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Sydnee Gatewood
Sydnee Gatewood
Articles (2199) 

Royce Investment Partners: Premier Quality- An Update and Outlook

By Chuck Royce, Lauren Romeo and Steven McBoyle

We recently asked Lead Portfolio Manager Chuck Royce (Trades, Portfolio) and Portfolio Managers Lauren Romeo, CFA and Steven McBoyle for an update and the latest outlook for our Small-Cap Premier Quality Strategy that Chuck has been managing since 1991.

How did the Small-Cap Premier Quality Strategy perform in 1Q20?

Chuck Royce (Trades, Portfolio) Royce Premier Fund, the mutual fund we manage in this strategy, was down 27.8% in the first quarter. We were pleased that in this very difficult period the Fund lost less than its small-cap benchmark—the Russell 2000 Index fell 30.6%, which was its worst quarterly performance ever. This quarterly outperformance also helped Premier to beat its benchmark over the trailing one-, three-, five-, 10-, 15-, 20-, 25-year, and since inception (12/31/91) periods ended in March.

Steven McBoyle I think the portfolio’s outperformance in the first quarter was that much more impressive because investors rushed out of stocks in economically cyclical areas, perhaps bracing for an impending recession. That mad rush led to defensive stocks outperforming the cyclical areas we typically favor. So the portfolio’s more than 90% weighting in cyclical stocks at the start of the quarter created a meaningful headwind to returns—but fortunately our high-quality focus more than compensated.

What factors helped give the portfolio its advantage versus the Russell 2000?

Lauren Romeo We were pleased with the strong stock selection during the quarter, which drove all of the fund’s relative outperformance. Our largest relative sector contribution came from Financials where we were close to equal weight but significantly outperformed the index (-4.3% vs. -34.7%). Our longstanding avoidance of banks and mortgage REITs, which lagged, helped, but stock selection mostly drove outperformance in the sector. Two capital markets holdings—Virtu Financial (NASDAQ:VIRT) and Ares Management (NYSE:ARES) were notable relative outperformers. Consumer Discretionary was another important source of outperformance. This sector contains businesses that were particularly hard hit by COVID-19 driven closures, so our low absolute weight and relative underweight insulated us from the severe stock price declines in industries such as hotels, restaurants & leisure, specialty retail, and textiles, apparel & luxury goods. Additionally, our three Consumer Discretionary holdings outperformed the index.

Which sectors and industries hurt relative performance in 1Q20?

CR Health Care was the largest source of our relative underperformance. Although our holdings did relatively better, their stronger performance couldn’t overcome our large underweight in the sector. Health Care held up better than most sectors in small-cap, boosted by biotechnology, where we had no exposure. Utilities was a similar story—a relatively strong defensive sector where we had no holdings in the first quarter and which was the best—that is, the least bad—performing sector in the index, as it often is in steep declines.

Sectors RYPRX(%) Russell 2000 (%)
Industrials 36.4 15.2
Information Technology 23.6 15.1
Financials 15.6 16.8
Materials 9.9 3.4
Health Care 5.9 21.3
Consumer Discretionary 4.0 8.7
Energy 3.4 1.7
Real Estate 1.1 7.6
Consumer Staples 0.5 3.4
Utilities -- 4.5
Communication Services -- 2.3
Cash and Cash Equivalents -0.3 --

How have you been investing through the decline?

SM We’ve been leaning mostly toward select, high-quality cyclical companies in order to position the portfolio for the eventual recovery. These are the kinds of businesses that look most capable of rebounding to us. We’re mostly looking at those that appear best positioned to participate in, and therefore benefit from, long-term secular trends—those that, while currently interrupted, are likely to reemerge with strength.

In all of these areas, we’re aiming to increase our holdings in companies where we see adaptability, differentiation, and financial strength. These are all hallmarks of high quality in our view.

Did you add any new holdings in the first quarter?

LR We added six new holdings, which is more than we typically do, because the bear market has given us some really promising opportunities to buy what we think are high-quality companies at attractive prices. ESCO Technologies (NYSE:ESE) is a multi-line industrial focused on niche markets with favorable long-term demand dynamics. Its most attractive segments are Aerospace & Defense, where it makes highly engineered filtration and fluid flow products, and Utility Solutions, where its products and services include testing instruments, software, and data solutions used for their extensive grid asset base.

SM We also bought shares in two companies that we’ve owned previously in the portfolio, Cirrus Logic (NASDAQ:CRUS), a fabless semiconductor company that develops audio and voice IC and software solutions for mobile communications, automotive entertainment, and consumer audio applications. Additionally, Premier returned to Haemonetics (NYSE:HAE) which produces automated blood processing systems and related consumables that are used in surgical blood salvage, blood component collections, and plasma collections. We think the firm’s new leadership and fresh strategies can pave the way for renewed success for its business.

Rogers Corporation (NYSE:ROG) is a new name in Premier, though it’s one that we have been following for a long time. Rogers designs and manufactures high specification, very reliably engineered materials for a diverse set of industries. While often viewed as a technology company, Rogers is actually a specialty chemicals company serving high-growth, niche applications, including 5G wireless base stations, ADAS (advanced driver assistance systems) and EV/HEV (electric and hybrid electric vehicles.)

LR Another addition was Inter Parfums (NASDAQ:IPAR), a business that we’ve owned in other portfolios, which is common for many of our Premier holdings. The company develops and markets prestige fragrances under exclusive brand licenses and owned brands such as Montblanc, Jimmy Choo, Coach, and Guess. Its strong track record has been driven by consistent sales growth—through new product launches supported by robust advertising—and proven global sourcing and distribution capabilities. These strategies have established the company as one of a handful of go to outsourcing partners for fashion companies seeking to further monetize their brand equity.

Finally, we added Forrester Research (NASDAQ:FORR) an independent technology research firm that companies use to understand how business technologies are evolving, evaluate which ones to buy, and leverage those investments to improve customer experience and retention. Forrester is an asset-light, high margin business with about two-thirds of its revenue recurring from annual research subscriptions and executive leadership boards. The business has room for meaningful margin expansion if management can accelerate sales growth through product cross-selling and an expanding sales force.

Why do you think this Strategy is well suited for both the current environment and a recovery?

CR I think that an important, and often overlooked, attribute is one that Steve mentioned earlier: adaptability. This is a key differentiator among high-quality companies, but its importance is usually less visible in calmer periods. Companies that have well-defined, effectively defended market niches and strong balance sheets possess the necessary resources to take action in times of uncertainty. The management groups we prefer to invest with have a history of thinking about and acting on more long-term concerns when their competitors are often focused on the short terms. It’s much easier to think long term when you don’t have a highly leveraged balance sheet going into a recession. These are the advantages that we have seen high-quality companies demonstrate over time. Our high-quality focus helped in the downturn and we think the portfolio’s cyclical tilt should be equally beneficial in the recovery.

Mr. Royce’s, Mrs. Romero’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.

About the author:

Sydnee Gatewood
I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg

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