How did Royce Small-Cap Total Return Fund in 3Q22 and over longer-term periods?
Miles Lewis: The Fund, which is part of Royce’s Quality Value Strategy, declined 10.1% for the quarter, lagging its benchmark, Russell 2000 Value Index, which was down 4.6% for the same period. The portfolio also lagged its benchmark for the year-to-date period ended 09/30/22, down 22.3% versus 21.1%. Most of our underperformance occurred for both the quarter and the year-to-date period occurred during the rally that ran from July to mid- August. The Fund beat both the Russell 2000 Value and the Russell 2000 in 2022’s first half.
How did performance shake out at the sector and industry level in 3Q22?
Joe Hintz: It was a very challenging quarter in which nine of 11 sectors in the benchmark finished in the red while all 10 of the portfolio’s equity sectors made a negative impact on quarterly performance. The biggest detractions came from Information Technology, Financials, and Consumer Discretionary while the smallest negative impacts came from Health Care, Communication Services, and Energy. At the industry level, insurance (Financials), electronic equipment, instruments & components (Information Technology), and household products (Consumer Staples) detracted most, while our biggest contributors were banks (Financials), machinery (Industrials), and hotels, restaurants & leisure (Consumer Discretionary).
At the sector level, how did the Fund perform versus its benchmark?
ML: The portfolio’s disadvantage versus its benchmark came primarily from stock selection in the quarter, with Information Technology, Financials, and Energy making the most significant negative impact versus the benchmark. Conversely, our substantially lower weighting in Real Estate, a combination of stock selection and lower exposure to Communication Services, and Utilities contributed most to relative quarterly results.
How did the Fund perform at the sector and industry level for the year-to-date period ended 9/30/22?
JH: Nine of the portfolio’s 10 equity sectors made a negative impact on year-to-date performance. Financials, Industrials, and Information Technology had the biggest negative impact. Energy made the only positive impact, while Health Care and Communication Services made the smallest detractions.
ML: At the industry level, two areas in Financials—insurance and banks—were the largest detractors, followed by electronic equipment, instruments & components (Information Technology). Our biggest contributors were containers & packaging (Materials), energy equipment & services (Energy), and entertainment (Communication Services).
Which holding detracted most for the year-to-date period ended 9/30/22?
JH: That would be Franchise Group (FRG, Financial), which owns four consumer businesses: The Vitamin Shoppe, Pet Supplies Plus, and two discount furniture retailers. Its shares suffered earlier this year after its plans to acquire retailer Kohl’s—a deal that would likely have been highly accretive for Franchise Group—fell through. Its stock has also experienced the same weakness that recessionary concerns have inflicted on most other retailers. Our view is that its core assets are uncommonly resilient and therefore likely to see a more limited impact from a recession, specifically the Vitamin Shoppe and Pet Supplies Plus, which account for the majority of the firm’s earnings.
What was the Fund’s top contributing position for the year-to-date period?
ML: Interestingly, it was an acquisition target that was also our top contributor for both the first quarter and the first half of 2022. It was industrial packaging company Intertape Polymer Group (ITPOF, Financial), which makes Water Activated Tape, the black tape on Amazon boxes. When we first invested, we saw it as an effective backdoor play on e-commerce that was trading at a deeply discounted multiple. Our research and due diligence were then validated in early March when Intertape agreed to be taken private by a private equity buyer at an 82% premium to its prior close.
For the year-to-date period, how did the Fund fare versus the Russell 2000 Value?
JH: The portfolio’s disadvantage versus the benchmark came solely from sector allocation in the year-to-date period—stock selection was marginally positive. Both our lower exposure and, to a lesser extent, stock selection hurt relative results in Energy. Stock selection hurt in Consumer Staples as did our significantly higher weighting in Information Technology. On the other hand, stock selection was a strength in Materials, as were both stock picks and our lower weighting in Communication Services. In addition, our lower exposure to Real Estate contributed to relative year-to-date results.
What is your outlook for the Fund?
ML: It was certainly a wild quarter, with sharp moves up and down in the market. Stubbornly high inflation has led the Federal Reserve to be more hawkish in their quest to stomp out inflation using their primary tool, interest rates. Consequently, interest rates moved up sharply late in the quarter, while stocks did the opposite. Historically, when the Fed is tightening, particularly as aggressively as they are at present, quality stocks have outperformed. This was not the case in 3Q22, when small-caps with the highest returns on invested capital underperformed. However, we expect this to mean revert over time, and for high quality–which remains historically inexpensive–to again outperform. There are three positive aspects to the current market environment. First, forward returns for small caps are again looking increasingly attractive due to the recent downdraft in the market. Second, volatility is creating a myriad of opportunities in individual stocks as valuations compress and increasingly decouple from their underlying fundamentals. Third, we believe a plausible argument can be made that interest rates are likely to remain above the historically low levels of the post-Great Financial Crisis era. If this is the case, we expect Financials–particularly regional banks and P&C insurance companies–to disproportionately benefit, as more than four decades of downward trending interest rates created meaningful headwinds to margins in the sector. With valuations in Financials already at highly attractive levels, the rate thesis need not unfold for Total Return to do well, but we believe it adds one more reason to view the portfolio favorably.
Mr. Lewis’s and Mr. Hintz’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.
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