Podcast: Three Small-Cap Stocks That Exemplify Our Quality Value Strategy
article , video 10-29-2024

Podcast: Three Small-Cap Stocks That Exemplify Our Quality Value Strategy

Lead Portfolio Manager Miles Lewis, Portfolio Manager Joe Hintz, and Assistant Portfolio Manager Jag Sriram discuss three key holdings in Royce Small-Cap Total Return Fund with Co-CIO Francis Gannon.

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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 the portfolio management team of the Royce Quality Value strategy, which we use in the Royce Small-Cap Total Return Fund: Lead Portfolio Manager Miles Lewis, Portfolio Manager Joe Hintz and Assistant Portfolio Manager Jag Sriram.

The Quality Value Strategy advanced 4.3% in the third quarter of 2024, underperforming its benchmark, the Russell 2000 Value Index. The Strategy has outperformed its benchmark over the 3-, 5-, 10-, 15-, 20-, 25-, 30-year, and since inception (12/14/93) periods going back to 1993 through the end of September 2024. Miles, let's start with performance. Can you describe some of the most prominent dynamics that drove performance in the third quarter?

“We know that our process leads us to attractive opportunities with asymmetric outcome profiles, and that the trajectory of a company's financial performance and operating fundamentals win out over the long run.”
—Joe Hintz

Miles Lewis: Thanks Frank. It was a very difficult quarter for us. We own that and we've spent a lot of time thinking about it and analyzing it. I would say that there are four primary drivers of the underperformance in the quarter. The first three were exogenous factors that are a little bit beyond our control, and the fourth reason is something that is really what I would call self-inflicted wounds. So starting with the exogenous factors—the first one is that there was a big rally in the month of July. In fact, from July 10th through the 31st, the Russell 2000 Value Index was up 16.0%. And that really is an environment where one would expect us to lag on a relative basis given our quality bias, and that's exactly what happened. In fact, if you look at the monthly performance relative to the index during the quarter, what you'll see is that the vast majority of that—in fact, over 75% of it—came in the month of July. So, that was by far the biggest factor.

Related to this is that high-quality factors in the market did not perform well during the quarter. It's interesting because our quant data at Royce showed that not a single one of the quality factors that we track and analyze worked during the quarter. So that was a headwind as well. What's interesting in the quarter is that even though it was a nice quarter on an absolute basis, there was a fair amount of volatility. In early August, the index dropped about 10% in three days, and we did not pick up performance on a relative basis during that time period. The reason for that is pretty straightforward. The 10-year Treasury yield declined 25 basis points in three days, which is a big drop. Because of this, the three bond proxy sectors in the index—Consumer Staples, Utilities, and REITs—were down about half as much as the index. That strong relative performance really masked much more significant underperformance in other parts of the Russell 2000 Value Index that were down as much as 13% or more. Total Return, for various different reasons, but primarily relating to what we look for in business models, has virtually no exposure to those three bond proxy sectors. The fourth thing that I think is most important to talk about is really what happened to us specifically. We struggled with stock selection.

Over time—because this is a relatively concentrated portfolio—we expect stock selection to be the primary driver of our returns, and that is in fact the case. But in the short run, there can be these kind of acute periods where we struggle. And so I want to dissect that a little bit. The first thing is that we had three mistakes in the quarter. We make those every year, but it just so happened that we had three in the quarter where we realized our thesis was broken and we acted decisively and we chose to move on. The second thing is that we typically have both good stocks and bad stocks from a performance perspective in one quarter, and you would expect that your good stocks do better than your bad stocks. What we found this quarter is that our bottom five stocks were twice as bad as our top five stocks were good. That is literally the opposite of what we see over the long run, where our good stocks are twice as good as our bad stocks are bad, so that made for a very difficult operating environment.

We actually have studied this over longer periods of time, and if you look at, say, the three-year number, it's the exact opposite of that—our best stocks were twice as good as our bad stocks were bad. So, that was an unusual environment. We went a level deeper from there and we looked at the top 25 stocks that typically comprise about 55% of our portfolio, so it is a high conviction portfolio. Of those top 25 stocks, only 10 outperformed in the quarter. If you look at it a different way—of those top 25, 10 were actually negative in the quarter when the index was up nearly 10%. So it was just a really difficult backdrop. The question then is well, what happened? And we looked at it by industry, by sector, by different members of the team, their research coverage, and there was no common thread.

It really all boils down to a difficult quarter with stock selection. The last thing I would mention here is that we have companies where we expected the fundamentals to be good, and the stock prices to follow suit. What I mean by that is a company reports earnings, they beat, they guide up because the valuation is undemanding. You would expect the stock to go up, and the opposite happened. We had stocks that reported earnings, they did well, they raised their guidance, and the stocks went down. That's a an environment where you'd expect that stock to be in the top five and instead it was in the bottom five during the quarter.

The reason that I'm optimistic about this is that we have a really disciplined process. We do deep fundamental research and we think that that process is still intact. We haven't changed anything. and then over the long run, our ability to analyze companies and get the fundamentals right, more often than not will lead to good stock selection and therefore good returns.

FG: Jag, why don't you spend a second on that last point because I think it's really interesting. Can you elaborate on this idea that stocks that had positive results but negative price movement in the quarter?

Jag Sriram: Sure, Frank. The example of that is Kyndryl Holdings. This is an IT infrastructure company that was spun out of IBM three years ago. Under the former ownership of IBM, Kyndryl had lots of legacy loss leader contracts, and I mean 0% gross margin. Also, they were prevented from selling any kind of technology that was not IBM-centric. Since the spinoff in November of 2021, this company hired the former IBM CFO as the CEO of Kyndryl, and he has unveiled a AAA strategy, which stands for accounts, advanced delivery, and alliances. Under this strategy, Kyndryl has done all the right things—they’ve renegotiated these loss leader contracts, they've implemented automation tools to free up employees and save costs, and they're now offering several non-IBM technology solutions via alliances with partners like Google, Amazon, and Microsoft. That increases their technological relevancy to their clients and also forbodes a higher growth profile relative to the past.

Now in the last quarter, to our surprise and the market’s surprise, unlike their competitors, Kyndryl did not see any macro pressure and also demonstrated steady progress towards these AAA goals, which strengthens the case of meeting their financial targets for the year. The other important point was that their consulting business was growing much faster than what the market and we expected, which provided incremental upside to our initial fundamental analysis. This was one of several reasons we thought that the stock would be up on earnings and instead it was down meaningfully on the earnings report.

We’ve scanned the market, we’ve talked to people, and we are not able to pinpoint any reasonable explanation for why this odd price behavior happened. One possible explanation could be that Kyndryl’s CEO threw cold water on a market rumor that they would be buying DXC Technology, which is a struggling competitor. The CEO categorically denied that, and maybe that's disappointing to the market. But what's odd is that this news or this rumor wasn't really material in the stock’s run up to the earnings quarter. So, we are not sure. Another reason could be that the stock had very high expectations building in because it was up 29% year to date going into the print. But then again, that doesn't make a lot of sense either, because even at those levels, the stock was very cheap.

FG: Miles, are there any other stocks in the portfolio that sit within this framework of performance for the quarter?

ML: Yeah, Frank, there's several. I would highlight a company called Pason Systems, which is an oilfield services provider. Energy is typically a tough space for our team given the dependency on commodity prices. When we do have exposure, we look for really high quality business models in the energy space. We want companies that have relatively less dependence on the commodity cycle to grow their earnings over time, and we think Pason fits both of those perfectly. Pason is, in our view, essentially a technology company that just happens to operate in the energy services space. They make sensors and the accompanying software that help operators to optimize their drilling rigs. I think the evidence for this being a quasi-tech company is the fact that they have 60% plus gross margins, 40% plus EBITDA margins, and very little CapEx, so they throw off a ton of cash. The second part is their dependency on the energy CapEx cycle. and we think that a really powerful proof point here is that since the start of 2023, the North American rig count is down roughly 20%, but Pason’s revenues are actually up during that time. This shows their ability to grow in a difficult energy CapEx spending environment, making it a good fit for our process.

The stock lagged during the quarter, and really because the entire oilfield services sector was down. That was a function of the fact that crude oil prices started the quarter somewhere in the low $80s and ended the quarter in the high $60s. What you'll see is that in the short run Pason’s stock price does tend to correlate somewhat with WTI [West Texas Intermediate] prices. But as I mentioned just a second ago, the fundamentals have far less of a correlation. We think that over time, while they're certainly not immune to the vagaries of the energy CapEx cycle, we do think that they can grow their revenue and earnings without being overly reliant on that tailwind of capital spending to do it. So, we like this company for the long term. We think the valuation is compelling, and we think it's a phenomenal business model.

FC: Jag, anything else you'd like to add?

JS: Thank you, Frank. Advance Auto Parts is an auto parts retailer with exposure to both the do-it- yourself and the professional buyer. The way we would describe our thesis on Advance is that this is a bad house in a great neighborhood. And what we mean by that is, this is a phenomenal industry because it has long-term tailwinds from an aging car parc and the prices of cars exploded during the pandemic, so people are holding on to their old cars for longer, which drives revenue to Advance. And when you think about it, cars themselves have become much more complex over the years, with more sensors. And that means that they have to go to the garage to get their cars repaired.

Our thesis in Advance is that this is a historically mismanaged asset in a great industry. Most importantly, we think that the operational issues are fixable. To that end, Advance has brought in a new CEO who has an exceptional pedigree and a very strong connection with the labor force. We have verified some of these elements through our primary research process. The CEO, since he joined in September of last year, has unveiled a new turnaround strategy that's focused on fixing important elements of the core business.

We look forward to further details during the next earnings call. In the last earnings call, Advance announced the sale of Worldpac, which is a non-core business unit, for $1.2 billion and that improves their balance sheet. But they also implemented $100 million of pricing investment and they slashed earnings guidance because there was pressure from low income customers as they deferred auto maintenance. Now we think that the near term outlook is very cloudy, and the stock is in the penalty box. But we think it offers good risk reward due to these long term tailwinds, and management taking the right step to narrow the performance gap versus their peers.

FG: Joe let's bring you into the conversation. Given the challenges outlined here in regard to third quarter performance, can you walk us through your outlook?

Joe Hintz: Absolutely, Frank. Thanks so much. For starters, we looked backward for historical precedents to help frame up the quarter that just ended. We actually had an eerily similar experience in the third quarter of 2022, when the market had a very similar performance contour. We studied our performance back then and came to a similar conclusion to the one we are coming to now as we study 2024’s third quarter performance. In both periods, there were a number of exogenous factors that combined with relatively poor stock selection. Looking at these parallels gives us optimism because back in 2022 the poor quarter of stock selection proved transitory and set the stage for a strong rebound in relative performance in both the fourth quarter of 2022 and the subsequent year. Even more importantly, though, as you can see from the stock examples that Miles and Jag just walked through, we have very strong confidence and conviction in the stocks that underperformed in the third quarter of 2024, with the obvious exception of the three stocks that we exited due to broken theses. And there are multiple examples beyond just those three stocks that we discussed here today, where our conviction in the long-term fundamentals for the company has been strengthening despite that fact not being recognized in the stock prices yet.

While looking at performance in any single quarter can provide helpful insights, we judge performance over longer periods, and our data shows that our philosophy of leaning into our rigorous research process and therefore leaning into our stock selection with high conviction does provide positive results over the long run. As Miles mentioned at the outset of our discussion, when we look over longer periods of time, our stocks that contribute to our performance have generally done so at roughly twice the level that our underperformers have detracted. We think this is an outcome of our process and we remain highly confident in our portfolio. We know that it isn't possible to outperform in every single quarter. However, we also know that our process leads us to attractive opportunities with asymmetric outcome profiles, and that the trajectory of a company's financial performance and operating fundamentals win out over the long run.

FG: Thank you, Joe, and thank you to the portfolio management team of the Royce Quality Value Strategy for their time today and thank you for all for joining us.

Important Disclosure Information

Average Annual Total Returns as of 9/30/2024 (%)

  QTD1 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE ANNUAL
OPERATING EXPENSES
NET               GROSS
Small-Cap Total Return 4.29 19.86 6.73 9.67 8.44 10.20 12/15/93  1.26  1.26
Russell 2000 Value
10.15 25.88 3.77 9.29 8.22 9.49 N/A  N/A  N/A
Russell 2000
9.27 26.76 1.84 9.39 8.78 8.83 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. 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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds and other investment companies.

Mr. Lewis’s, Mr. Hintz’s, Mr. Sriram’s, and Mr. Gannon’s thoughts and opinions concerning the stock market are solely their 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.

Percentage of Fund Holdings As of 9/30/24 (%)

  Small-Cap Total Return

Kyndryl Holdings

3.0

Pason Systems

1.9

Advance Auto Parts

2.3

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.

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.

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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. 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. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. 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 Foreign Securities" in the prospectus.)

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