This transcript has been edited for clarity.
Francis Gannon: Hello and welcome. This is Francis Gannon Co-Chief Investment Officer of Royce Investment Partners. Thank you for joining. Our conversation today is with Lauren Romeo, who, along with Steve McBoyle, is one of the lead portfolio managers of Royce Small-Cap Premier Quality Strategy which we use in the Royce Premier Fund. 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 the Premier Quality Strategy is outperforming its benchmark, the Russell 2000 Index, for the year-to-date, one-, three-, five-, 10-, 15-, 20-, and 30-year periods, as well as its since inception period, through the end of April. The Strategy has a strong history of outperformance in down markets, and this year has been no different, as it has navigated the volatility of the first quarter incredibly well, outperforming its benchmark by over 600 basis points. Lauren, perhaps that’s a great place to start—with this very volatile period we’ve been in. We’ve now been in a bear market for over 18 months. Why should one consider quality now?
Lauren Romeo: Hi, Frank and thanks for having me. It’s a great question. I’d say first, we think focusing on high quality businesses when investing is always a sound strategy because these are companies that have unique and sustainable competitive advantages that enable them to generate above-average returns on invested capital well into the future.
Why quality today? We think companies that have quality characteristics appear particularly compelling for a couple of reasons. The first is valuation. As you mentioned, small caps have been in an 18-month bear market in which they’re down over 25%. Many small caps in general are trading below their long-term average on various valuation metrics, and many measures are actually back to levels not seen since the great recession [in 2008]. So, we feel like small caps in general are discounting a lot of bad news and are attractively valued on an absolute basis. The opportunity to buy high quality at a discount makes it a particularly compelling time for a quality-driven strategy. The other factors are the general economic uncertainty, the rising cost of capital, the potential for a recession. Quality companies, while not immune to those conditions, are typically less volatile because of the nature of their businesses. They often have recurring revenues or asset light businesses and good free cash flow generation, which give them not only the ability to weather difficult economic periods, but also to go on offense and improve their existing market position, take share from, or acquire, weaker competitors during these times, and emerge from downturns even stronger than when they entered.
FG: Lauren, recession is perhaps the most overused word in the financial world today, and it seems as if companies have been able to prepare for this for a long period of time. Have you heard anything new from management teams following first quarter earnings?
LR: I would say it depends on the sector. There’s been what seems to be these kind of rolling recessions, or rolling contractions, across various industries, particularly where the combination of inflation, rising rates, and consumer caution are causing lower demand at the same time as an easing of some of the significant supply chain constraints that we’ve had over the past several years. As those are starting to ease, you’re having this imbalance now of supply and demand, and many sectors are seeing a lot of inventory rebalancing. For example, we’ve seen it in semiconductors, smartphones, and other consumer electronics. At the same time, in Industrials there are actually surprisingly encouraging results from the companies that we own and follow. It’s not just that they're working off backlogs. They’re still continuing to see good order rates, and Europe has proved more resilient than expected thanks in part to a mild winter. Across the board with those companies, there is a feeling that the secular trends like reshoring and the legislation and spending associated with the infrastructure bill—the Inflation Reduction Act and the Chips Act—are all taking root. These are things that companies are calling out as more permanent changes that are providing multi- year tailwinds for their businesses and could cushion any downturn.
FG: Premier quality has such a defined process. How’s it working in this uncertain environment?
LR: This is actually a great environment for this Strategy because one of the ways we’re able to buy quality at reasonable prices is to take advantage of bear markets or market sell offs where we have the chance to buy high-quality companies at reasonable valuations because the market, given its short-term focus, is worried about near-term earnings trends, and as a result is sort of undervaluing the long-term cash flow growth and earnings power potential of these companies—which are often being driven by very favorable secular trends that the company’s products or services are key to enabling.
FG: Are there any specific examples, Lauren?
LR: Sure. Within our quality Strategies, we have exposure to several secular trends, one being the digital age as we would call it, where semiconductor proliferation is occurring. And it’s moved beyond just your cell phone. Semiconductors are in your refrigerator and washing machine, and your car is essentially a rolling computer. As more and more semiconductors are being used, that’s increased the demand for semiconductor capital equipment, and at the same time at the leading edge as new technologies are evolving, you need smaller, faster, cheaper, and more energy efficient chips. To be able to achieve that, the chipmakers are coming up with new architectures for the chips and how the chips are packaged, which is also creating more demand for new—and actually more—equipment. We own companies like FormFactor (FORM, Financial), which provides test probe cards, that are used to test chips.
FG: What are some of those secular opportunities you’re finding today?
LR: We have several companies that have good exposure to the infrastructure buildout that’s occurring, thanks in part to the infrastructure bill. Companies like Arcosa (ACA, Financial) that is a major provider of aggregates in the southwestern United States, or Reliance Steel (RS, Financial), the world’s largest steel service provider. A third secular trend would be automation. Companies that are providing solutions to address labor shortages while driving greater efficiency and productivity. For example, John Bean Technologies (JBT, Financial), which is the largest food processing equipment provider, is seeing increased demand as food manufacturers try to deal with labor shortages and improve productivity by replacing labor with automation.
FG: Is there one high confidence holding that you’d like to discuss?
LR: A name that we’ve added in the past several quarters is FirstService Corporation. It’s a stock that at the beginning of the bear market was around $200.00 and fell all the way down to the low $120s. It has two businesses: one is FirstService Residential (FSV, Financial), where they’re the number one player in providing outsourced residential property management to condo buildings and homeowners’ associations. They’re the largest player in North America, yet they only have a 6% market share—so a lot of room to continue to grow in that business. What we like about the property management businesses is that it’s a high recurring revenue business because these are typically one- to three-year contracts, and FirstService has a 95% retention rate. So, there’s nice recurring revenue that accounts for about 50% of the company’s business. The other half of FirstService’s revenue comes from FirstService Brands, which is a collection of businesses that provide essential property services. About 50% is from restoration businesses where these are companies that are providing either for residential customers or commercial customers restoration in the event of fire, water, mold, or any other kind of storm damage. Lastly, the company generates significant free cash flow given its asset light business model and high recurring revenues. And what we particularly like about FirstService is that it has significant reinvestment opportunities to redeploy that cash at rates of return that are similar to or greater than what the company is currently earning, and that for us is the key component of a compounder and a key aspect of the quality companies that we seek to own.
FG: I think we’ll leave it there, Lauren. Thank you for your time today. It seems like a perfect environment to uncover small-cap companies in this uncertain time. Thank you.
