This transcript has been edited for clarity.

Francis Gannon: Hello and welcome to the Royce Investment Partners Podcast. I'm Francis Gannon, Co-Chief Investment Officer, and I'm joined today by Portfolio Managers Jim Stoffel and Kavitha Venkatraman, who along with Brendan Hartman and Jim Harvey manage our Small-Cap Opportunistic Value Strategy, which we use in the open-end Royce Small-Cap Opportunity Fund.

The Strategy has performed well in recent years, but it's trailing its primary benchmark, the Russell 2000 Value Index, through the end of August. I think performance is a great place to start. Jim, what are some of the factors or decisions that have been helping drive the Strategy’s results during what I believe to be a very volatile period for small-cap value?

James Stoeffel: Thank you, Frank. There are really just a handful of themes relative to performance, the most important of which has been the allocation effect. The Fund is very typically underweight in Financials, and particularly underweight banks and REITs. Those assets don't typically or necessarily fit within our four themes of asset plays, turnarounds, undervalued growth, and broken growth stocks—although they do occasionally. Earlier this year when we had the mini banking crisis, Kavitha and I spent a week doing a deep dive into banks because we thought they had gotten cheap enough on a price to book basis where they were trading at 50% or 60% of book, to add stocks, and we added a couple of points of exposure. But generally, we're going to be underweight banks and REITs and are typically overweight Information Technology, and that’s had an allocation impact wherein banks have had a nice run, particularly here in the third quarter, and technology has been a little bit more challenged. We do tend to play in areas of technology with maybe a little bit more beta, semiconductor equipment stocks being a primary example. Quite candidly, there was clearly an inventory correction going on in the semiconductor arena. We thought that was going to clear out a little earlier than it's proven to, so we've been wrong on that trade for sure in the short term. Although interestingly we were at a number of tech conferences this week and had a chance to talk to a number of senior management teams, and it does feel like we're going through the bottom on the inventory side. Those have been the thematic things on the negative side.

On the positive side, stock selection has actually been pretty good and has been a source of outperformance, and that's been true of the energy area as well as construction & engineering. Those are the big themes, and those are the ones that have accelerated here a little bit in in the third quarter. We'll continue to be underweight banks and overweight technology, which we think is the appropriate decision over a three to five year time horizon.

FG: Before we dive further into the portfolio in terms of where you're finding opportunities today and some specific stocks, many people are anticipating the Fed is going to be cutting rates in September—a non recessionary cut. We're not in a recession, at least for the moment. What kind of effect do you think this will have on small-cap stocks? I'll throw that out to both of you.

JS: It's a pertinent question and really relates to the question as a small-cap value investor that you get all the time: what's going to drive an outperformance cycle in small-caps? It's been a challenging number of years. Everyone talks about the mega-caps and the Magnificent 7 and things like that, and they're great businesses—and by the way, we like them to be successful because we own a significant number of companies that sell into that supply chain, so we want them to be successful. The question becomes, what drives relative outperformance of small-caps? And I really think it's going to be a reacceleration in relative earnings growth. Our companies tend to have a lot more operating leverage than the large-cap companies because they don't necessarily have the scope and scale that you have in these large-cap companies. So, economic growth is important for these companies, and I think the Fed cutting will be one of the spurs to driving a reacceleration in economic growth.

Kavitha Venkatraman: And from a capital allocation standpoint, that's a horizontal which I think will benefit our portfolio. In the first quarter of 2024, we saw a fair bit of M&A activity, both things getting taken out of our portfolio and our companies going out and using their balance sheets to buy other smaller companies. That's basically come to a halt, I would say. Certainly takeouts from our portfolio have gone down to zero.

In terms of our companies buying things, it's not that they don't want to go out and make acquisitions; it’s that the sellers are all waiting for this rate cut so that they can extract a better price. So, that's choked up that M&A pipeline a little bit and that freeing up should benefit our portfolio quite a bit because valuation dislocation has been pretty significant, especially in the second half of this year. To the extent that there's that much value available, we expect more takeouts. I think the catalyst for that has to be rate cuts. That's one thing. The second thing, which is not maybe immediate, maybe not in the first rate cut—but as people are able to refinance their mortgages—we see a lot of pressure on the low end of the consumer landscape—that should help demand as well over time. Eventually, once rates come down to something a little bit more normal, because there is a mental block, I think. So, at a 6% or 5% mortgage rate when people refinance, I think it should help the consumer and certainly some of our consumer stocks.

JS: If I could add one more thing, and this is waxing philosophical a little bit, but you know, you've had these phenomena—we’re not in a recession, but nominal growth has slowed pretty significantly because inflation has come down so much. Again, our companies have a lot of operating leverage, so the slowdown in nominal growth has impacted their business models. I feel like the Fed is really tight right now, and I think they need to be cutting. Real rates are pretty high right now, and I think it's something that needs to happen.

FG: Given that, and maybe I'll throw this to you, Kavitha—where are you finding opportunities in the market today?

KV: It's not so much related to rate cuts, I would say, but in general given the valuation dislocations we've seen and some of the themes that are structural growth drivers, we've been adding a fair bit to our Energy exposure. Jim and I can tag team and talk about some things we've been doing. One thing, which is related to rate cuts, is adding to liability sensitive banks, which are struggling today because rates are where they are. They have to fight for deposits, which makes them a little uncompetitive and hurts their net interest margin, it's hurt their return on assets. All of that should reverse. So we've been adding some exposure there. Those are the two I would call out.

JS: I'll do another sort of advertisement for small-caps now. One of the big themes we see throughout our industries is what I'm going to call infrastructure investment. You obviously have a lot of money going into infrastructure investment from the federal government, either for building roads and things like that, or you have the bids coming in for building out telecom infrastructure. You have the whole phenomenon of reshoring or nearshoring as companies suddenly realize that having these just in time, highly extended supply chains maybe wasn't such a good idea after all. And then you have the whole electrification of the grid. I mean, if we're going to go to electric vehicles, or probably more likely hybrids, you're going to need a lot of electricity. You're building out these AI data centers, and they take a lot of electricity.

So, there's a tremendous amount of infrastructure investing going on in the United States. If you think about small-cap companies, they are disproportionately exposed to domestic demand. That's why we own a lot of companies that sell into this phenomenon. The natural gas stocks—actually that's part of the reason we own them; you have to power all this electrical generation somehow. At least in the intermediate term, for sure that's going to be using natural gas. So we think there's a built-in step function change in the demand for natural gas. But it's really across our industries. We own a lot of companies and have been adding to companies that are building transmission lines. We're adding to companies that are selling into AI data centers. We own a little company called Applied Optoelectronics, which has got a nice little contract from Microsoft, and we think it will get other component business from some other big data warehouse companies. So that's really a big trend. I think it's very good for small-caps given their domestic exposure.

KV: And the power angle is interesting. We looked at the demand for power. Until AI and EV's came into the picture, more so AI, all of the demand for power was basically coal switching to some other power source. There wasn't real growth in power demand. Now, suddenly we're sitting and looking at probably a decade where we're going to have real power demand. Estimates are anywhere from low single digits in terms of a very conservative assumption and all the way up to high single digits. The wild card there is what happens to AI. Our view has been, it'll take time. There's always a hype cycle, and then people digest how much investment is needed.

That's in the AI stocks—but none of this is possible without actual power—and that's where we as small-cap investors get to buy things that will benefit from that demand but not pay up for it—nowhere near Nvidia’s multiple, for instance. When we did the work, we couldn't figure out how you meet this power demand without natural gas as a part of the equation. Because all renewable sources are intermittent. We don't quite have the storage technology to go 100% renewable, which makes natural gas the perfect bridge fuel. And there's also LNG [liquified natural gas], which is going to suck up some of the natural gas from the system. So, there's a lot of latent natural gas capacity, which we expect will get turned on to meet this demand. Correct me if I'm wrong, Jim—but that's basically how we've positioned our portfolio: people who have access to that resource in the ground.

JS: Yes, that's right. And talking about performance in the Fund, one of the single best performing industries for us has been construction & engineering. That's not something you would intuitively say, “Well, this is related to what's going on in AI and reshoring” because you don't think about it that way. Going back to electricity—you have to build transmission lines to get the electricity to where it needs to go if you want to charge your EV batteries. We have neat little companies like Primoris Services that do all of that construction. We have a company called Newpark Resources, which has this really different business where they sell polyurethane mats and all the companies that are building transmission lines use these mats so they can drive the trucks over very rough terrain without doing damage to what are oftentimes very environmentally sensitive areas. And so there are these—mundane is sort of a bad term, I hate to use that term—but these mundane companies that have massive exposure to these trends that are going on, and that's the exciting thing to being a small-cap investor. You can find these things that most people aren't thinking about to take advantage of what we think will be a 5- or 10-year trend, I suspect.

FG: Kavitha, can you mention a couple of stocks that you have long term confidence in as well?

KV: Sticking with the natural gas theme, we've added to two names in the second quarter: one is SandRidge Energy. When we invested, I think 50% of its market cap was in cash. The management was very committed to doing the right thing both from a capital allocation standpoint as well as how much to produce. They could produce more if they wanted to and were waiting for the right price. From a capital allocation standpoint, they didn't want to overpay—they were trying to buy the right type of resource, and that's when we got involved. Since then, they've announced a transaction which we view as pretty smart. They added to their oil exposure while still keeping their exposure to natural gas pretty high, which helps them through this period where the commodity price is so low that rationally you shouldn't be producing and they're not, but they can generate cash flow on the oil side. They're returning all of that through dividends, share repurchases, special dividends, very conservative management, and a good balance sheet. So we continue to like that. And Jim, do you want to talk about Comstock Resources, which is the other name we've added?

JS: Comstock is a pure play dry natural gas play in Texas and there aren't very many of those. Most players have both natural gas and oil, and actually a lot of the natural gas that many of the companies produce is associated gas, where they're really drilling for oil and they pick off the natural gas, which has been a supply problem, candidly, because they’ll sell that for anything to get a little bit of money. There's clearly demand for pure play natural gas equity values, and Comstock certainly fits that. But it's a pure commodity play, which is a little more challenging than SandRidge, which I think has an interesting capital return dynamic.

FG: Any other ideas you'd like to mention?

KV: We've spoken about ad tech in the past, and just to give people a refresher, when we when we got involved at the time it was during a slump in ad spend. This was early 2023 when we started investing in ad tech. There’s been a big slump in ad spend and then a lot of uncertainty around Google’s cookie deprecation timeline and who survives that and who doesn't. There was a consolidation angle where we thought there were too many ad tech players, but clearly we could identify who the leaders would be or the survivors would be. Those are the ones we invested in. Now 18 months into that investment cycle, ad spend has recovered, and a lot of our companies have proven themselves in that recovery as they've kept or gained share.

On the Google deprecation Cookie deprecation issue—Google has now basically walked away from it. They've got to give consumers like you and me the choice to say, do I want to be tracked or not, essentially. But when you flip this and look at it from the standpoint of the advertisers—for them, it's still a murky world because they should have access to 100% of their target audience through cookies, and now they probably have access to, let’s say, 50% of their audience. I'm just making this up, but that's not an unreasonable assumption. But what that creates is, you still need technology that helps you improve the resolution you have for your target audience so that you can market to them. That's where all of our companies come in.

So one in particular that's a huge beneficiary of this is Criteo. About 90% of the retargeting was done by Criteo. And they knew that business was challenged. The terminal value was probably zero at the time, so they're very smart. They pivoted the business away from that to retail media. Now they've become the dominant force in retail media, which they get to preserve, and they also get to keep some of their targeting business because cookies are not going away. That's one that's done really well for us, but it's still not fairly valued because now there's uncertainty around, is it 50% cookie deprecation or is it 80%? Time will tell, but they're very well positioned because their earnings just objectively will be higher than what people thought in the prior regime before Google’s decision to walk away from cookies. So that's one I would point out as something where the thesis has played out and it's actually getting better than we thought because of developments in the industry.

FG: Great—thank you both. Thank you both Jim and Kavitha for the conversation today.

JS: Thanks.

KV: Thank you.

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