Fund Performance

The name may have changed, but the outperformance record for Royce Small-Cap Fund (formerly Royce Pennsylvania Mutual Fund) remained the same, as the Fund beat its small-cap benchmark, the Russell 2000 Index, for the year-to-date, 1-, 3-, 5-, 10-, 15-, 20-, 25-, 30-, 35-, and 40-year periods ended 6/30/24. The Fund gained 4.5% for the year-to-date period ended 6/30/24 versus a 1.7% advance for the Russell 2000.

What Worked... and What Didn’t

Five of the Fund’s 10 equity sectors finished the first half of 2024 in the black, with Information Technology, Industrials, and Financials making the biggest positive impact. The largest detractors from performance were Real Estate, Communication Services, and Consumer Discretionary. At the industry level, the biggest positive contributions came from semiconductors and semiconductor equipment, electronic equipment, instruments & components—both in Information Technology—and insurance, which is in Financials. The leading detractors at the industry level were real estate management & development (Real Estate), life sciences tools & services from Health Care, and interactive media & services from Communication Services.

At the position level, the Fund’s top contributor was TransMedics Group, a medical technology company that specializes in innovative organ transplant therapies for patients with end-stage lung, heart, and liver failure. Operating in an $8 billion addressable market, the company’s primary product, the Organ Care System (OCS), is a portable organ perfusion, optimization, and monitoring system that replicates near-physiologic conditions for donor organs outside the human body. This technology aims to improve the viability and function of donor livers (64% of revenue), hearts (31% of revenue), and lungs (5% of revenue), making more organs suitable for transplantation. Further, Transmedics has developed the National OCS Program, which provides a comprehensive solution for organ retrieval, management, and logistics. This program includes services such as air and ground transportation, as well as the provision of trained organ procurement surgeons and transplant coordinators. The company continues to see fundamental momentum in new product development and end-market adoption. We remain constructive on its long-term prospects, as we did for Onto Innovation, a leading semiconductor capital equipment supplier with a more than 50% market share in metrology and inspection equipment and software for backend semiconductor packaging. Onto operates in what is essentially a rational oligopoly and is benefiting from secular trends driving an increasing importance and complexity of chip inspection resulting from new forms of chip packaging to perpetuate Moore’s Law. With this proliferation of advanced packaging and heterogeneous chip architectures that address growing semiconductor performance requirements, process control capital intensity continues to increase, benefiting Onto Innovation.

Cirrus Logic is a fabless semiconductor supplier that specializes in analog, mixed-signal, and audio DSP integrated circuits. Its audio processors and audio converters are used in audio and consumer entertainment products, including smartphones, tablets, digital headsets, automotive entertainment systems, home-theater receivers, and smart home applications, such as smart speakers. Cirrus has reaped rewards from product content gains with its largest customer while also moving into high performance mixed signal applications in both smartphones and laptops. Additionally, Cirrus has been gaining momentum in the laptop market and winning with new product designs for smartphones. The company remains cash rich, debt free, and on a continued journey where their markets are expanding via new applications and content gains.

Other top contributors included FormFactor, a leader in semiconductor testing and measurement that produces probe cards and related components to help chip manufacturers with the yield management of chip production. The company has been benefiting from a general trend toward increased test intensity, and more specifically from tests for the high bandwidth memory chips used in Artificial Intelligence applications. Headquartered in Houston, Kirby Corporation is the largest tank barge operator in the country, transporting bulk liquid products such as petrochemicals, black oil, refined petroleum products, and agricultural chemicals throughout the continental U.S., along all three U.S. Coasts, and in Alaska and Hawaii. The company is benefiting from reshoring, the growing need for power generation in novel settings, and a $150 billion petrochemical infrastructure investment cycle.

The portfolio’s top detractor at the position level was Enovis Corporation, an orthopedic-focused, medical technology company with leading a global market share in Prevention & Recovery, including braces and rehabilitation products, as well as a growing Reconstruction segment—for example, surgical implants for extremities. Its stock has been under pressure since Enovis closed its largest acquisition earlier this year, including a 28% drop in 2Q24. The strategic fit and valuation of the deal make sense to us, but near-term integration is always a risky process, especially with new leadership in Enovis’s Reconstruction segment. Investors appear to be waiting for evidence that product line rationalization, salesforce integration, cost synergies, and, ultimately, revenue growth from cross selling the combined company’s product are materializing consistent with management’s expectations.

Forrester Research is a subscription-based information technology research company geared toward helping businesses understand, determine their needs, and maximize the utilization of emerging technologies and their key vendors. While we like the company’s asset light, high contribution margin model, management’s execution has admittedly been inconsistent in recent years. The decline in IT spending in 2023, as well as Forrester’s ongoing change to its go-to-market strategy, which includes culling smaller clients and retraining its existing salesforce, are weighing on contract value and sales growth in 2024. Although the pace of progress is testing investor patience, we acted in a contrarian fashion by adding shares in 2024’s first half. We chose to hold our position in Globalstar in the first half of this year. The company offers a low Earth orbit satellite constellation for satellite phone, data, and earth observations and offers services to various industries and users in more than 120 countries. The company issued guidance for 2024 that disappointed some investors and analysts, which was a major factor in its share price decline in the first half. We are confident that the company’s long-term prospects remain sound.

Elsewhere among the top detractors, we increased our stake in Ziff Davis, which acquires and operates digital media and internet brands in high-value verticals, generating relevant content designed to attract high “intent to purchase” consumers. Roughly 60% of its revenues come from advertising on its sites, which include Everyday Health, What to Expect When You’re Expecting, PCMag.com, IGN.com, and RetailMeNot). The remaining 40% is subscription based revenue from its broadband connectivity data services (e.g., Speedtest) and its marketing technology and cybersecurity offerings. While the digital ad spending recession appears to be ending, and Ziff Davis is projecting a return to organic revenue growth in 2024, the pace of recovery pace has been slower than its target 7.5% growth, which in part reflects conservatism, given that its advertising revenues are more weighted to the holiday selling season in the second half of the year. Uncertainty related to the rise of subscription-based “answer engines,” such as ChatGPT, and their potential impact on Google search traffic remain an overhang since the AI technology is still in its early stages. Finally, despite the strong and consistent free cash flows of the business model and a solid past acquisition track record delivering returns on investments of at least 20%, investors appear impatient that Ziff Davis has gone more than two years without making a sizeable acquisition in the digital media space. We believe investors will ultimately be rewarded by management’s discipline and patience on the capital allocation front. Quaker Houghton 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, with recurring revenues and strong customer loyalty. Its stock performed well in 2023, rising roughly 29% as global volumes stabilized while the company was highly successful in its pricing strategies, which was most evident in its European markets. Equally important, Quaker de-leveraged further following its successful acquisition of Houghton and is now operating close to its targeted leverage model, opening up further consolidation opportunities. We therefore suspect that its stock’s underwhelming first-half of 2024 performance mostly reflects profit taking, particularly with the company facing more difficult sales growth comparisons this year in light of 2023’s successful pricing initiatives, as well as recent headwinds for the chemicals industry.

The Fund’s advantage over the Russell 2000 for the year-to-date period ended 6/30/24 came mostly from stock selection, though sector allocation decisions were also positive factors. At the sector level, stock selection and, to a lesser degree, an overweight in Information Technology and stock selection in Financials were particularly additive, as was the Fund’s overweight in Industrials. Hurting relative results most were stock selection and the Fund’s lower weight in Consumer Staples, its substantially lower weight in Energy, and stock selection in Communication Services.

At the position level, the top relative detractors were Enovis Corporation, Forrester Research, and Ziff Davis, while TransMedics Group, Cirrus Logic, and Onto Innovation were the top contributors versus the benchmark.

Current Positioning and Outlook

We anticipate that active managers who focus on earnings growth remain best positioned for strong performance going forward. Our outlook is rooted first in the fact that the Russell 2000 ended June with a near-record number of companies with no earnings. Second, earnings acceleration is expected to be higher for small-cap companies than for large-cap businesses through the end of 2024. This encouraging earnings picture is buttressed by a growing U.S. economy that in the coming months will see more and more tangible benefits from reshoring, the CHIPS Act, and infrastructure improvements. Along with increasing recognition for the small-cap companies that are providing the ‘picks and shovels’ for AI applications, these activities should foster advantages for active small-cap managers who focus on profitable companies and other fundamental measures of financial and operational strength. Needless to say, we think our flagship Fund is very well positioned to continue outperforming the overall small-cap market in this kind of environment.

Average Annual Total Returns Through 06/30/24 (%)

Annual Operating Expenses: 0.94

¹ Not annualized.

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