How did the Small-Cap Premier Quality Strategy perform in 4Q22 and the calendar year?
Lauren Romeo: Royce Premier Fund, the mutual fund we manage in the Strategy, advanced 10.0% for the quarter, and outperformed its small-cap benchmark, the Russell 2000 Index, which was up 6.2% for the same period. The Fund also beat the Russell 2000 for 2022, down -15.5% versus -20.4% and outperformed the small-cap index for the 3-, 5-, 15-, 20-, 25-, 30-year, and since inception (12/31/91) periods ended 12/31/22.
What sectors had the biggest effect on 4Q22’s performance?
Steven McBoyle: Eight of the portfolio’s nine sectors made a positive impact on quarterly performance. Industrials, Materials, and Information Technology made the largest positive contributions while the only negative impact came from Communication Services. Health Care and Real Estate made the smallest contributions to quarterly performance.
What made the biggest impacts at the industry level in the Fund?
LR: Media in the Communication Services sector, auto components from Consumer Discretionary, and semiconductors & semiconductor equipment from Information Technology detracted most for the quarter, while the biggest contributors were machinery in the Industrials sector, chemicals from Materials, and capital markets in Financials.
Quarterly performance was better relative to the Russell 2000. What were some of the details on Premier’s relative outperformance in 4Q22?
SM: Our advantage over the benchmark was primarily attributable to stock selection. Although our sector allocation decisions were also additive. At the sector level, both our lower weighting and—to a lesser degree—stock picking helped in Health Care. Our higher weightings and stock selection in both Industrials and Materials also had sizable positive impacts versus the benchmark. Conversely, our lack of exposure to Energy—which continued to perform well within the Russell 2000—hampered relative performance in 4Q22, as did the Fund’s cash holdings and stock picks in Real Estate.
Moving to the calendar year, which sectors made the greatest impacts of performance in 2022?
LR: Eight of the portfolio’s nine equity sectors had a negative impact on 2022’s performance. The sectors making the largest detractions were Information Technology, Consumer Discretionary and Industrials. The only positive impact came from Materials while Consumer Staples and Communication Services detracted least.
What about at the industry level?
SM: At the industry level, semiconductors & semiconductor equipment, electronic equipment, instruments & components—both in Information Technology—and capital markets in Financials were the largest detractors while construction & engineering in Industrials, metals & mining in Materials, and software in Information Technology contributed most for the calendar year period.
Which holding detracted most from performance in 2022?
LR: That would be Mesa Laboratories (MLAB, Financial), a company that develops and manufactures electronic measurement instruments for industrial and hemodialysis customers, including pipeline flow meters and calibration instruments. Mesa saw its results temporarily depressed by higher labor costs in its Sterilization and Disinfection segment and lost sales in its Clinical Genomics business in China due to Covid lockdowns. While management quickly took actions to address its issues, the stock’s lofty valuation and our concerns that Mesa’s strategy of continuing to shift its portfolio exposure toward faster-growing health care markets such as clinical genomics, as well as protein-based and cell and gene therapies, will require additional expensive and dilutive acquisitions. We therefore opted to exit our position in order to realize a tax loss and reevaluate the name, particularly relative to other candidates and existing holdings where our conviction was higher.
What was the portfolio’s top-contributing position for 2022?
SM: The portfolio’s top contributor was Valmont Industries (VMI, Financial), which manufactures fabricated metal products and produces metal and concrete pole and tower structures in its Engineered Support Structures & Utilities Support Structures businesses. Valmont also makes mechanized irrigation systems. It had healthy earnings throughout most of 2022, driven by continued investments in grid resiliency and infrastructure upgrades, steady demand for renewable power and clean energy solutions, and the 5G network transition. Its agriculture markets also remained strong thanks to elevated commodity prices resulting from tighter global grain supplies, the need for increased food production, and a heightened focus on food security concerns.
What were the sources of the Fund’s advantage over the Russell 2000 in 2022?
LR: The portfolio’s advantage over its benchmark came exclusively from stock selection in 2022—sector allocation was marginally negative. Among sectors, stock selection, as well as our higher weighting, helped in Industrials and Materials while we also benefited from our lower exposure and some savvy stock picks in Health Care. Conversely, our lack of exposure to both Energy and Utilities, along with a lower weighting in Consumer Staples, detracted most from relative results in 2022.
What’s your long-term outlook for the Strategy?
SM: Small-cap companies with the highest returns on invested capital (“ROIC”) outperformed in 4Q22, reasserting leadership following a pause in the 3Q22. As of the end of 2022, these high-ROIC small caps had outperformed in six of the last seven quarters. As rising rates and increasing recessionary fears drove further multiple compression, we continued to optimize the portfolio by adding to existing holdings while also initiating positions in new names where we had been awaiting attractive entry points. Our strategy of buying high-quality companies for the long term when they are out of favor due to what we see as near-term market fears, cyclical, or other temporary reasons has been a core tenet of our Premier strategy since its inception more than 30 years ago. These market dynamics allow us to buy what we think of as high-quality companies without paying premium valuations.
LR: The majority of the Fund’s holdings created economic value because they produced returns on invested capital (“ROIC”) well in excess of their cost of capital. The fact that most of this value has not yet been capitalized in these companies’ valuations should improve the portfolio’s long-term risk/reward profile. Investor sentiment is often focused on the near term, but over the long run the stock market has proven efficient at reflecting the economic value companies generate and compound in their market valuations. So, regardless of what 2023 may bring, experience has shown that our best course of action is to stick to our approach of trying to identify high-return, durable business models when they are trading at reasonable valuations and hold them for the long run (assuming, of course, that the underlying investment case remains intact or improves). Cyclical headwinds could pressure financial results in 2023, but we believe that the normalized earnings power and growth that our holdings can generate over time remain very attractive. This conviction is rooted in their unique competitive advantages (for example, switching costs, brand equity, and network effects), strong cash flows, and low-debt balance sheets, all of which should help them to not just weather a recession but also to go on offense and emerge from any downturn even stronger, poised to capitalize on secular long-term growth tailwinds such as automation, reshoring, infrastructure spending, sustainability, and electrification and digitization.
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.
