This transcript has been edited slightly for clarity. Listen to original here.
Francis Gannon: Hello and thank you for joining us. This is Francis Gannon, Co-Chief Investment Officer of Royce Investment Partners. Today I'm joined by two members of the Royce Small-Cap Opportunistic Value Strategy, Portfolio Manager Jim Stoeffel and Assistant Portfolio Manager Kavitha Venkatraman, who manage this Strategy along with Brendan Hartman and Jim Harvey.
We're excited to hear about their views of the market and where they are seeing opportunities in this very dynamic economic period. But before we do, let's take a look back before we look forward and focus a little bit on performance for the trailing one-year period at the end of 2022. This Strategy underperformed its benchmark, the Russell 2000 Value, which is not surprising and in line with probably historical context in the down market, but is outperforming on both this, excuse me, but is outperforming on both the three and a five-year basis. It is also outperforming nicely on a year-to-date period and from the low of the Russell 2000 and June of last year. So maybe Jim, starting with you, do you want to help me put some of this in context from a performance standpoint?
James Stoeffel: Yeah, I'd be happy to. Well, as you indicated, first and foremost, this is an investment Strategy that is designed to generate alpha over time by capturing disproportionate upside when the market is working. And definitionally when you have that structure, you do tend to take a little bit of incremental downside. And to your point, the benchmark was down 14% and change last year we were down 17%, which is never where we necessarily want to be, but the Fund is sort of designed to do that, candidly. If you go back over time, that's actually a reasonably acceptable performance when you have a drawdown.
The thing that I really want to focus on is, we're very cognizant of what the Strategy is designed to do. Our real focus is to make sure that we stay fundamentally true to the Strategy and use that period of volatility to position ourselves for whenever the inevitable upturn occurs, which is what we did in this downturn, either looking for stocks where we had very high conviction that were down and to make hard-nosed decisions on stocks that were down where perhaps we had our investment case wrong and sell them. Any type of downturn in the market provides unique investment opportunities. And so, we really stayed fundamentally true to what the Strategy is designed to do, which is challenging and difficult in this environment.
You have a lot of indications that inflation is starting to roll over pretty aggressively. You have a Fed that's been uniquely aggressive in raising rates, and it usually takes 12 to 18 months for that to find its way into the economy, and we're not quite 12-18 months into that. So , there are a lot of conflicting data points. Our view is we look at companies on a company specific basis. We'll use volatility to our benefit. If we get into another downturn, we'll use that to position ourselves, and we'll just position ourselves for when the world eventually normalizes.
I think having a normal term structure of interest rates is a good thing for us. I think it's a good thing for active management and I think it's a good thing for value investing based on the fact that we recognize that things go in cycles and then things are down, we'll buy the things we like, and then things are up we'll try and take money off the table on the things that have gotten overvalued relative to our price to sales discipline.
FG: Kavitha, when we think about this Strategy and the consistent application of the process through time, as Jim alluded to, we typically see this Strategy do worse in down markets and better in the up markets. How have you thought about performance over that time period and what have you been doing from a Fund perspective for investors to be able to capture that?
Kavitha Venkatraman We always say volatility is our friend. And I would say when the volatility really started some of the bets we took, things that got really beaten down, like Consumer Discretionary, for instance, or the auto dealers, things which are considered both economically sensitive and sort of exposed to interest rates, if not directly, tangentially. So , we did increase position size in sectors like that at the very bottom. And I thought an interesting space to talk about is the auto dealers, which have actually performed really well for us off the bottom. The thesis going into the auto dealers, which we had held even before the volatility started, was it was an industry that was ripe for consolidation, and the large guys--I say large, they still have like 2-3% market share--were participating in this consolidation. They were the consolidators, and we liked that they had massively increased the size of their businesses and had a lot of operating leverage to enjoy when auto volumes came back. The Fed started hiking interest rates, there was a disproportionate impact on these stocks, and we actually increased our position sizes in a lot of stocks like Asbury Automotive Group (ABG, Financial) is a good example. Auto volume is still depressed, but they are massively over-earning because of where prices are, and what they're doing with their excess earnings or returns that they're making at this time is very interesting. They're paying down debt, they’re returning share capital to shareholders and that's really fueled a rally in these stocks. That's sort of one of the ways in which we've taken advantage of volatility at the bottom and it's already yielding results for us.
FG: What are your current thoughts on those stocks given the fact that economic expectations for the recession are being pushed out a little bit and you're hearing the beginning of the consumer cracking just a little bit, especially around auto volumes?
KV: So, when you zoom out and look at where we bought these stocks valuation wise, they were trading at about 5 times, sometimes even lower than that EBITDA (earnings before interest, taxes, depreciation and amortization) tops. What was priced into that was all of this uncertainty around when will auto volumes recover, what would margins look like in a normal world? Today, after being up quite significantly, 20-30%, they're still trading at what we think is 7 times normalized earnings, and what people I think are missing there is look at what happened to SAAR (Seasonally Adjusted Annual Rate), where peak SAAR was almost 18 million cars where people expecting somewhere in the fourteens this year, maybe lower, but at the same time the car parc is actually aging, and consumers need these cars to get to work and run their lives.
We actually think will be this pocket of resilience where there is catch up in demand that needs to happen and that will come as auto production improves. We also think in terms of margins. They've actually improved their businesses in terms of scale. We're in this unique situation where as an OEM (original equipment manufacturer), if there ever was a time for you to not discount and make better margins, now is the time because you could take that cash and put it into your EV (electric vehicle) efforts. We're increasingly hearing that OEMs are subscribing to that thought process.
But it feels like they are, at least in the medium term, committed to keeping inventory levels at the dealerships lower than history, even as volumes come back, so we think it's a great situation where there is pent up demand, there's a little bit of discipline in the industry. So we're actually quite positive on these stocks because that normalization of profit and how profitable these companies can be in a normal world is actually not played out yet.
I've never had the opportunity to be as excited about good capital allocators. The reason why I say this is in a normal interest rate world where it becomes economically not viable to pursue growth at any cost, the benefits accrue to the good capital allocators who can borrow conservatively, run a conservative balance sheet, and invest the right amount in the right things. We have a lot of that in our portfolio. This period of volatility, we've actually used to our advantage to buy some of these companies where we think there was a capital allocation angle to the next three to five years where we think they have this opportunity to put their balance sheet to work and make their businesses stronger and potentially even become acquisition candidates themselves as we come out of this. It's not that visible to the outside, but there are several examples of companies where that thesis has not changed, but they were down with everything else. So we increased our position sizes in in those companies.
FG: I think that's a really important to understanding why you actually continue to own the these particular companies. Jim, switching to you: this recession that we've been talking about now for almost two years has been, as I like to say the most telegraphed recession we've had probably in our investment careers. But it seems to me that coming into 2023 people thought the recession was imminent. Now it seems to be being pushed back towards the end of 2023 into 2024. The economy has been a little bit more resilient than people might have thought, given what the Fed has done over the past year. How are you positioning the portfolio today for an economic recovery should we ever have a recession?
JS: That's a great question and a great observation. This has been the most predicted recession in my career, and I've been doing this a long time. Interestingly, I think you've had sort of a rolling recession in a way. If you look at the tech stocks, they had a huge boom around the work from home phenomena everybody had to get a new PC, and everyone started doing Zoom, which meant you had to build out data centers and you had to build out fiber optics and all that stuff and particularly on the memory side, you had a big boom. And you've taken a lot of hits on that on that, particularly on the semiconductor aside as all of a sudden you realize you had plenty of capacity and everyone had a new PC and everyone had a new iPad and so you know, there's been a pretty significant correction in earnings expectations.
We have four thematic approaches that are the key to what we do. We have asset plays, we have turnarounds, we have undervalued growth, and we have interrupted growth. We've obviously as you'd expect, finding a lot of opportunities in interrupted growth because of what's going on with the economy. The auto makers fit within that category. The other area we've been finding a lot of interesting opportunities and is in on ad tech, which is an advertising phenomena. Ad tech is interesting, particularly digital ad tech, because it’s the first place you cut spending. You're probably still going to advertise on the Super Bowl or whatever your brand building advertising is, but it's very easy to cut off digital advertising. You have a lot of these high-quality companies in a space where digital advertising is going to continue to take share from linear TV. And you found a lot of these really interesting companies where you have a dynamic of a consolidating industry where we found a significant number of ideas.
We own this neat little company called QuinStreet (QNST, Financial). QuinStreet does a lot of different things, but 50% of their businesses is doing targeted advertising for insurance companies on the Internet, and they're very good at it. They have scale. When you saw the inflation impact on the insurance companies, basically the cost of repairing your car went up significantly, the cost of replacing a car went up significantly. So, when you had auto accidents, their loss ratios ended up being significantly higher. They immediately cut off advertising, then you go back to the insurance agency or the rating agencies and say, look, we need to increase our rates to make this stuff profitable and you get this one year where it’s very difficult to generate any revenue from advertising on digital media. But the flip side is the next year, every consumer is going to get an insurance policy, and their rates are going to go up by 20%, even if you’re a good driver. And they go out and they shop their insurance policy, and that’s great for QuinStreet. We're now finally getting into that part of the cycle.
Then Jim Harvey, our partner, says, well that's sort of interesting. I know this company called EverQuote (EVER, Financial) that does that. So we bought EverQuote as well, which is been a good stock. So digital advertising is a great example of a space that of interrupted growth.
FG: It seems to me that you all benefit from the institutional knowledge base you have around investing in small-cap value companies for a long period of time. It seems there's a lot of interplay between the four of you on the team.
JS: It's a little bit of the unique Strategy in that sense. You get this concept of pattern recognition, and you know, I've seen this story before and it crosses industries--you know, turnarounds are turnarounds regardless of the industry, and there's sort of a playbook I do think that the experience level of the team is a huge, huge benefit, particularly in small cap where the vast majority of companies we’re looking at are things that someone has looked at in the past.
You know, we go through the portfolio every day at 8:00, and then at 3:00 we have more in-depth conversations every day about the stocks in the portfolio. There's always a peer review aspect to what we're doing.
KV: We tend to know these managers from other businesses, right. We own a company called Helios Technologies (HLIO, Financial). It’s a turnaround which we think will morph into an undervalued play. But we know this manager from his—at least I did—from his prior role at a company called Welbilt where he was actually passed up for CEO. And he took this job. So just having that institutional knowledge where we, like, looked at these people in other contexts.
I think the big driver of that is just the low ego that I think is true for all of Royce. It's certainly true for the Opportunity Fund team. We care about getting things right. What are we trying to solve for here? What are we trying to understand? How can we help each other? This is sort of front and center every day, Any sort of one-upmanship blame game just doesn't exist in this in this particular team. And I think that's really important for a team environment because most teams have a loudest voice, and that loudest voice tends to silence other voices, and that's certainly not the case here.
FG: Jim and Kavitha, thank you for a great discussion about where you're finding opportunities in the market today and how your system, your and how your consistent application of the opportunity process is enabling you to capitalize on opportunities in this volatile moment of the market. Thank you.
Mr. Stoeffel’s, Ms. Venkatraman’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.
