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Royce Funds Commentary: 4 Key Holdings for Our Deep Value Strategy

Our Deep Value strategy, which we use in Royce Opportunity Fund, uses an opportunistic approach to invest in companies with low P/B and P/S ratios. Portfolio Manager Bill Hench and his team, Assistant Portfolio Manager Rob Kosowsky, Assistant Portfolio Manager Suzanne Franks, and Analyst Adam Mielnik, work to identify a catalyst for future earnings growth in the form of new management, more favorable business cycle, product innovation, and/or margin improvement. They then categorize portfolio holdings into one of four themes: Turnarounds, Unrecognized Asset Values, Undervalued Growth, and Interrupted Earnings.


It's been among our more effective strategies, outperforming its benchmark, the Russell 2000 Index, in 78% of all monthly rolling 10-year periods for the 20 years ended 6/30/19.

We recently asked Rob Kosowsky and Suzanne Franks to discuss some key holdings--one that has done well so far this year and another that's earned their confidence but has not yet taken off.

Rob-Kosowsky

Rob Kosowsky: Digi International (NASDAQ:DGII) is a stock in our undervalued growth category that's appreciated about 40% so far this year. Led by a relatively new CEO, the company successfully executed a turnaround and is now poised for accelerating growth in both segments: Products and Services, which makes connectivity devices like cellular routers, and Solutions, which manufactures temperature monitoring for the cooling units found in pharmacies and grocery stores.

The Products and Services segment has a refreshed offering that followed the turnaround, which has sparked demand drivers as more and more devices are connected by the Internet of Things ("IoT"). This same segment just won a large $20 million contract for a new product offering that should support sales growth in fiscal 2020. Digi is also pushing device management software that comes in the form of recurring software-type revenue.

The new CEO has a background in IoT, having founded PeopleNet, which provided tracking services for trucking fleets and was bought by Trimble in 2011. His vision is to create a similar IoT monitoring service for refrigerators in pharmacies, grocery stores, and other locations. This is a large potential market, and Digi has the leading market share in these early days of adoption.

It seems as though the market is starting to see tangible benefits from this repositioning via the previously mentioned large contract as well as from Digi's growing recurring revenue in both its device management and temperature monitoring segments. Investors usually reward recurring revenue handsomely, so as these sales grow, Digi could see its valuation multiple expand. Finally, we believe the new CEO can also effectively put the company's ample cash--nearly $90 million, or about $3.00 per share--to work in the M&A market.

Cohu (NASDAQ:COHU) is a semiconductor capital equipment maker whose stock is down around 10% so far this year. It fits into our interrupted earnings category. Unfortunately, its growth has been hurt by a tough macro environment. Compounding its weak end market and decline in business activity, Cohu also took on a large amount of debt to fund the acquisition of its close competitor, Xcerra, late in 2018.

We continue to hold shares because Cohu has a strong competitive position and the opportunity for significant upcycle EPS growth that the Xcerra deal creates. The Xcerra acquisition doubled the size of the firm and gives Cohu a better position in growth markets such as radio frequency and 5G. Since the two companies were very similar, Cohu can cut costs out of the combined entity.

Additionally, Xcerra excelled in selling consumable contactors to its installed base, an area of relative weakness for Cohu. With Xcerra's contactor technology in tow, Cohu is poised to better cross sell to its large stable of customers, creating a major revenue opportunity. We also believe that once the semiconductor cycle turns around, Cohu can reap the benefits of by generating strong EPS growth while also deleveraging its balance sheet.

Cohu also boasts a strong market position, with a more than 50% share in various niche applications for the equipment that's used to help automate semiconductor testing. Given this formidable market share strength, we believe its revenue weakness is cycle driven. Our thought is that once large and important customers such as Intel begin spending again, Cohu is very well positioned to participate.

Suzanne-Franks

Suzanne Franks: LGI Homes (NASDAQ:LGIH), is a homebuilder that caters exclusively to first-time buyers with limited resources. LGI offers attractive homes at a relatively affordable price primarily in the South and Southwest U.S. The company does this by typically locating communities farther outside urban centers than most suburban locations--locales where land offers compelling value--but that are still within proximity to retail and transportation. Thanks to the strength of this niche, its stock is up around 74% year-to-date.

LGI may also be the best positioned homebuilder for the expected influx of millennial first-time buyers in the next several years as they marry and start families. The company has continued to grow its community count while expanding into California and the Pacific Northwest where buying a home at a relatively modest price point is challenging.

Even during short-term periods of housing market softness, such as we had earlier in 2019, LGI has managed to maintain its gross margin by adhering to its unique operating strategy. The typical gross margin in its industry is 20%, but LGI Homes targets a 25% figure by keeping the number of floor plans and options limited. This simplifies construction and therefore generates a meaningfully faster building cycle time of 45-75 days compared to the 150-180 days that's more common for its industry rivals.

The firm's practice of working with a limited number of suppliers and contractors lowers building costs and also contributes to the faster building time. In addition, LGI exercised disciplined control over its sales incentives earlier in 2019, preferring to maintain its gross margins even at the expense of slightly lower monthly sales per community.

Playa Hotels & Resorts (NASDAQ:PLYA) acquires and selectively develops beachfront hotels in Mexico, Jamaica, and The Dominican Republic for renovation into all-inclusive luxury resorts rebranded under the Hilton and Hyatt names. There's a reasonable expectation that Playa's operating income should almost double by 2021 upon completion and full ramp of current renovation and development projects. We think that supports the company being an undervalued growth opportunity.

A couple of transitory events have pressured the stock over the near term. First, negative headlines on the mysterious deaths of tourists in The Dominican Republic caused a short-term disruption in business even though these tourists were not staying at Playa resorts. Still, Playa revised downward operating income expectations for 2019.

Second, renovation projects continue to ramp, increasing near-term expenses, which has led to depressed profits but also created an upside opportunity for the stock via a meaningful increase in operating income by 2021. As Playa sees gains in operating income, renovation projects should have less and less of an impact on its financial performance as they become a smaller and shorter-term drag relative to the rest of the business.

Despite these recent challenges, then, Playa looks well positioned to succeed. The all-inclusive resort market is growing at three times the traditional hotel market. The company's all-inclusive business model generates higher operating income margins compared to the traditional hotel model thanks to its increased ability to manage yield and staff due to higher and more predictable utilization. Guests also receive compelling value with the budget capacity to purchase high-margin ancillary services such as spa treatments or a round of golf.

Playa differentiates itself from other all-inclusive resorts by being one of the few to offer luxury accommodations at affordable rates. Furthermore, Playa's strategy capitalizes on the Hilton and Hyatt brand names, accessing members of each chain's respective loyalty programs and lowering customer acquisition costs by offering direct reservations.

Securing new management contracts and / or asset-light partnerships, implementing a vacation club, and realizing the full benefit of recently launched technology initiatives are also catalysts for our confidence.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.roycefunds.com. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Mrs. Frank's and Mr. Kosowsky's thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.

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.

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund's portfolio in the future.

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This article first appeared on GuruFocus.