This transcript has been edited 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 is with two members of the Royce Small-Cap Special Equity Strategy, Portfolio Manager Charlie Dreifus and Senior Analyst Tim Hipskind.
We’re going to look back at performance in this very volatile period and look forward to the opportunities the team is seeing in the overall market. I should note that Small-Cap Special Equity is outperforming its benchmark, the Russell 2000 Value Index, for the year-to-date, one-, five-, 15-year, and since inception (5/1/98) periods through the end of April. The Fund has a strong history of down market results, and this year has been no different, as it navigated the volatility of the first quarter, outperforming its benchmark by over 400 basis points. Charlie let’s start there, with this very volatile period, where the average small-cap stock is down around -35% from its peak. How do you avoid value traps in this environment?
Charlie Dreifus: We are very disciplined, and that discipline has been further enhanced with the addition of Tim Hipskind to our team. There often is business risk involved in a value trap. The financials are OK. But where we’ve gotten involved in value traps in the past was getting into businesses where the business model had changed. We have essentially three generations working on Special Equity: myself, Steve McBoyle, and Tim Hipskind now. Tim is the younger member of this team, and he brings enhanced skills to find out how well a company is navigating the current business environment and how the model is withstanding that. Perhaps we’ll have time for Tim to describe how he successfully got me out of a value trap, which I put into the portfolio, at a price that is double where it’s selling it now.
FG: Tim, we’re really excited you’re able to join us today. Perhaps we could follow up on Charlie’s comment. Talk a little bit about that particular company and how you’re adding to the team.
Tim Hipskind: The company specifically is a computer networking company. They sell things like Wi-Fi routers. We faced the challenge of determining how much revenue was pulled forward from future periods as everyone upgraded their home Wi-Fi router during Covid and faced the same problem: the company had to determine how much inventory to buy to meet uncertain future demand. In this period of dislocation, we saw a fact pattern that caused concerns. The company discloses the number of weeks' worth of inventory held in their distributor channel, which had increased significantly, and at the same time the inventory held in the company’s balance sheet had also grown significantly. Further increasing those concerns, the company’s receivables, as measured in day’s sales outstanding, had also been increasing, which can indicate a few things, but in this case raised the risk of offering extended payment terms to customers, which can further pull forward revenue. We also did some work to track price discounting at retailers and noted some deterioration there as well. So, for these reasons, we exited the position and, as Charlie mentioned, that was around twice the price of what the stock trades at today.
FG: So it comes down to good old-fashioned bottoms up research, essentially, Charlie?
CD: We’re known obviously as financial statement nitpickers and seekers of good governance. This company had those, but their challenge was what had happened through the pandemic, and the challenges the company faces competing against a Google and the like these days.
FG: Tim, can you spend a second on your role on the team? I know you’ve done an awful lot to enhance some of the deep critical accounting around the process, but could you spend some time on your role?
TH: One of the things I try to do is keep up with Charlie. That entails following all the companies in the portfolio, reading every 10K, 10Q, every SEC filing, including the proxies. That’s a big part of the role. I also seek to do more idea generation in the portfolio and find companies that are interesting and fit the framework of the portfolio. In addition to that, we have our weekly meetings where I set the agenda and go through the things that I’d like to talk about for the week, including earnings and company filings of note. You know—that interesting footnote that I’m sure we’ve all come across in the week to set out and discuss. Those are the primary responsibilities, continuing to do that deep dive forensic work that the product is known for.
We certainly seek out former executives to try and talk about their experiences and understand industry dynamics a bit better. We’ve certainly done quite a few of those as of late. In particular we spent some time on a company called Encore Wire (WIRE, Financial), which has become a large position for us. It's important to understand the ecosystem that that company operates on.
FG: Tim, can you spend a moment on Encore Wire? What do they do and why is it relevant in today’s world?
TH: Encore Wire is a manufacturer of electrical building wire. Historically, people associate that with the residential building cycle, but Encore is also increasingly in commercial and industrial applications. There’s a concern now in a period of rising interest rates and slower residential housing starts that this business could be under pressure. But I think that view underestimates the business transformation and the ecosystem transformation that Encore wire operates in. We have several mega trends that they’re exposed to, such as grid hardening, electrification, EVs [electric vehicles], so they have much stronger end markets than they perhaps have had through prior downturns in the residential market. And they also operate in a little bit of a different market map now, with the industry consolidating to where three players are around 80% of the market, and that remaining 20% of the market that has historically been a little bit perhaps irrational during periods of weaker pricing. We have reason to believe that in this cycle, they may do a little bit less of that and help hold pricing and margins in the industry.
FG: Switching gears a little bit here, this has been, as we’ve been saying, one of the most telegraphed recessions. I’m just curious, what are your thoughts on where we are from a top down perspective?
CD: Technically, we haven’t reached a recession—an official recession—because it’s two consecutive quarters of declining GDP. It feels like a recession, although the unemployment rate is far from what we see during recession times. The economy is slowing. For sure, inflation overall is cooling, although remaining very problematic and perhaps the reason why the market may be in error. The market is assuming that interest rates will decline soon. But service inflation, the super core PCE—Personal Consumption Expenditures—which is a single-minded metric that Chair Powell and much of the Fed focuses on, has really not budged. It’s gone sideways and is still at an annual rate above 5%.
That is too high, and unemployment is too low, for the Fed to reduce rates. Unemployment needs to be 5%-plus for the Fed to reduce rates, and we’re at 3.4% now, so we’ve got a long way to go. The market in my view is having the worst of everything right now. We have slowing business and no decrease in rates. We’re very happy and excited about our portfolio. The downside is, we can’t find many new names. We have a long history of deploying cash, which is sizable currently in the portfolio, into very attractive names that have significant bounces off what, if not the absolute bottom, is nearly the bottom. We’re not finding that yet.
FG: What are you hearing then from your portfolio companies either on their first quarter earnings calls or in your travels of late?
CD: We do visit companies and visited some in early fall last year. The smart ones, then, were already preparing for poorer business conditions in terms of resetting employment levels, cutting costs and so forth. What companies are telling us now is, they still have way too elevated inventory levels. Many have reduced inventories, but they had built inventories because of all the shortages and double ordering by so many people because of the scarcity of items that inventories remain bloated. And that suggests price cuts ahead, which obviously helps inflation but damages profits.
TH: One of the other things that that has been an interesting point in conversations lately has been pricing power in some of the companies that we look at. Oftentimes they tend to be at the bottom of the value chain, and they’re providing something that’s used upstream. Through this period of supply chain dislocation, that pricing became at a premium. I think an interesting thing here will be the bifurcation of those companies who have discovered that they in fact were underpricing all along and have been under-appreciating their pricing power in the market and those who benefited from a point in time where supply and demand allowed them to price at a premium that will subsequently fade away as supply chains improve.
FG: Charlie, why Special Equity now, given the uncertainty of this environment?
CD: I think it’s particularly attractive now. I’m sure everyone expects me to say that. But the truth is, there’s so much uncertainty. You know we’re getting close to a bottom. I don't know exactly where we are in that time period now, but we’re not there yet. I think inflation’s going to be higher in the long term, so bonds may be attractive now because of potentially reduced rates ahead. But that will come to a quick end as inflation rears its head again. So equities make sense, but people just don’t have the conviction yet. I believe Special Equity allows people to straddle that divide between wanting to invest more but being still apprehensive because the shoe is yet to drop. As our stocks become more expensive, we trim them and ultimately sell them in their entirety. And if we can’t find replacements, cash builds automatically. It’s a self-governing device. But the real alpha, the real improvement in the portfolio’s performance, comes about when you put those monies to work in names. I learned very early in the business; you can’t buy cheap stocks with other cheap stocks. You need cash. Otherwise, you’re just moving chairs around.
FG: This idea of dollar cost averaging.
CD: Yes. Every time during bear markets, we never used all the cash at the absolute bottom, but we’ve used most of it, and we’ve deployed it in a means where the average cost benefited by buying over time.
FG: I think we could leave it there. Charlie, Tim—thank you so much for your time today. I think it’s worth emphasizing that in the midst of all of this uncertainty, it’s worth emphasizing the Fund’s strength in the recent bear market, with Small-Cap Special Equity down -3.6% from the most recent small-cap peak on the 8th of November 2021 versus respective declines of -19.7% and -24.7% for the Russell 2000 Value and the Russell 2000 Indexes at the end of the first quarter.
Mr. Dreifus’s, Mr. Hipskind’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.
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.
