This transcript has been edited for clarity.

Francis Gannon: Hello and welcome everyone. This is Francis Gannon, Co-Chief Investment Officer at Royce Investment Partners. Thank you for joining us. Our conversation is with two of the portfolio managers of the Royce Quality Value Strategy, which we use in the Royce Small-Cap Total Return Fund, Lead Portfolio Manager Miles Lewis and Assistant Portfolio Manager Joe Hintz.

The Quality Value Strategy advanced 4.3% in the opening quarter of 2024, outperforming its benchmark, the Russell 2000 Value Index, which was up 2.9% for the same period. The portfolio also outperformed its benchmark for the 1-, 3-, 5-, 10-, 15-, 20-, 25-, 30-year, and since inception (12/15/93) period ended March 31st, 2024. Miles, you've been lead manager of this Strategy for over three years now. How has this Strategy’s selection process evolved?

Miles Lewis: Hey, Frank, good morning. That's a great question. We've done a lot over the last three or four years to really enhance the underwriting process, but I'd probably focus on two areas. The first would be formal underwriting memos. There's a great quote from Shane Parrish at Farnam Street, who I think is one of the best investment thinkers out there, and he says the best way to improve your ability to think is to spend time thinking. “One way to force yourself to slow down and think is to write—good writing requires good thinking. Clear writing gives poor thinking nowhere to hide” I think that really nicely summarizes how we think about our investment memos. It's a template. It's almost like a checklist for us. We focus a lot on the risks, on the opportunities, on the narrative, and the fundamentals. But we don't write just to write. We write to make ourselves better as thinkers and to help everybody in the team understand each opportunity.

The second area that I would mention would be our use of data analytics and technology. We will study our winners and our losers and overlay the data to figure out if there are any common threads among those two groups and to figure out how to find more winners and fewer losers. We use a lot of our data and analytics to help support portfolio construction and portfolio management. These are some of the areas that we think have really enhanced the process, made it more robust, more disciplined, and more repeatable over time.

FG: Can you spend a second talking about the team and how the team has changed?

ML: We have a fantastic team. There are two things to note here. One is that we operate what we call a player-coach model. That means that the portfolio managers function as both portfolio managers and analysts. We do portfolio management, portfolio construction, and client-related activities, but we also roll up our sleeves and do those underwriting memos that I was just talking about. We function as analysts as well. We just do a little bit less than the rest of the team.

The second would be that we have what we call a hybrid generalist specialist approach. We specialize where we think specialization matters. For example, in areas like financials and tech, where there are a lot quants—both the accounting and the financial statements. In the case of tech, we think that specialization there really does add a lot of value. Those are areas where we focus on having deep domain expertise, and we're a little bit more generalist in other parts of the market.

In terms of the team, Joe is here with us and joined us from American Century, where Joe and I worked together for six years. I was elated when Joe expressed an interest in coming to Royce. He came here as a Senior Analyst and very quickly became a portfolio manager. He is an outstanding investor overall, but Joe is particularly good at tech. He lives in the Bay Area, so he's immersed in it every single day and does an extraordinarily good job covering that space. He's also made significant contributions to the process that you were alluding to earlier, and I think Joe's probably going to talk about some of those things today.

Jag Sriram is another recent addition to our team. He joined shortly after me here at Royce, and he is particularly good at what we call ecosystem research. That's something that's pervasive both on this team and throughout the organization, but I think Jag raises the bar for everyone. This would be speaking to suppliers, customers, former employees, things like that. He's got a really uncanny knack for picking apart business models and breaking them down to their unit economics, and he's really, really good at new idea generation. He's also been very contributory in terms of helping us define the process. He's helped to streamline our idea generation process and our screening process. That's been really helpful.

The last member of the team is Matt Fedorjaka, our most recent addition. He's covering Financials for us, particularly banks, and then he'll expand from there. Matt’s relatively young, but we think he has a very high ceiling. He came to us from an investment bank covering banks on the sell side. We've been very impressed with his bank knowledge, particularly relative to his experience. He was mentored by one of the best sell side bank analysts out there, and he's come to us and hit the ground running. He's already completed his first memo and is creating a ton of value. For example, we have a master bank file that he created that as KPIs (Key Performance Indicators) across all of our banks, compares them to the broader group, to the large-caps, the small-caps, the mid-caps. It's been an invaluable file that we look at on almost a daily basis. We’re just elated with how the team has come together. We have a great rapport. We're almost like a family—we can finish each other’s sentences, and I think the best is yet to come.

FG: Thank you for that. I'm looking forward to spending some time on Financials a little bit later in this discussion. Let's turn back to the portfolio a little bit. Where are you now in terms of the average holding period for positions?

ML: One of the things that we say to our clients is that we are long-term investors but are not necessarily buy and hold. The reason for that is that we use the volatility that is inherent in our asset class, in small-caps, to our advantage. We will trade around position sizes from time to time when there is extreme volatility and I think Joe, I've hogged the mic. You should talk about Coherent last year as a great example of how we did that.

JH: Thanks Miles. Coherent is a perfect example of where we traded around some pretty significant volatility. The stock price we thought became very much untethered to the underlying fundamentals of the business. When that happens, we like to take advantage of those movements by trading around it.

Coherent is basically a materials engineering company. They sell foundational technology into many different end markets, one of which is optical networking for data centers. I'm sure you'll recall back in May of 2023, Nvidia reported blowout numbers, and all of a sudden there was a bunch of hype in the market around Generative AI and what that was going to mean for the markets. Investors started looking for what the next AI play was going to be, and Coherent got very much caught up in that. The stock was up 120% in four weeks, and we trimmed very aggressively into that strength because we knew that, while Coherent was going to benefit, it was going to take a while for that to materialize into their fundamentals. Indeed, the stock gave all of that 120% move back over the next four months. Then we bought aggressively after the stock came back down because we really believed in the underlying long-term fundamentals of the business. That's why we own it.

FG: Joe, we talk a lot about risk-adjusted returns over full market cycles, but how do you and the team execute risk management?

JH: Thanks for bringing up risk management as that is a very important piece to our Strategy. As you know, we really focus on downside protection. We look at risk management from three different lenses: original underwriting, position monitoring, and portfolio monitoring. Let me dive into each of those a little bit. With the underwriting, we view the depth of our research as critical for downside protection because we like to say that we want to find the problems before they end up in the portfolio. Just to take a step back for a second, we think that by looking for high quality companies at attractive valuations, that's a great starting point for what we call margin of safety, which already provides some level of downside support, we think. Taking that a step further—really digging in with our primary research and understanding the businesses down to the level of unit economics provides another level of critical insights into the potential range of outcomes for specific investment cases. We use that same depth of research for position monitoring after something gets into the portfolio, we continue to monitor those positions with our high quality research.

Within this area of position monitoring about a year and a half ago, we made a little tweak to our investment notes that we write after quarterly earnings for each company. We've always done investment notes, but we've made a few small changes about a year and a half ago. One of those changes was adding what we call a thesis section—and we did this to avoid a risk that we call ‘thesis creep,’ meaning you buy it for one reason and then, over your three to five year holding period, that reasoning changes. We want to avoid that. We want to understand why we own it and bring new insights every quarter into why we own that stock so that we avoid the risk of thesis creep. Second, we added a risk section, which is essentially a nice checklist where we can go through and monitor all of the identified risks for that security over the holding period over a long period of time. Third, we added a section around market sentiment and stock narrative. We're analyzing some of the near term things that are impacting the stock and providing some analysis around that. We're kind of marrying our long term view with the near term view. We think the tweaks we've made to that investment note have continued to increase the level of our analysis that we're doing around position monitoring.

Finally, we have multiple levers where the first and most obvious is position sizing. You might think that we put position size based on the amount of upside in a stock, but that's not how we view the world. We view the world from a range of outcomes perspective. So just because a stock has the most upside doesn't mean it's going to be the largest position. We marry the upside with the potential downside. So, what you'll see is a stock that has good upside but very little downside will generally be the largest position in the portfolio.

Again, hitting this theme of intense, rigorous research, we think that looking at things from a unit level economics perspective allows us to not just look at what GICS industry or sector company is in, but also look at the surrounding risks across other industries that that company might be exposed to. For example, our Communication Services companies, generally speaking, have ties into the consumer as well, and so we're not just looking at the Communication Services sector—we're looking at how it's related to overall consumer health. Similarly, our Materials sectors companies generally have either side door exposure to Tech or Consumer Staples. So we're thinking about those companies as surrounding those end markets. Similarly, we have an Industrials company that's actually predominantly driven by regulation in the healthcare industry. We think that that level of rigorous research helps us to look for and manage the sector and industry risk not just by the GICS breakout, but actually the true economic exposure breakout. Lastly, the Royce Risk Management Team provides us lots of great data and insights into the portfolio on a regular basis as well.

FG: How are you actually thinking about risk when you’re looking at some of the weightings in the portfolio today? And let's spend a second on Financials, specifically the sizable weighting in banks.

ML: Let me set the stage for how we think about the banks. We are overweight versus our peers, but we are underweight versus the benchmark and have been for some time. We do believe we have some expertise in this area and that we can add value. A great example of that would be First Citizens last year, where we returned to that holding shortly before they announced the deal with Silicon Valley.

We also think that valuations in this group are attractive on both an absolute and relative basis. A common metric for banks is price to tangible book value—and the group on that basis, if you exclude some of the impacts of AOCI [Accumulated Other Comprehensive Income—special gains and losses that are listed as special items in the shareholder equity section of a company’s balance sheet], is trading at about 1.1 times, and that compares to about 1.8 times just recently, and they're trading at about 10 times earnings. For our banks specifically, we expect them to grow earnings about 15-20% in 2025 with a handful of them growing significantly above that. So that’s an attractive backdrop given the valuations.

The group has underperformed the market pretty dramatically. The community and regional banks that we own also dramatically underperformed large-cap banks. This is a highly correlated group, which creates opportunities, particularly during times of stress or concern. So, in March, April, and May of last year during the little mini banking crisis or even more recently with the issues facing NYC, we think created opportunities for active stock pickers like us. We have a big quality bias, as you know, given our Strategy. But for us, within banks at a high level that means strong capital levels, really good underwriters, or strong credit performance and good or improving returns on capital. We also like certain geographies more than others. We tend to gravitate towards growth markets like Texas, Florida, the Southeast, and the Southwest, but we're also open minded enough to look at things where the migration patterns aren't great. For example, Los Angeles is an area that's not well talked about or well liked in terms of its business friendliness or its population growth. But if it were a standalone economy, it would be one of the top 20 largest economies in the world—and that creates opportunities for banks in those markets.

FG: Miles, how about an example?

ML: A recent addition to the portfolio that that we think is really interesting is the Banc of California—the ticker is BANC. It is the combination of legacy Banc of California and Pac West, where there was a merger and Banc of California was actually the acquirer, even though it was the smaller bank. The combined entity is now a top ten bank in the Los Angeles metro area and the number two California based bank in that market. It's got a very strong deposit franchise, which we think is actually going to improve over time. There are a lot of reasons we like it, but I would say it really boils down to it being a self-help story. There are few banks that are completely immune to the rate backdrop or the economy. But in BANC’s case, there are some things that are uniquely within their control which we think can help drive outsize returns: It’s reducing non-interest expense, which is bank jargon for SG&A [Selling, General and Administrative Expenses, which is a major non-production cost presented in an income statement], and they’re going to do that by things like reducing their FDIC expense, which is formulaically driven. They’re going to do merger cost saves from real estate, personnel, IT systems, etc. that are going to be meaningful.

The second bucket, which is a little bit of a self-help lever they can pull, is reducing their cost of funds. If you go back about a year, legacy Pac West was forced to take on a lot of expensive sources of funding to shore up liquidity during the bank crisis. Those sources of funding are now rolling off and being replaced by lower cost deposits and, in some cases, non-interest bearing deposits. As a result of that, we actually see the net interest margin at Banc of California improving over 130 basis points between 2023 and 2025. These two factors really underpin what we see as an acceleration in the improvement of fundamentals from an ROA, or return on assets, of about 40 basis points today to a much more peer like 1.0% in 2025. We think that's going to drive significant EPS growth next year to the tune of 50%-plus. They don't need a lot of balance sheet growth to get there. We think that the balance sheet risk here has been dramatically reduced. We think the CEO is impressive with a great track record of implementing turnarounds at the legacy bank—and we think he's going to do a really good job here.

We also like the fact that there's been a lot of discussion in the L.A. and California markets about M&A, and that's going to create opportunities for them. From a reward perspective, this is a bank that trades at a little less than tangible book value. We think that provides a pretty good downside margin of safety. If we're right on the fundamentals, this is a company that we think is going to be worth 1.5 times tangible book, maybe more than that in a couple of years. It’s plausible that this stock could double during that time frame. We think it's a really interesting opportunity, and we really like it because of the fact that it’s not entirely reliant upon a normalization of the yield curve or the Fed cutting rates in order to drive outsized returns.

FG: Let’s conclude with your outlook. What are you seeing today and how's it affecting your portfolio positioning?

ML: As we just discussed, we see a lot of opportunity in the bank space and think that's a stock picker’s market. We think we’ll create some value there. But there are a couple of other interesting ideas. Joe, do you want to hit on a couple of those that are big weights in the portfolio?

JH: Absolutely. One theme that fits into that bucket of having their future outcomes not so heavily dependent on the macro are what we call self-help stories. Two examples that I would highlight here are Advanced Auto Parts and Kyndryl. We think both of these companies have self-help levers that should improve fundamentals over time, regardless of what's happening in their end market. Let me hit each of those briefly. Advance Auto Parts is a retail auto supply, retail, and auto parts store. This is a company that has been poorly managed for a very, very long time with returns and results below that of its peers. The company now has a new management team that has come in with a strong strategic execution plan around improving their supply chain ecosystem. We think that's going to drive better store economics, which will then provide more opportunities for growth—and that will happen regardless of what's happening in the macro economy.

Kyndryl is a very similar story. It’s an IT services company that used to live in the IBM family and then was spun out a couple of years ago. When Kyndryl was part of IBM, the economic incentives were obviously different at the time. IBM used Kyndryl essentially as a loss leader, using the contracts with clients with either no profit or negative profit to drive the rest of the business. Now that Kyndryl has spun out, they can go through the portfolio of contracts and renegotiate them over a long period of time to weed out those negative or zero profit contracts and replace those with profitable contracts—again, they can do that regardless of what's happening in the broader tech landscape.

FG: Great. Thank you, Joe and Miles for what is always an interesting conversation around the Royce Quality Value Strategy and thank you all for joining us today.

ML: Thank you for having us.

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