Small-Cap Premier Quality Strategy—3Q24 Update and Outlook —Royce
article 10-22-2024

Small-Cap Premier Quality Strategy—3Q24 Update and Outlook

Co-Lead Portfolio Managers Lauren Romeo and Steven McBoyle update investors on the Strategy’s recent performance while providing an optimistic outlook for high-quality U.S. small-caps.

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How did the Small-Cap Premier Quality Strategy perform in 3Q24 and over longer-term periods?

Steven Mcboyle: The mutual fund we manage in the Strategy, Royce Premier Fund, advanced 5.4% for the quarter, lagging its benchmark, Russell 2000 Index, which was up 9.3% for the same period. The portfolio also trailed the benchmark for the year-to-date period ended 9/30/24, up 6.5% versus 11.2%. However, the Fund outperformed the Russell 2000 for the 3-, 10-, 20-, 25-, 30-year, and since inception (12/31/91) periods ended 9/30/24. So, although short-term results were somewhat disappointing, we’re very pleased with the Fund’s long-term results.

How did Fund’s results break down on a sector basis in 3Q24?

Lauren Romeo: Five of the portfolio’s nine equity sectors made a positive impact on quarterly performance, led by Industrials, Real Estate, and Consumer Discretionary while the largest negative impacts came from Information Technology, Materials, and Communication Services.

What happened at the industry level in 3Q24?

SM: Real estate management & development from the Real Estate sector, machinery in Industrials, and capital markets from Financials contributed most for the quarter. The biggest detractors were semiconductors & semiconductor equipment from Information Technology, chemicals from the Materials sector, and electronic equipment, instruments & components from Information Technology.

Which position contributed most in 3Q24?

SM: Our biggest contributor in the third quarter was Colliers International Group, a leading global professional services firm that operates in real estate leasing, advisory, outsourcing, capital markets, and investment management, along with growing activities in engineering services. Colliers has a high recurring revenue, asset light business model and serves large and highly fragmented markets. It also features a unique partnership structure for capital allocation and founder-led high insider ownership. In July, Colliers announced the closing of its recent acquisition of Englobe, a leading North American inspection and environmental services business which serves a diverse set of public and private customers with a high recurring revenue oriented professional services business model. Colliers adds Englobe to its existing Engineering and Project Management platform, with Englobe providing much needed scale in this high recurring revenue business line that Colliers intends to continue building both organically and inorganically. Early in July, Colliers also acquired in partnership form a leading Swiss commercial property advisor that will become part of the company’s European advisory platform. Similarly, Colliers acquired a bolt on business in Western Australia to bolster their already strong engineering platform in Australia. Importantly, in the third quarter, the company reported strong results with growth across all service lines and segments where, importantly, leasing exceeded expectations and capital markets returned to growth after a two year down cycle. We continue to believe Colliers is a well-established business with distinct competitive advantages, as well as strong and large reinvestment opportunities.

Which position detracted most in the quarter?

LR: The Fund’s biggest detractor was MKS Instruments, the market leader in supplying critical components and subsystems for semiconductor capital equipment and microelectronics manufacturing. MKS makes components, subsystems, and process control solutions that measure, control, power, and monitor semiconductor manufacturing processes. It also has leading positions in the chemicals and equipment used to manufacture advanced electronics, including specialty plating chemicals. Its shares rallied through the first half of 2024 as both the company and industry datapoints indicated that the slump in the semiconductor memory sector had bottomed and was poised to rebound in the second half of 2024. This thesis was derailed somewhat as most semiconductor stocks stalled in both August and September. In our view, this downturn is likely to prove temporary, and our long-term confidence in MKS remains strong.

How did the Fund perform relative to the Russell 2000 on a sector basis in 3Q24?

SM: The portfolio’s disadvantage versus its benchmark was attributable to stock selection in the quarter. At the sector level, stock picking hurt most in Information Technology and Materials while a combination of stock selection and our much lower weighting detracted in Financials. Conversely, our lack of exposure to Energy, stock selection and a higher weighting in Real Estate, and stock picking in Consumer Discretionary contributed most to relative quarter results.

How did the Fund perform at the sector level for the year-to-date period ended 9/30/24?

LR: Five of the portfolio’s nine equity sectors made a positive impact on year-to-date period performance, with Industrials, Financials, and Information Technology making the biggest positive contributions while the largest negative impacts came from Health Care, Communication Services, and Materials.

What were the biggest industry contributors and detractors in year-to-date period?

SM: Our top contributing industries were capital markets from Financials, semiconductors & semiconductor equipment in Information Technology, and machinery from Industrials, while chemicals from Materials, health care equipment & supplies in Health Care, and interactive media & services in Communication Services were the largest detractors.

Which holding contributed most for the year-to-date period ended 9/30/24?

LR: Our top contributor at the position level in the year-to-date period was Cirrus Logic, a fabless semiconductor supplier that specializes in analog, mixed-signal, and audio DSP integrated circuits. Its audio processors and converters are used in consumer entertainment products like smartphones, tablets, digital headsets, automotive entertainment systems, and home-theater receivers, as well as in smart home application speakers. Cirrus has reaped rewards from product content gains with its largest customer while moving into high performance mixed signal applications in both smartphones and laptops. The company has also been gaining momentum in the laptop market and winning with new product designs for smartphones. Cirrus remains cash rich, debt free, and on a runway where their markets are expanding via new applications and content gains.

Which holding detracted most from performance in the year-to-date period?

SM: The portfolio’s biggest detractor was Quaker Houghton, which produces, develops, and markets industrial chemical products, including heat treatment, metal forming, forging, and tin plating fluids, as well as cleaners, casting lubricants, greases, ground control agents, and metal rolling oils. We see Quaker as an attractive asset light business that exhibits strong customer relationships and benefits from high recurring revenues. Quaker’s stock rose roughly 29% in 2023 as the company benefited from stabilizing volumes across the globe while enjoying success in its pricing strategies, particularly in its European markets. Its balance sheet continues to improve due to de-leveraging following its successful acquisition of Houghton and has recently returned to growth through tuck-in acquisitions with the ability for more formidable consolidation opportunities going forward. Its performance has been disappointing so far in 2024 largely due to the lower volumes in both its U.S. and EU markets due to exposure to the automotive and steel production end markets, as well as challenging price comparisons given the prior year’s successful pricing initiatives.

What were the sources of the Fund’s advantage over the Russell 2000 in the year-to-date period ended 9/30/24?

LR: Premier’s disadvantage over its benchmark was due to stock selection in the year-to-date period. At the sector level, stock selection hurt most in Materials—where our portfolio overweight also detracted—Industrials, and Health Care. In the last two sectors, our respective higher and lower weightings were additive, though not enough to overcome short-term stock selection miscues. Conversely, stock picking boosted performance vis-à-vis the benchmark in Financials and Consumer Discretionary, as did our lack of exposure to Energy.

What is your outlook?

LR: The Fund’s biggest sector weights at the end of September were Industrials—which was substantially overweight compared to the benchmark—Information Technology, and Consumer Discretionary, with the last of these also having a higher weighting than the Russell 2000. It is too soon to tell if small-cap’s outperformance versus large-cap in 3Q24 is a short-term “risk on” rally or the long-awaited onset of a sustained small-cap leadership cycle driven by reversion to the mean. In either scenario, it is common for low quality factors to initially drive small-cap performance. Given Premier’s disciplined focus on owning quality companies--those with high returns on invested capital, consistent free cash flow, and strong balance sheets--underperformance in the quarter was not surprising. Several sectors and industries where we rarely find companies with superior economics fueled the benchmark’s performance, including banks, utilities, and biotechnology. As we have seen in several previous small-cap leadership cycles, however, the low-quality bounce often wanes within the first year before giving way to quality factors that assume long-term leadership and outperform.

SM: In addition, many of the Fund’s detractors in the quarter reflect stock price underperformance from positions that were multi-year outperformers and/or were down due to cyclical or macro concerns, as opposed to any deterioration in the business’ long-term cash flow and earnings power. While many investors often react to underperformance by chasing winners, a key differentiator of our Strategy is the long-term investment horizon inherent in taking a business buyer’s approach. This enables the Fund to arbitrage time by adding to existing names or buying new high-quality holdings when their valuations contract due to short-term sentiment that often overshadows attractive and sustainable long-term value creation drivers.

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
Premier 5.41 19.90 6.31 9.21 9.07 11.19 12/31/91  1.19  1.19
Russell 2000
9.27 26.76 1.84 9.39 8.78 9.30 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. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. 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 and other expenses.

Ms. Romeo’s and Mr. McBoyle’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. 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.

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

  Premier

Colliers International Group

3.0

MKS Instruments

2.6

Cirrus Logic

2.5

Quaker Houghton

2.2

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.

Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

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 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. The Fund also generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) 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 in 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Foreign Securities" in the prospectus.

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