Secular changes in economic trends, interest rates, and monetary and fiscal policies are creating seismic shifts in the investment landscape. The types of companies that benefited most from the past decade’s zero interest rate, low inflation, and low nominal growth regime—specifically, mega-caps and growth stocks—are unlikely to lead going forward. From our perspective, the unfolding macro environment appears to be set for quality small caps to capture and sustain long-term outperformance over large cap through this currently uncertain period of near certain transition.
More specifically, we think that the Small-Cap Premier Quality Strategy we use in Royce Premier Fund offers a particularly compelling opportunity in today’s unsettled climate. In this Strategy, our team—which includes Portfolio Manager Chuck Royce and Assistant Portfolio Manager Andrew Palen—looks for small-cap companies with high returns on invested capital (“ROIC”) and conservative capital structures, among other attributes, that we believe can compound value by reinvesting their current earnings back into the business at durable high rates of return over the long run.
The Fund's portfolio companies typically hold leading positions in markets with attractive growth rates thanks to favorable secular trends for which their products or services are solutions or key enablers—areas such as automation, digitization, infrastructure, and sustainability and renewables. Our investment framework goes beyond screening and involves a comprehensive analysis of a company’s industry, competition, and business model. History is also an important guide to determine how persistent a company’s ROIC has been over time—which is significant because we want companies whose long-term fundamentals indicate consistent levels of ROIC, while allowing for the typical ups and downs of the business cycle. This stability helps to reveal an important and related attribute: the presence of management teams who are effective capital allocators.
We think the effectiveness of the Strategy has been borne out by the Fund’s performance. Premier beat its benchmark, the Russell 2000 Index, during recent short-term periods, while over longer-term periods of three years or more, results were strong on both an absolute and relative basis.
With rising rates, economic uncertainty, and the recent banking sector scare, business fundamentals and valuations appear to be returning to their rightful place as key determinants of investors’ equity investment decisions. This has been—and we believe should continue to be—beneficial to the Fund’s absolute and relative performance given the Strategy’s unwavering focus on identifying companies trading at what we believe are reasonable valuations with durable business models that generate—and appear capable of sustaining—superior ROICs well into the future. Our holdings tend to produce consistent free cash flow and possess the balance sheets strength that provides the financial flexibility to deftly navigate and take advantage of near-term uncertainty. These attributes are especially important because we believe they should help portfolio companies to not just weather a recession but also to go on offense and emerge from any downturn even stronger.
These characteristics also underlie the Fund’s favorable downside capture ratio. While preservation of capital has been a core component of Premier’s long-term total return, the Fund offers more than “winning by losing less,” as is seen by its upside capture ratio.
Royce Premier Fund’s Upside/Downside Capture Ratios for Periods Ended 3/31/23
| UPSIDE CAPTURE RATIO | DOWNSIDE CAPTURE RATIO | |
|---|---|---|
Five Year | 97 | 85 |
From 12/31/91 (Start of Fund's First Full Quarter) | 94 | 75 |
These ratios underscore our belief that investing in high-quality small-cap businesses makes for an effective all-weather approach.
We are confident as we look ahead. While the recent small-cap bear market has been challenging, we are pleased that the Fund’s more than three decades of history has shown that low return periods have been followed by double-digit returns on average over the next three years.
100% of the Time, Positive 3-Year Returns Have Followed Low Return Markets Royce Premier Fund’s Positive 3-Year Returns Have Often Followed Low 3-Year Return Periods
Subsequent Average Annualized 3-Year Performance for Premier Fund Following 3-Year Annualized Return Ranges of Less Than 5% from 12/31/94-3/31/23
The reasons we have given above epitomize why we think the time is right for our Small-Cap Premier Quality Strategy.
Ms. Romeo’s and Mr. McBoyle’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.
