big bout of inflation? Were they over-earning? And it’s really critical for shareholders to understand how important it is to have an experienced team, and we have an incredibly experienced team.

You hit on, I think, one of the key aspects of our investment philosophy, which is the theme-based aspect. We have an asset play theme, a turnaround theme, an undervalued growth theme, and then we have what we call a frustrated, emerging growth theme, which are sort of broken growth stocks. The nice thing about that is it provides a really broad lens into the market. One of the areas where we have found a lot of opportunities has been in the undervalued growth stock category because the markets are volatile. People are worried about what's going on in the economy, people are worried about what's going on politically, and this creates a lot of volatility. There are a lot of these companies that we look at that are really interesting companies with long-term growth opportunities—and I'm sure we'll get into this—but there's a tremendous amount going on in the country right now in terms of reshoring, which everyone talks about. Everyone talks about AI and all these exciting things. We're invested in a lot of companies that are playing into those themes. And when you get periods of volatility, those stocks sort of move into our wheelhouse, which has been a really interesting opportunity for us in terms of really good companies that have become disproportionately cheap because of market volatility.

JD: Kavitha, Jim talked about AI as well as a few other areas. What other industries or trends have you all been focusing on most recently?

Kavitha Venkatraman: What's not visible when you just look at the individual stocks in our portfolio and don't have this overlay is that we own a lot of companies that are beneficiaries of structural growth. It could be where the government is investing, and it could be what they're doing with supply chains. The government is also spending a lot of money on rural broadband. So, we have companies that are suppliers to that space. Those companies have better growth prospects today than they've ever had in the past. And to the extent that they meet our valuation criteria, that's where we were adding to our names during the trough.

That October trough is a good sort of anchor point. A couple of things were obvious. The cyclicals had gotten pretty cheap at that time—levered cyclicals even more so. Similarly, on the other side, if you were a growth story but were unprofitable at the moment or the path to profitability was unclear, those also got cheap. So, to Jim's point, we would call them category four as an interrupted earnings or broken growth theme, but they're not broken companies. They're good companies which are executing a good strategy that are going through some sort of temporary pain. And what we're really underwriting is that we understand the pain, that it looks temporary, and they have a path out of it. It's not a particular industry; this was true in IT services and in some cyclical industries. So, it's across several industries.

This is what the Strategy does. We're trying to identify temporary things, and at the trough a lot of the companies that had merely temporary pain tended to get priced like they were going out of business, so it's great for us. We just take advantage of that short-termism in the market.

JS: And Kavitha to add on a little bit to that: the government is spending a lot of money to invest in semiconductor capabilities in the United States, which is a reshoring theme and probably a strategic opportunity as well. Why I love small-caps is that our companies are selling into these trends. We’re selling the picks and shovels. That’s a little bit of a cliché that I hate to use it necessarily, but it’s true.

When you think about AI, we own a company called Applied Optoelectronics. They make optical components. Their largest customer is Microsoft, which needs tremendous numbers of optical components to go after their AI strategy. We also own a number of companies that are building out the transmission and distribution infrastructure for the electric grid. You know, if everyone’s going to drive an electric car, you have to have electricity. And there are so many really cool companies that are selling the picks and shovels to these large companies. We get this question all the time: you have the Magnificent 7—what’s going to make small caps outperform relative to the Magnificent 7? I have an answer to that, but I'll wait till you ask the question. We want those companies to be successful because we own the companies that are selling into that supply chain. It's a huge opportunity for our companies if we get them right. So, there's just a tremendous amount to do in our space and it's a very exciting time right now to be invested in small-caps.

JD: Kavitha, I want to talk to you about volatility. But before we move on to that, you made what I think is a very interesting distinction, especially given how the Strategy functions. Which is that companies can have broken growth, but they're not necessarily broken companies. What are some of the things that you all look for in making that determination?

KV: I'll give you a great example to bring that to life. We are invested in a company called ACV Auctions. This was a company which, if I remember right, listed at nearly $30 during its IPO and fell all the way down to $5. They are helping used car auctions go from physical auctions—where you run cars down the lane, and dealers are standing there bidding on cars—to digital auctions, which tend to be 24/7 and could be timed 20-minute auctions. But what it really does, when you think about it from a dealer's perspective, is to take this inventory that's available nationally now and make it available versus you having to go to an auction at a physical location. That's really powerful. This company had the best technology. They were opening doors, which means adding dealers to their platforms, during a period when all they were getting paid to do was grow, grow, grow—and then suddenly that growth stopped. They also have a supply issue—with fewer new cars that turn into used cars three years later. They had a supply disruption there. You put these two together, and this looked like a company that was growing at any cost, and the stock traded down to $5 because the market didn't like it.

So that looks broken, but it's not a broken company. As I said, they have the best technology. They're doing all the right things for their growth strategy. A key insight that the CEO had at the time was, ‘My supply is not going to recover for three years, so I'm going to turn profitable.’ As he was articulating this, people didn’t believe him, though we started becoming shareholders when his strategy was clear: he’s going to pause this growth at any cost, continue to invest in technology, but otherwise turn profitable. And he's done that. You can go look at the stock price now. It's done really well for us since that point. That would be an example of a broken growth story for completely identifiable aspects. It's not a broken company. If anything, it’s the best-in-class company in that space which has sort of winner-take-most economics.

We have the patience. We are OK making money three or four years after we buy something because sometimes it just takes that long for a strategy to prove itself. As long as the management is doing the right thing and our thesis is not broken, we can wait. Diversification is key there—how many stocks we own. We're all very patient people, and we're willing to give management time. All of that plays to our advantage and I hope this brought this exact thing to life.

JS: It goes back to the thematic approach that we have. There are certain periods in the market cycle that certain things are going to do well, and certain things might not do well that will provide opportunities. I do think that the interrupted growth category will be interesting over the next year.

JD: Jim, you mentioned the Magnificent 7, and I think the really strong performance of those companies—the Amazons, Apples, and Alphabets of the world—has kind of masked the fact that small-cap has been fairly volatile over the last few years. Kavitha, can you talk about how you all have been using volatility, whether it's to harvest gains and use proceeds to buy new companies or has otherwise affected your portfolio positioning?

KV: I went and looked at what we've been doing and what is clear is that the volatility we've had in the past couple of quarters, particularly around earnings, helped us delineate between ideas that are just simply not working; investments where the thesis is intact but delayed; investments where the thesis is intact, but the valuation has not caught up; and things that have worked, and the valuation is already there. So, volatility is a great tool. I can sift through all the ideas that we have in the portfolio and say OK, if it's not working, and we don't think there is a chance, we deploy that capital into things that are working but where the valuation is not there yet or companies where we believe in the management’s strategy. Similarly, on the other end of the spectrum, if it's working and both fundamentals and valuations are already well above our fair value, we redeploy capital into these middle two categories. That's where we generate returns if you look through the activity in the portfolio.

JD: Jim, I guess this is sort of two different ways of asking a similar question. You had mentioned you wanted to talk about what it might take for small-cap to outperform the Magnificent 7, and in light of the recent strong performance for the Strategy, why should investors consider our Opportunistic Small-Cap Value Strategy now?

JS: I'll start at the Magnificent 7. I want to be clear; these are some of the greatest companies that have ever existed, quite candidly. They're great businesses that get sort of better every day because it's a network impact. People talk about whether this is like the Internet bubble, and the stocks may or may not be overvalued. This is not the Internet where people are paying for eyeballs or whatever they were paying for. This is really different, but there's still an inherent limit to what those stocks can be.

I was marketing three weeks ago. Our meetings were packed, our lunches were oversubscribed, and our breakfasts were oversubscribed—back-to-back-to-back-to-back meetings for five straight days. People are thinking that you need just a little bit for investors to begin thinking about the fact that, OK, these are great companies, but is there some inherent limit to what they can be? You don't need much of a change in mindset to really drive small-cap stocks. Microsoft's market cap is greater than the entire market cap of the Russell 2000. Again, you don't need much money to flow out of Microsoft and Apple and Amazon into small-cap stocks to make a difference.

The question I got in every single meeting was, ‘Well, what does that? What changes the mindset?’ I think the answer is going to be earnings. If you look at earnings expectations heading into the second half of 2024 and into 2025, small-cap stocks’ earnings are expected to accelerate. Following whatever economic slowdown, we’re having right now, when we reaccelerate, small-cap stocks have a tremendous amount of operating leverage, and you're going get that earnings growth. I think fundamentals are the most important factor, and the reacceleration in fundamentals and earnings growth will help.

Then you look at valuations of small-cap stocks, and in particular small-cap value stocks, which is what we do, they’re at historically low levels relative to large-cap stocks. It’s the same if you’re a value investor relative to growth stocks. I do believe that the normalization of interest rates is a good thing for small-cap value investing, and active management in particular, because you now have an actual cost of capital that people have to deal with. I think that's great for our companies. We were just talking about this in our morning meeting. Which companies are going to be able to take advantage of a normal cost of capital? We have companies that will be able to do that. They're going to be building long-term growth capabilities. Specifically, we look at price to sales and price to book value as our primary valuation metrics, and our portfolio is particularly cheap relative to small-cap value. So, you have this sort of cascading impact of small-cap versus large-cap, small-cap value versus small-cap growth, and the Opportunity Fund in particular. And we are really, in my opinion, really well positioned to benefit over the next couple of years from where the market is positioned. I'm obviously very passionate about this stuff.

JD: Kavitha do you want to add anything to that?

KV: What is so interesting is, we’ve had companies that were disproportionately impacted by labor availability issues or supply chain issues. And then on the other side, distortions because of COVID. Both on the upside and downside to businesses, COVID created all these distortions. To Jim's point, when we go into the second half of this year, we'll finally be in a period where all of these things have returned to normal. They're returning to normal as we speak. So, we'll finally be able to look at companies’ growth and earnings profiles through a lens that we all sort of recognize from pre-COVID, which should be very helpful in analyzing these businesses. A lot of the over-earning is gone, and a lot of the under-earning is behind us. That should help valuations because they’re cheap and people have trouble using a certain base for the valuations unless they're willing to look at history pre-COVID.

JD: Jim and Kavitha, I want to thank you both for joining us today on the podcast, and we invite investors to take a closer look at the Small-Cap Opportunistic Value Strategy. Thanks again.

KV and JS: Thank you, John.

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