This transcript has been edited slightly for clarity.
Listen here.
Francis Gannon: Hello and welcome everyone. This is Francis Gannon, Co-Chief Investment Officer here at Royce Investment Partners. Thank you for joining us today. Our conversation today is with two of the portfolio managers for Royce’s Small-Cap Total Return Strategy, Lead Portfolio Manage Miles Lewis and Assistant Portfolio Manager Joe Hintz. We're going to both look back as well as look forward on the outlook and opportunities that we see for the Strategy. Let's begin with you, Miles. The Strategy has had a strong start to the year, but more importantly has outperformed from the low for the Russell 2000 Value Index at the end of September of last year. What are your thoughts about performance?
Miles Lewis: Thank you, Frank. Good to be here. We’ve been pleased with our performance. We’ve continued to provide good downside protection. And as you noted, we’ve done pretty well in up markets recently. So I’ll kind of put that in context. The market, which for us means the Russell 2000 Value Index, which is our benchmark, peaked on November 8th of 2021. And through that time period through yesterday's close the Strategy was down about 720 basis points versus the index down about 1500 basis points. So pretty significant spread there with less than 50% downside capture. At the bottom on September 30th of last year through yesterday’s close, we were up a little north of 20% versus the index, up a little north of 14%. So we did well on the upside. And as many of our listeners know, we have low volatility. We consistently rank in the bottom decile of small-cap value managers for volatility [please see the “Low Volatility” note below].
The upside capture that you noted is something we're particularly pleased to see. We really think that the process, which is very robust and goes very deep, is enabling us to build conviction and thus concentration within the portfolio, and we think that can drive better outcomes in up markets due to stock selection. So we had high conviction names last year like FTAI Aviation (FTAI, Financial), Vontier (VNT, Financial), Teradata (TDC, Financial), Kyndryl (KD, Financial) that were weak that we leaned into very heavily. Those have been big contributors this year. In fact, if you look at our performance year to date and in the fourth quarter, it's been disproportionately driven by our largest holdings. We're also getting a little bit of a bid from our insurance stocks, which are finally starting to catch up to the fundamentals which have been strong for a couple of years now. And quality’s done well in recent quarters. And so that's been a tailwind for us.
FG: Great, Miles. Thank you. One of things you talked about were the companies that you invested in during the downdraft of the market last year and thought maybe you could spend a second on the current market environment overall just given the fact that this has been perhaps one of the most telegraphed recessions that we're supposedly going into at some point. What are you hearing from the companies as they report their fourth quarter earnings?
ML: We don't know what the macro holds. It's an incredibly volatile environment right now, with interest rate volatility and everything else that we're reading about in the news. But we continue to be pleasantly surprised at the resiliency of the companies that we own in the portfolio during this difficult macro backdrop. And I think that's a testament to the quality of the portfolio. The companies that we own had generally strong fourth quarters. The thing that I would also point out is that, despite our companies doing well, we have noticed some trends where, if there's a whiff of weakness in the fundamentals or the outlook, the market is unduly punishing those companies, and we're using that to our advantage.
One company I would highlight would be Newtek (NEWT, Financial). This is a really interesting business model transformation. They're one of the largest SBA [Small Business Administration] lenders in the United States. They used to be a business development company or BDC, and they're now transferring or have transferred to becoming a bank holding company or more simply, just a bank, and they did this because they were required to pay out all of their earnings as dividends, as a BDC, and that resulted in a very high dividend yield. So as a bank, they decided to cut the dividend, something that's been well telegraphed and is not new news. Yet when they formally did this last week in in conjunction with their earnings call, the stock was down 20% on extremely heavy volume. This is kind of proof in our opinion that markets are not perfectly efficient. So we used this weakness as an opportunity to aggressively accumulate shares, and we think there's meaningful upside in the stock over the next few years.
FG: And Joe, I think you've probably seen some examples in some of the names you cover as well, right?
Joe Hintz: Yes. Another really interesting example is a company called Hackett (HCKT, Financial), where they have an underlying business model transformation underway that is really compelling for the long term. But the stock did get hit in the near term on more technical stuff that we think is really sort of a near-term focus. Hackett is a technology consulting firm where they use benchmarking to inform best practices for software adoption. The model transformation that they're pursuing is essentially taking this decade's worth of benchmarking data that they've built through that business model and looking to ways to monetize that. And we think that will have a materially positive impact to growth margins and quality revenue over time. In the most recent quarter, they did report a loss of one implementation contract, and that is negative obviously, but it happens relatively regularly with project-based businesses. The stock sold off 13%, which we thought was an aggressive overreaction. More to the point, there were actually a lot of positive updates in the quarter around this long-term strategy. So this data set revenue grew well into double digits in the quarter and gross margins expanded by over 300 basis points, which we think is a great indication of the long-term outlook for this company. So again, similarly, we used this as an opportunity to significantly accumulate shares.
FG: Joe sticking with you, can you talk a little bit about the overall positioning of the portfolio?
JH: Thanks, Frank. Yes, absolutely. So as always with Total Return, our overweights are really a function of our bottom up process as opposed to taking a top down approach—that’s driving our overweights in Technology, Financials, and Industrials where we see perceived cyclicality and quality remaining very inexpensive.
We've discussed the tech sell off in 2022 before and that provided fertile hunting ground for us. Technology was really viewed as a toxic place in 2022 across the board. But we think that the reasons underlying that weakness are only applicable to unprofitable high growth companies. As the era of free money ended and rates rose dramatically, that impacted what I call the public venture capital approach to technology investing, where investors were really bidding up the valuations of companies that focused only on market share and growth at the expense of profitability and cash flow. But despite that, the market was essentially treating all technology shares the same in 2022.
We've always stayed steadfast to our approach in Total Return, gravitating to high quality companies within tech that have both strong existing cash flows and future growth opportunities. So really the end of the free money era is not a concern for our technology investments. All the tech companies got hit hard in 2022, which created a great opportunity both to add significantly to high conviction holdings in this sector and to find new opportunities within the sector for us where we were seeing phenomenal entry points.
Insurance companies are finally seeing their investment portfolios contributing meaningfully to earnings and return on equity. To give a tangible example there, on average, we think that every hundred basis point change in investment yields can contribute up to 225 basis points to return on equity improvement. So, again, rising rates should actually get positive for the insurance companies.
FG: As we think about in industry themes within the portfolio, housing is an area that you've been looking at.
ML: Housing has been on a wild ride the last few years, Frank, as I'm sure you know. One of the things we do in this team is, we normalize earnings for cyclical businesses and housing would fall under that. So when margins and sales are elevated, we normalize them down. And that makes the valuations look a little less attractive than the near-term multiples would imply. And we do the opposite when companies are underearning: we normalize their margins up, and that makes them look more attractive from a valuation perspective, despite the optics of maybe an elevated near-term multiple. So when we go back to late 2020, early 2021, we were very constructive on the housing cycle given the newly created demand from the pandemic coupled with structural supply shortages which still exist, by the way. And we expressed this view in somewhat of an indirect manner, which is something that we do pretty frequently on this team.
We're always looking for the highest quality way of getting exposure to a specific theme, in this case housing. What we did not do during this time period where we were constructive is buy home builders and those companies did quite well, the stocks did quite well. However, we don't view the business models as being overly high quality. What we did instead was, we found more oblique ways of getting that exposure. For example, we bought title insurance companies. This is an oligopoly-like industry structure. It has very high margins due to economies of scale. There are very high barriers to entry, and these businesses, and thus their stocks, effectively represent pure plays on housing demand despite the fact that they live within insurance, which is a part of Financials. We viewed that as an opportunity to add to what we think of as housing exposure. Later in 2021, the housing market started to feel pretty frothy to us. You could see it in the stocks which were doing extremely well. You could see it in our own lives. Multiple cash offers in the town that I live in, people waiving inspections, just really really surprising behavior.
Despite this, the stocks looked very cheap on near term-earnings. But this process that we have of normalizing earnings helped us to realize that earnings on a structural, through-the-cycle basis were lower than what forward estimates were showing. Because of that, we sold significant amounts of stock and in some cases exited entire positions. We are now on the opposite side of this. We see signs of housing fundamentals stabilizing. They are not necessarily good, but they are getting less bad, and there are some green shoots. As I noted, we continue to think the housing market is structurally underbuilt. This is something that's going to play out over many years, and we recognize that the near term will be pretty choppy given volatility and interest rates. The stocks have sold off meaningfully, and in some cases we have opportunities to invest in companies trading at trough earnings on trough multiples, which is a pretty attractive setup.
FG: Can you give us an example?
ML: One title insurance companies is Stewart Information Services (STC, Financial). It trades at less than eight times forward estimates and those estimates have been cut by about 40%. The stock is off over 50% off its highs from 2021. So we don't think there's a lot of optimism for the housing market priced into shares of Stewart. We think the company is meaningfully underearning right now, and that they can grow their earnings in the future from a combination of a few things: a rebound in housing demand, obviously, and the second would be that Stewart, unlike the larger title players, has an opportunity to be a consolidator at the fragmented tail end of this market. Because of the scale nature of this business, as Stewart grows both organically and inorganically, there's significant operating leverage built into their model, which is going to allow them to drive margins higher over time.
FG: Joe, as you mentioned, Technology was a fertile ground last year, given the carnage that took place in the in that specific sector of the market. And yet ironically, some of your top contributors year to date are technology companies. Can you take us through some of those companies?
JH: Rather than going too deep on individual names, I think it's interesting to kind of take a look at what we think of as kind of some of these companies providing an offensive and defensive contribution to the portfolio. So let me dig into what I mean by that. While unprofitable growth companies may have a short-term rebound here in the near term, we do think that there are, on a granular company-by-company basis, examples where investors are actually starting to reward companies that commit to a margin focus as opposed to the growth at all costs approach.
Furthermore, the current macro environment is actually leading to things like lengthening sales cycles and customer decision timelines at most companies, which ultimately allows companies with highly sticky, mission critical offerings to shine through on a revenue basis relative to some of these growth companies right now.
Two of our top three contributors year to date within IT have been Teradata and Kyndryl, which I would describe as inverted legacy technology companies, yet they both provide very mission critical products and services that make them extremely sticky. They are also extremely profitable, cash generative type companies. Teradata is a warehousing software company and Kyndryl is a provider of IT infrastructure services. In the past people have looked at these companies as too legacy. But again, coming back to that mission critical aspect, that creates a lot of stability right now in these turbulent times of lengthening sales cycles. Both companies in their most recent earnings talked about not seeing any distress in their underlying demand, so that provides some downside support.
At the same time, since they are very cash generative right now, they have the ability to invest, whereas the growth companies are having to cut back and reprioritize investing. So they actually continue to build their relevance within the newer technology areas like cloud computing. They get to do both at the same time. They provide that downside protection, that defensive element, and they also provide the upside offensive characteristics through some of these investments. The growth darlings are going to suffer, we think, through this period, whereas these offense / defense companies can really contribute positively to the portfolio.
FG: So stronger companies will get stronger in the uncertain economic times. Any final thoughts about the portfolio you would like to share?
JH: We've talked a lot about sort of the macro here and how that is impacting some of the industries that we look at. But no matter what direction the economy takes in the next few quarters, we are incredibly bullish for Total Return in the years ahead. Looking at the portfolio from a returns based perspective and a valuation perspective both on an absolute and relative basis, it's incredibly attractive. So what do I mean by that? The return on invested capital right now is hovering near the highest levels it's been in the past eight years while the valuation of the portfolio is hovering near the lowest level it's been in the past eight years on an absolute basis. Then if we look relative to the Russell 2000 Value Index, the return on invested capital (ROIC) for Total Return is over two times greater than that of the Russell 2000 Value Index while the valuation is actually cheaper, so you're getting greater quality at a lower price [please see the notes on ROIC and Valuation below]. We think that's a potent combination for the years ahead, particularly given an environment where free money is likely over and where quality and value are likely to continue to outperform.
ML: The only thing I would add is that Joe and I both have significant amounts of our own money invested in the Fund, so our interests are very well aligned with our shareholders.
FG: I think that would give all listeners an investors good comfort. Thank you both Miles and Joe for walking us through this strategy and outlining the opportunities that you see ahead. Thanks all of you for giving us your time and attention today.
Mr. Lewis’s, Mr. Hintz’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.
